How Safe is Your Pension on Bankruptcy?

Julia Miller discusses the extent to which occupational and personal pension benefits are protected on bankruptcy

In bankruptcy cases there has been a growing awareness that a bankrupt’s most valuable asset is often his pension. Creditors and trustees in bankruptcy are therefore showing an increasing interest in pensions, but to what extent are they entitled to make use of them?

Trustee in bankruptcy’s right to pension benefits

The general rule is that a bankrupt’s estate vests in his trustee in bankruptcy. The extent to which pension benefits are included in that estate depends on the type of scheme involved.

Until recently, the established view was that only a pension actually in payment at the time of the bankruptcy would form part of the bankrupt’s estate. However, in 1996 the case of Re Landau decided differently. The case concerned a bankrupt who had an annuity policy. Its terms prevented him from assigning it to anyone else but did not provide that his benefits would be forfeit in the event of bankruptcy. The benefits under the annuity came into payment after his discharge and his trustee in bankruptcy applied for a ruling on the entitlement to the amounts payable under the annuity.

The court held that the trustee in bankruptcy did have a right to future pension income, even after the discharge, so long as the entitlement to the future benefit had existed during the bankruptcy. The entitlement formed part of the bankrupt’s estate.

The arrangement under consideration in Landau was an individual annuity contract and very different from an occupational pension scheme. However, the wording used in the Insolvency Act to describe what forms part of a bankrupt’s estate is very wide. It covers “every description of interest” including, apparently, interests under pension schemes. Therefore, it seems that the decision in Landau applies equally to an entitlement to benefits under an occupational pension scheme, which therefore form part of a bankrupt’s estate.

Provisions in scheme documentation

Landau did not consider whether it is possible to include wording in a pension scheme to protect a member in the case of bankruptcy. Such wording usually takes the form of a provision which purports to forfeit the member’s pension in the event of his bankruptcy and to apply it for his benefit, or for the benefit of someone connected with him. This type of provision, known as a “protective trust”, was considered in the Australian case of Ramsey v Caboche and more recently in the UK in Re The Trusts of the Scientific Investment Pension Plan (1998).

The rule at issue in Ramsey v Caboche provided that “if a person entitled to a benefit under [the scheme] becomes bankrupt..., then that benefit shall immediately be forfeited to the fund”. The court held that the rule was attempting to forfeit an entitlement which already existed and was therefore invalid on the basis of the general principle that a provision in a trust purporting to forfeit an absolute interest (ie. one to which the member is already entitled as of right) is void as contrary to the nature of such an interest.

This does not mean that all protective trust wording is ineffective. The Australian Court criticised the drafting of the rule in Ramsey v Caboche and said that if it had provided that the members did not have an absolute interest, but merely an interest that continued only so long as they did not become bankrupt, then it might have worked. This was the approach taken in the English Scientific Investment Plan case.

The rule in this case provided that if a member did anything which resulted in benefits which “if belonging absolutely to the Member... would be vested in or payable to or charged in favour of” someone else, then that “Member... shall forfeit all rights whatsoever to such benefit”. The court held that the effect of the rule was that the benefits conferred were not absolute but continued only until the happening of certain events (such as bankruptcy).

This distinction may seem very fine but the point the courts were making is that you cannot have a provision which removes an entitlement that a member already has, but you can ensure that no entitlement arises until the benefit comes into payment without the member having become bankrupt in the meantime.

Public policy?
There is a well-established legal principle that an individual cannot transfer his property to a trust in order to put it beyond the reach of his creditors, on the basis that a device to get around the bankruptcy rules would be contrary to public policy. This principle was recently explored in a pensions context in a New Zealand case, NZI Life Superannuation Nominees Ltd, where the court held that the principle applied in a pensions context.

What does this mean in relation to protective trust provisions? To the extent that benefits are derived from employer’s contributions there will be no problem, as the rule applies only to monies paid into the trust by the member. The problems arise in relation to member contributions both to personal and occupational schemes. On the face of it, these contributions would seem to be caught by the rule, and therefore any forfeiture provision that puts benefits derived from them beyond the reach of creditors will be void for public policy.

Fortunately, in the case of contributions to occupational pension schemes, forfeiture provisions are specifically protected by section 92 Pensions Act 1995 (see legislation section below) and therefore cannot be against public policy. However, there is no such saving for personal pension schemes. It may be arguable that forfeiture provisions in personal pension schemes should be valid, as the English cases in which the public policy arguments were advanced mostly concerned trusts where the primary intention was to put money beyond the reach of creditors. In a pension scheme such provisions are merely incidental and protective. However, this was certainly not the view that the courts in New Zealand chose to take.

Legislation
The Pensions Act had an impact on most areas of pension law, and pension rights on bankruptcy were no exception.
So far as the efficacy of protective trusts is concerned, section 92 specifically prevents forfeiture of pension rights under occupational pension schemes. However, this section contains an exception for provisions relating to bankruptcy, so forfeiture provisions in occupational pension schemes would currently seem to be valid (subject to the general rules discussed above).

Unfortunately many of the provisions of the Pensions Act dealing with the protection of pension benefits on bankruptcy have not yet come into force. Further, the Act only offered protection to occupational pension benefits and not to benefits deriving from personal pension schemes. Some change was therefore needed.

If the Welfare Reform and Pensions Bill becomes law in its current form, forfeiture of pension benefits will not be permitted on bankruptcy. Instead the Bill provides for statutory protection on bankruptcy for all approved pension benefits (including those payable under personal pension arrangements).

The Bill provides that rights under approved pension arrangements will be excluded from a bankrupt’s estate. However, this protection will not generally apply to unapproved schemes (except in “prescribed circumstances”) or to schemes which fail to get approval, so there may still be room for the use of carefully drafted forfeiture provisions.