Pensions Update: Abolition of DB contracting-out – your questions answered

Written on 15 Apr 2015

From April 2016 state pension reforms will come into force, with the removal of the state second pension (S2P) and introduction of the single-tier state pension. A consequence of this is that contracting-out from S2P on a defined benefit (DB) basis will be abolished from 5 April 2016. This has a number of implications for affected schemes, which trustees and employers need to be addressing now. In this update we look at what schemes are affected, what issues this raises, and the steps that need to be taken.

What schemes will this affect?

DB schemes that are contracted-out and that remain open to the future accrual of benefits will be most significantly affected by the end of DB contracting-out, and in particular by the cost implications. DB schemes that are contracted-out but closed to the future accrual of benefits will be affected to a lesser extent, but still need to consider implications, and in particular need to go through the process of GMP reconciliation. Any occupational pension schemes that integrate in some way with the state pension will need to consider the impact of changes to the state pension on the scheme benefit design structure, and any changes to benefits and drafting changes to the scheme documents required.

What impact will this have?

The most significant impact will be a cost implication for employers and employees who will no longer benefit from the contracted-out rebate. The cost increase for employers may be offset by changes to the scheme, and the government has given employers a statutory override power to make such changes unilaterally without trustee consent, subject to a variety of restrictions.  We set out more details on this below.

There are also a number of other issues which affected schemes and employers need to be addressing, including the impact on state pension offsets or bridging pensions within a scheme, communications with members and GMP reconciliation.  We set out these issues in a table below.

DB contracting-out is still a year away, do we need to address this now?

We advise that employers and trustees do need to be considering the impact of the abolition of DB contracting-out now. A variety of actions are required prior to 6 April 2016, and many of these will take some time to plan, agree upon and put in place.

What exactly are the increased cost implications?

For employers there will be an increase in National Insurance contributions (NICs) payable for each contracted-out employee of 3.4% of a band of earnings.  For affected employees the increase will be 1.4% of a band of earnings. While NICs will go up, in nearly all cases this will not result in any automatic change to scheme benefits.

The government acknowledges that many employers will find it unreasonable to be asked to bear the cost of paying higher NICs, while still maintaining the same level of benefits in their occupational scheme. Employers may wish to reduce future benefits or to increase employee contributions, to offset the increase in NI contributions.

How can we use the statutory employer override?

In order to enable employers to make the necessary changes, legislation has been brought into force giving an overriding statutory power to employers in this position to amend their scheme’s rules to alter a member’s future accrual rate, or to increase employee pension contributions.  The amendment can be made without trustee consent. The power is subject to a number of restrictions, including the following:

  • The power can only be used to increase employee contributions or to reduce the future accrual of member benefits by an amount that offsets the increase in NICs that the employer will incur.
  • An actuary appointed by the employer must certify that the value of the proposed amendments is not greater than the increase in the employer’s NICs. Regulations set out details of how the actuary must carry out the necessary calculations, and what assumptions can be used. 
  • The power will only apply to future benefits and cannot be used in a way that would or might affect benefits that the member has already accrued prior to the date of the amendment.
  • The statutory requirement to consult affected members will usually apply to changes made using the statutory override.
  • Trustees will be obliged to provide relevant information to the employer (such as membership data) for the purpose of the employer exercising the statutory override. 

Alternatively, employers could decide to amend the scheme rules in the usual way through the scheme amendment power, but this will often require the agreement of the trustees.

During the consultation on the final regulations about the employer override, concern was expressed that some employers may ‘double dip’ by making changes under the scheme’s normal amendment power to take account of increased costs due to the end of DB contracting-out, and by then seeking to make further changes using the statutory override. To avoid this, trustees should seek written confirmation from the employer that it will not use the statutory override power before they agree to amendments being made using the scheme’s normal amendment process in relation to the increase in NICs.

Should employers be making use of the override now?

