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

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:

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.