Abolition of Contracting-out – Issues for Pension Schemes and Employers

The article discusses issues for contracted-out occupational pension schemes (and their employers) which will arise on the introduction of the single-tier state pension and abolition of contracting-out, both on 6 April 2016.

18th October 2013

Background

On 6 April 2016 the current basic state pension and state second pension (S2P) will be abolished and replaced by a single-tier state pension. The abolition of S2P will also mean the end of contracting-out. The measures to implement the single-tier state pension and abolition of contracting-out are contained in the Pensions Bill 2013.

Currently contracted-out schemes must provide a certain level of DB benefits, sufficient to satisfy the statutory reference scheme test, and in return both employer and employees pay lower National Insurance Contributions (NICs). The abolition of contracting-out will therefore have cost implications for both employers and employees because of the loss of the NIC rebates. As a result, employers’ NICs will increase by 3.4% (of relevant earnings) and employees’ NICs will increase by 1.4% (of relevant earnings). The relevant earnings for this purpose being employees’ earnings between the Primary Threshold (£149 a week) and the Upper Accrual Point (£770 a week).

Statutory amendment power

Recognising the increased costs this would otherwise entail for employers, the Government intends to allow employers to amend contracted-out schemes to increase employees’ contributions and/or reduce future accrual rates in order to offset the increase in their NICs. A statutory power, to allow employers to amend schemes to achieve this, has therefore been included in the Pensions Bill 2013. This power will not apply to public service pension schemes, however.

The statutory modification power in the Pensions Bill would allow employers to amend a scheme to increase member contributions and/or reduce future benefit accrual in order to offset the additional cost in the NICs payable by the employer from 6 April 2016. Employers would not have to obtain the consent of scheme trustees before using the statutory power but an exercise of the power would be subject to some restrictions:

  • The power would only apply to future benefits and could not be used in any way that would or might adversely affect members’ accrued benefits.
  • Actuarial certification that a modification complies with the statutory requirements would be needed.
  • The statutory modification power would only be available for five years from 6 April 2016.
  • The power could be used to increase members’ contributions and/or amend members’ future accrual rates, subject to the following conditions:

             - members’ annual contributions could not be increased beyond the annual increase in the employer’s NICs

             in respect of them;

             - members’ annual future benefits could not be reduced by more than the annual increase in the employer’s NICs

             in respect of them; and

             - the sum of any annual increase in contributions and reduction in members’ benefits could not be more than the

             annual increase in the employer’s NICs in respect of them.

  • Although the power could be exercised more than once in relation to the same members, all of the amendments would be treated as being made together for the purposes of the above restrictions.

Future regulations would provide more details and might impose further restrictions on the use of the power.

Pensions Consultation

At present, an employer must consult with its affected employees where it terminates its pension scheme’s contracting-out status.  The Government has confirmed that employers will not have to consult with affected employees about the termination of a scheme’s contracting-out status due to the abolition of DB contracting-out, as this will be a direct result of Government policy. We understand that the Government intends to amend the Pensions Consultation Regulations[1] to remove this requirement.

However, if the employer proposes to amend a scheme to increase members’ contributions and/or modify the future accrual rate, then this would be a listed change requiring the employer to carry out a 60 day consultation, in accordance with the Consultation Regulations. This requirement would apply whether or not the proposed listed changes would be made using the statutory amendment power.

Interaction with Scheme Rules

Many pension schemes have benefit structures which are designed to be integrated with the existing basic state pension. Examples of this include bridging pensions (payable between retirement and state pension age) and deductions from pensionable salary of a multiple of the basic state pension. The introduction of the new single-tier state pension could therefore have implications for scheme rules, where rules use terminology which relates to the basic state pension and/or the benefits are framed with the current basic state pension in mind.

Quality test for auto-enrolment

Contracted-out DB schemes automatically satisfy the quality test for schemes to be qualifying schemes for auto-enrolment purposes. When DB contracting-out is abolished this automatic qualification would no longer be available and DB schemes would need to meet the “test scheme standard” in order to be a qualifying scheme for auto-enrolment. This will potentially result in more complexity for employers.

Protected Persons

Legislation limits the ability of employers to amend future pension benefits for “protected persons” formerly employed in nationalised industries. Without overriding legislation, employers would be unable to amend protected persons’ benefits to offset their increased NIC costs when contracting-out is abolished. The Government has recognised the issue and consulted on whether it would be fair and appropriate to permit a relaxation of the protected persons legislation, to allow employers to amend protected persons’ benefits to recover their increased NIC costs in the same way as for other employees. The consultation is now closed and the feedback is being analysed.

Anti-franking

Finally, on a cessation of contacted-out service accrued guaranteed minimum pensions (GMPs) become subject to the “anti-franking” legislation, which prevents GMP revaluation from being offset (or franked) against a member’s benefits above the GMP. This would normally arise on a member leaving pensionable service and becoming a deferred member of a scheme. Where a member continues as an active member of the scheme, however, the application of the anti-franking legislation is more complicated. Without legislation to address this issue, the end of contracting-out would result in greater complexity for schemes through the need to apply the anti-franking requirements to members remaining in pensionable service.

 

 

[1] The Occupational and Personal Pension Schemes (Consultation by Employers and Miscellaneous Amendment) Regulations 2006