Send to a friend
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 Act 2014.
Currently contracted-out schemes must provide a certain level of Defined Benefit (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' Class 1 NICs will increase by 3.4% (of relevant earnings) and employees' Class 1 NICs will increase by 1.4% (of relevant earnings). The relevant earnings for this purpose being employees' earnings between the Primary Threshold (£153 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 Act 2014. However, this power will not apply to public service pension schemes such as Local Government Pension Scheme (LGPS).
At present, an employer must consult with its affected employees where it terminates its pension scheme's contracting-out status. The Government has confirmed 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. I understand that the Government intends to amend the Pensions Consultation Regulations 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 standards" in order to be a qualifying scheme for auto-enrolment. This will potentially result in more complexity for employers although the qualifying test is being simplified in the Pensions Act 2014 as follows:
The "alternative quality requirements for UK defined benefit schemes" enable regulations to be laid so it can provide a DB scheme having its main administration in the UK satisfies the quality requirement in relation to a jobholder if any one or more of the following is satisfied:
- The scheme is of a prescribed description and satisfies the defined contribution (DC) quality requirement in relation to that jobholder
- The cost of providing the benefits accruing for
or in respect of relevant members over a relevant period would require contributions to be made of a total amount equal to at least a prescribed percentage of the members' total relevant earnings over that period
- In the case of each of at least 90% of the relevant members, the cost of providing the benefits accruing for or in respect of the member over a relevant period would require contributions to be made of a total amount equal to at least a prescribed percentage of the member's total relevant earnings over that period.
The first route will make it possible for schemes that are regarded by the auto-enrolment legislation as DB, but have a DC-type structure, to be assessed against the DC quality requirements. For such schemes it may currently be difficult to show how the "test scheme standard" applicable to DB schemes is met. The new route should benefit a scheme that provides guaranteed conversion terms for contributions, such as through running an internal "with profit" deferred annuity structure, or a scheme that provides a guarantee on investment performance during the accumulation phase. Such DB schemes will also be able to take advantage of the phasing of contributions allowed to DC schemes. However, any scheme that qualifies under the first route will not be able to utilise the deferral of entry option (until 1 October 2017) that is generally available to DB schemes.
For the second and third route the prescribed percentage must be at least 8%. Regulations will set out further detail such as the method and assumptions to use, the benefits that should be ignored and certification by the scheme actuary. These are intended to be simpler tests than the test scheme standard and may be of particular use to currently contracted-out schemes that come 6 April 2016 would otherwise be subject to unnecessary complex and burdensome assessments against this standard, having prior to this point been more than adequate by virtue of being allowed to contract out. In the fullness of time they could also benefit DB schemes that are modified to enable some risk sharing to take place between the employer and scheme members, once enabling Department for Work and Pensions (DWP) legislation is in place for such changes.
Under the second route the benefit accrual for the scheme as a whole is tested to see whether it is worth at least a prescribed percentage of the members' total relevant earnings. Under the third a similar test is carried out for each individual member and at least 90% must pass.
This is good news. Not only does this hold out the promise of easing the compliance burden for good quality DB schemes that cease contracting out in April 2016, but it also lifts unnecessary regulatory requirements on certain risk-sharing schemes that currently class as DB but whose benefit structure does not fit naturally with the test scheme.
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 said that on balance, taking into account the small number of workers, it thinks this issue can and should be resolved through negotiation between employers and their employees. Therefore the government proposes that employers should not be allowed to use the statutory override to alter pension schemes in relation to members with protected status.
Employers in the Public Sector will have to factor into future financial budgets the ending of National Insurance contracted-out rates and the consequential increase in both employer and employee Class 1 NICs from 6 April 2016.