Abolition of contracting-out – action needed by employers

United Kingdom

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary and implications

Contracting-out of the state second pension is to be abolished from 6 April 2016, coinciding with the introduction of the new single-tier state pension. This will increase national insurance contribution (NIC) liability for employers currently offering a contracted-out scheme.

This briefing considers steps employers with open contracted-out schemes should be taking (urgently), as well as implications for schemes holding deferred contracted-out benefits. It also looks at possible implications for schemes operating state pension offsets or offering bridging pensions (whether or not they have ever been contracted-out).

Open contracted-out schemes – three key steps

1. Consider amendment

Legislation is now in place enabling employers to amend schemes to take account of the increase in NICs which will take effect when contracting-out is abolished. The power to amend can be exercised by the employer before 6 April 2016 but cannot be effective until that date, and can be used more than once.

The statutory power may be used to:

  • increase employee contributions; and/or
  • alter future benefit accrual.

It may not be used to:

  • increase the total amount of employee contributions by more than the increase in employer’s NICs;
  • reduce the amount of the scheme’s liabilities in respect of benefit accrual by more than the increase in the employer’s NICs; or
  • give the result that the sum of employee contribution increases and benefit accrual reductions is more than the increase in the employer’s NICs.

In other words, amendments made under the regulations cannot be used to create a windfall for the employer. They can only be used to set off the additional NIC liability the employer will have as a result of the abolition of contracting out (3.4 per cent of relevant earnings).

Where a scheme provides for matching contributions, the power can be used to increase only the employee contribution (so the employer contribution remains at the current level). Where the effect of a reduction in future accrual would be also to reduce employee contributions (i.e. where accrual is linked to the level of employee contribution), the power can be used to ensure that employee contributions are not reduced.

Any amendments made under the statutory power must be certified by an actuary, appointed by the employer, as being compliant with the requirements set out above.

Employers could take this opportunity to rethink benefit design generally and to make amendments beyond the limited statutory power. These will be subject to the scheme's own amendment power and will require input from (and in many cases the consent of) the trustees.

The issues may be more complex for employers operating "broadly comparable" schemes for former public sector employees as described in this briefing, which we issued in June.

2. Reconcile data

Employers should make sure that the scheme trustees are taking steps to reconcile data with HMRC. Trustees have until April 2018 to reconcile scheme data with that held by HMRC relating to contracted-out benefits. HMRC have set up a dedicated Scheme Reconciliation Service (SRS). Trustees must register with SRS by 6 April 2016, but the earlier they do so the better. Failure to take the opportunity to use SRS to reconcile data could lead to benefit disputes in the future – the costs of which would most likely fall on the employer.

3. Consult employees

If a decision is made to reduce future accrual and/or to increase member contributions then the employer will be required to consult affected employees on the proposals (this does not apply to employers with generally fewer than 50 employees). The consultation is subject to a prescribed process and at least 60 days' notice must be given to affected employees. This means that if employers want to have the new provisions in place on 6 April 2016, they should have finalised their plans and commenced consultation by the end of January 2016 at the very latest.

There are a number of other connected issues that employers should also be considering.

Open contracted-out schemes – automatic enrolment

Currently, a valid contracting-out certificate means a scheme is a "qualifying scheme" for the purposes of automatic enrolment. This straightforward qualification will fall away on 6 April 2016 and any employer wishing to continue to fulfil its automatic enrolment obligations using a defined-benefit scheme will need to ensure that the detailed quality requirements are met and, where appropriate, to certify that this is the case.

Open and closed schemes holding contracted-out benefits

Existing contracted-out benefits are to be protected (so GMPs will remain in their current form post-6 April 2016). Regulations are in place confirming these requirements but there are some areas where the detail has yet to be finalised. These include GMP equalisation, commutation, transfer and conversion. Legislation currently allows trustees to convert GMPs into main scheme benefits but the rules are very complex and have not been used much (if at all). The DWP has committed to issuing amended legislation and guidance to make the process easier but consultation on this is still awaited.

GMP equalisation is also still unresolved. Draft guidance issued in January 2012 was rejected by the pensions industry as too complex – further word from the DWP is expected. The Pensions Ombudsman has recently confirmed that trustees are not acting incorrectly in not equalising GMPs in view of the legal and practical uncertainties.

The reconciliation of GMP data is just as important as for open schemes (see above). Schemes are almost certain to have to equalise GMPs in the not too distant future and accurate data will be crucial to this exercise.

GMP increases

The treatment of increases in GMPs in payment are changing from 6 April 2016. Currently increases of three per cent LPI must be paid by schemes on GMPs accrued between 6 April 1988 and 5 April 1997. There is no statutory obligation for schemes to pay increases on GMPs accrued between April 1978 and April 1988. In practice, increases on that tranche are currently picked up by the state. The total GMP payable is deducted annually from the additional state pension but as the additional state pension is uprated by CPI, the overall effect is that the whole GMP is subject to annual CPI increase.

From 6 April 2016, when assessing the level of new state pension, a contracted-out deduction will be made only once when calculating the initial entitlement. The effect of this will be that there will be no annual increases paid on 1978–1988 GMPs. Increases at three per cent LPI will continue to be payable by schemes on post-5 April 1988 GMPs.

This change should be made clear to relevant members.

State pension offsets and bridging pensions

The new single-tier state pension will, for many people, be significantly higher than the current basic state pension. Schemes (whether open or closed) which have some form of offset based on the basic state pension should urgently consider the effect of the change on their benefit provision. If scheme rules are drafted by reference to the current basic state pension then it may not be necessary to make any changes but this will depend on the exact wording of the scheme rules. Failure to address this could result in the scheme inadvertently having to pay substantially increased benefits. Changes to state pension offsets are not covered by the statutory modification power mentioned above (which is only for dealing with additional NIC costs) and so any amendments to state pension offsets would have to be made under the scheme's own amendment power and would be subject to any restrictions under the rules and to statutory provisions protecting accrued benefits.

Issues could also arise with bridging pensions (typically where a higher scheme pension is paid up to state pension age and then reduced by the value of the basic state pension). Schemes may want to consider whether the wording of their bridging pension rules remains appropriate in the context of the new state pension and (most importantly) in view of the gradual increase in state pension age. There are regulations enabling trustees to modify schemes by resolution, with employer consent, to bring bridging pensions in line with changing state pension ages (or to fix them at a specified age). Any more wide-ranging change would have to be made under the scheme's amendment power.

Communicating with members

Employees currently contributing to a contracted-out scheme will see an immediate change on 6 April 2016 because their own NICs will increase. Employers should ensure that they communicate this to relevant employees in good time. The DWP has published a series of leaflets and it may be helpful to draw these to the attention of employees.

In addition to the statutory consultation requirement (where changes are to be made to future accrual or contributions) trustees will be required to notify members of any benefit modifications.