I can’t say I have ever met an employment lawyer who has admitted to a keen interest in pension contracting-out. But in the coming months this subject is going to be very interesting indeed to a great many employers and their employees as huge changes come into effect, some of them affecting what’s left in pay packets at the end of each month.
Most people will know by now that a new single-tier state pension is being created in April 2016. This will combine into one the current basic state pension and state second pension. The removal of the separate top-up element means there will no longer be anything to contract out of, so the option for occupational pension schemes to contract out on the defined benefit (DB) or salary-related basis is being abolished alongside the introduction of the new state pension.
Contracting-out on the defined contribution (DC) or money purchase basis was abolished back in 2012, but that was in practice a lot more straightforward. While in that case DC contracted-out rights simply ceased to have any special status and for the future could be treated as normal rights under a DC scheme, a different approach is being taken on the abolition of DB contracting-out.
On this occasion, contracted-out rights that have been built up by employees in the past – whether in the form of so-called guaranteed minimum pensions (GMPs) or their more recent incarnation (section 9(2B) rights) – will continue to benefit from statutory protection. This means certain restrictions that apply to these rights (for example, that they have to be revalued for inflation if frozen, or used to provide a spouse’s pension on the member’s death) are still going to remain in force after abolition. DB schemes will have to comply with these protections as long as any of their members hold these rights.
For most employees, the idea is that they should not be any worse off after abolition, both in relation to the past and the future. But while employees may appreciate the statutory protections for their past contracted-out rights, they may be less willing to accept that they are going to be no worse off for the future. At the moment, an employee in a contracted-out scheme benefits from a reduction in their National Insurance contributions (NICs) of 1.4% of their earnings between the lower earnings limit (LEL) and upper accrual point (UAP). Essentially this is a quid pro quo for giving up the state second pension and instead receiving benefits from a contracted-out scheme. From 6 April, employees will no longer receive this rebate. They will see an immediate rise in their NICs and a fall in their take-home pay. They may wonder what they are getting in return. This is where things get complicated, as anyone who has yet tried to work out how much they think they will receive under the new state pension can vouch. What is more, recent research commissioned by the DWP suggests not all individuals are going to be better off.
For their own part, employers sponsoring contracted-out DB schemes are going to have to think carefully about the ramifications of abolition. And there isn’t much time left for them to do so. On the upside, with contracting-out gone they will no longer have to worry about applying for contracting-out certificates or varying these after things like a corporate reorganisation. But with immediate effect from 6 April employers too will face higher NICs in relation to employees who are members of their DB scheme. They will have to pay additional NICs of 3.4% of each employee’s earnings between the LEL and UAP.
However, employers will be able to cover the cost of the extra NICs by restructuring their pension arrangements either to reduce the accrual rate or increase members’ contributions. A special overriding statutory power has been enacted that will allow them to do this even if they don’t have the power to make these changes under their scheme’s normal rules. Using the overriding power correctly is not entirely straightforward, and any employer thinking of doing this, or considering making any other changes at the same time (as some may do), should talk to a pensions lawyer first. One point they should certainly bear in mind is that the overriding statutory power can only be used to the extent necessary to defray the extra NIC cost arising from abolition.
Also, if a “listed change” is being made, as for example increasing contributions would be, the usual pension consultation rules would apply in the case of employers with 50 or more employees.
Whether pension restructuring changes are being made or not, employers should warn members in advance about the NIC changes. Separately, the scheme trustees will need to tell members their employment is no longer contracted-out as this amounts to a material alteration to the basic information members were (or should have been) given when they joined the scheme.
If employers can effectively neutralise the cost of the extra NICs they will have to pay by making their scheme cost less in the future, can they get rid of their liability for past contracted-out rights, for example by arranging for a buyout of their DB pension scheme with an insurance company? The answer is that buyouts are not entirely straightforward and there are downsides as well as upsides. Apart from anything else, the employer has to be willing to crystallise a pension scheme deficit at a level that may be unappealing. With regard to accrued contracted-out rights, unfortunately for employers (and fortunately for employees), the protections covering these rights referred to above continue to apply when these rights are transferred to another pension scheme or annuity provider. And while it’s theoretically possible to convert GMPs to normal scheme benefits under a specific statutory mechanism, as far as I’m aware this mechanism has been rarely (if ever) used. The reason is to do with certain technicalities dictating that the replacement benefits have to be actuarially equivalent to the contracted-out benefits foregone. The DWP has consulted on introducing a new, improved GMP conversion regime, but this has yet to appear.
One other change that employment lawyers should be aware of is the repeal on 6 April of the requirement applying under section 3(5) of the Employment Rights Act 1996. This is the point that a written statement of particulars of employment under section 1 of the Act must include a note effectively saying whether the employment is contracted-out or not. For obvious reasons, such a note won’t be needed for new employees from 6 April.