Employers and trustees of contracted-out schemes that are open to accrual should start considering amendments that they wish to make to the scheme now, and putting in place a plan to implement the amendments so that they will take effect from 6 April 2016.  It is likely that this plan will need to include 60 days consultation under the statutory consultation requirements with affected members. Some schemes may consider closing to future accrual at this point, which again will take some time to put in place.

The employer override power can be used before DB contracting-out is abolished on 6 April 2016, but amendments made under it cannot take effect before that date.  The detailed legislation setting out how the power can be used has come into force from 6 April 2015 to give employers and schemes a year to decide and implement the changes that they wish to make in advance of DB contracting-out being abolished.

How does this affect public sector employers and ‘protected persons’?

Public sector employers will not be given an equivalent statutory override power. This is due to the government’s commitment that the public sector pensions reforms contained in the Public Service Pensions Act 2013 should endure for 25 years.

Private sector scheme employers will not be able to exercise the employer override power in relation to any ‘protected persons’ in the scheme – being members who are former employees of nationalised industries who benefit from statutory protection of their accrued pension rights. Employers of protected persons therefore need to factor in the increased costs they will incur in relation to these employees’ pension benefits from 6 April 2016.

What other issues are going to arise on the abolition of DB contracting-out?

We set out in the table below a number of other issues that affected schemes need to be considering and dealing with:

Issue Details When law changes
State pension offsets Some schemes are designed to ‘integrate’ with the state pension scheme,
for example by deducting the value of the state pension from a pension in
payment. The impact of the changes to the state pension and how this affects
the benefit design within the scheme needs to be addressed. Rule amendments
may be necessary.
6 April 2016
Bridging pensions Schemes that provide pensions designed to ‘bridge’ the gap in pension
provision where scheme members’ normal retirement date falls before state
pension age need to consider the implications of the changes to state pension
provision on this aspect of scheme design.
Rule amendments may be necessary.
6 April 2016
Amendments to the scheme Draft regulations setting out the rules that formerly contracted-out DB
schemes will need to comply with following abolition of contracting-out were
issued for consultation by the government last year. The DWP has confirmed
that it is now unable to publish the final form of these regulations until
after the general election in May 2015. When these regulations have been
finalised, any detailed amendments to the scheme rules can be drafted.
Final regulations to be issued after the election in May 2015
Member communication It will be necessary to communicate with members about the abolition of
contracting-out and its implications for the scheme and members.  Any amendments that are made to scheme
benefits to offset the increased costs will need to be communicated to
members. Scheme booklets and other information will need to be reviewed and
updated.
Action needed pre-6 April 2016
GMP reconciliation Trustees have until April 2018 to reconcile scheme membership and
ensure that contracted-out data, for example the amount of GMPs, matches HMRC
data. Scheme administrators need to contact HMRC’s GMP reconciliation service
as soon as possible in order to reconcile their records with HMRC’s data.
Queries on the position will continue to be dealt with by HMRC until December
2018, but requests for data reconciliation must be made by April 2016. More
information on this scheme reconciliation service is available here.
Action needed ASAP
Auto-enrolment
certification
Where a DB scheme is used for the purposes of automatic enrolment, it
must be a qualifying scheme.  A contracted-out
scheme is automatically a qualifying scheme, but when DB contracting-out is
abolished, affected schemes will need to satisfy alternative quality
requirements. A new cost-of-accruals quality test has been introduced which
contracted-out schemes will be able to use from 6 April 2016. Broadly
speaking, the cost of future accruals in a particular scheme must require
total contributions of at least 10% of DB members’ qualifying earnings or 9%
if no dependants’ pensions are available. Affected schemes need to ensure
that they satisfy the alternative quality requirement.
6 April 2016
Keeping up to date with
the changes
HMRC is issuing a quarterly Countdown Bulletin designed to keep pension
providers who are operating DB contracted-out schemes updated on what is
happening in the lead up to the changes in April 2016. These are available here.
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Action required!

As can be seen from the various issues highlighted in this update, trustees and employers of contracted-out DB schemes that are open to future accrual need to consider various action points. If your scheme is affected, get in touch with your usual OC contact, who can give you scheme specific advice.