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, to coincide 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 the role of trustees of open contracted-out schemes, as well as what they need to be doing where their schemes hold 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 – two key steps
1. Reconcile data
Trustees should take urgent steps to reconcile data with HMRC. They 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.
2. Engage with employer on any scheme amendments
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.
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).
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. Trustees have almost no formal role in this process (other than being consulted on the effective date of any changes).
Employers may 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 may well require input from (and in many cases the consent of) the trustees.
It is certainly worth trustees approaching the employer to find out what their plans are and try to be as involved as possible in any discussions about future benefits and contributions. 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). This requires at least 60 days' notice to affected employees which in turn means that employers should have finalised their plans and commenced consultation by the end of January 2016 at the very latest. We would expect trustees to be asked by the employer to review any consultation materials.
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.
We would advise a general review of the rules of any scheme holding contracted-out benefits to make sure the abolition will not have unintended consequences. In particular there is a statutory requirement that where a scheme ceases to be contracted-out it must contain a "protection rule" to ensure that the benefits are not worse than they would be if the member ceased to be in service at the date of cessation of contracting-out. The legislation is to be amended to make sure this rule is not automatically engaged on 6 April 2016. However, for schemes which have ceased to contract out before 6 April 2016 protection rules will still have relevance. There are some schemes which will have a protection rule hard coded into the documentation and consideration may need to be given as to whether this can be amended.
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 1978–88 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 paying more than was originally intended. 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
In addition to the statutory requirement for employers to consult affected members (where changes are to be made to future accrual or contributions) trustees will be required to notify members of any benefit modifications and to update all communication materials.
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 be ensuring 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 employers and active members.