Fond farewell

The 6 April 2016 marks the end of an era, with the end after 38 years of contracting-out on a salary-related basis. The changes have come about as a result of reforms introduced by the Pensions Act 2014, which will result in a single-tier state pension in place of the current two-tier model which consists of the basic state pension and the earnings-related state second pension (S2P).

Since S2P was introduced on 6 April 1978, members of certain pension schemes have, in exchange for lower national insurance contributions (NIC), had the option to contract-out of the S2P and instead receive retirement benefits from their employer’s scheme. However, this will automatically cease with the abolition of S2P and introduction of the single-tier state pension on 6 April 2016. Employers and members of schemes that are contracted-out will then automatically revert to paying the full rate of NIC as at this date.

Employer concerns

The most obvious and immediate issue facing employers in relation to schemes that are currently contracted-out is the potentially significant increased cost of paying the full rate of NIC. There are a number of options available to employers to address these increased costs, including increasing contribution rates or altering accrual rates. For a period of five years, employers will have a statutory modification power to amend the scheme rules to the extent that the amendments offset the additional cost of the higher NIC that will become payable by them. It may also be possible to use the scheme amendment power, subject to the usual conditions being met.

Further rule amendments, using the scheme amendment power, may also be required for schemes that incorporate elements of the state pension scheme into their benefit structure (such as offsets, bridging pensions, underpins etc).

Employers that are currently using a contracting-out scheme as a basis for auto-enrolment compliance will need to consider whether the scheme will continue to meet the quality requirement under legislation after 6 April 2016, and make any changes necessary to ensure continued compliance by this time.

Regardless of the mechanism used, employers will need to establish whether the proposed amendments constitute a “listed change” on which there is a requirement to carry out a 60-day consultation with members, in accordance with the Occupational and Personal Pension Schemes (Consultation by Employers and Miscellaneous Amendment) Regulations 2006 (SI 2006/349).

Member concerns

From a members’ perspective, the immediate concern will be the cost of increased NIC and reduction in take-home pay, and employers should notify employees in advance.

In the longer term, members’ accrued rights to a guaranteed minimum pension (GMP) from the scheme will continue to exist and will be offset from the single-tier pension. This will mean that their eventual pension should not be lower than the pension they could have become entitled to under the current system’s rules. However, HMRC has confirmed that it will no longer track contracted-out members’ GMP rights from 5 April 2016.

In order to avoid any future disputes arising from discrepancies in the deduction to be applied to the member’s single-tier pension, employers should liaise with scheme trustees to ensure that steps are being taken to reconcile data relating to contracted-out benefits by comparing scheme GMP records with the National Insurance Contributions Office’s GMP records. This will allow discrepancies indented in the data to be reconciled. Requests for reconciliation data have to be made by 5 April 2016. HMRC has confirmed that it will not accept submissions for data after this. Scheme trustees will have until April 2018 to complete the reconciliation, after which time HMRC will withdraw its support for contracting-out reconciliation queries and assume that its records are correct.

Act Now

With 6 April 2016 fast approaching, it is imperative that contracted-out schemes act now to mitigate the impact of the contracting-out. Employers may also wish to take this opportunity to overhaul their benefit design and put their scheme on a secure footing for the future, but for now the key tasks are:

1. assess the cost implications of the changes and the impact on funding, and ascertain the amendments required;
2. communicate with affected members as early as possible, taking into account disclosure and consultation requirements;
3. trustees beginning the reconciliation process.