The end of contracting-out and the introduction of the new single-tier State Pension on 6 April 2016 is now just over a month away and there are a number of issues that employers and trustees of schemes containing contracted-out benefits will need to consider and potentially take action on before then. This Pensions Alert highlights the key tasks for employers and trustees - it starts with a brief overview of key issues (some of which apply to all schemes and some of which only apply if the scheme is open to future accrual) and then provides some further information on each of them. Finally, it flags some areas where further consultation or regulations are still to come.

Overview of key issues

All schemes 

  • Benefit design issues: check whether any scheme benefits are calculated by reference to the current State Pension. 
  • Rule amendments and administering accrued rights: review the rules in relation to contracted-out rights to ensure that they remain appropriate, and speak to the administrators to ensure that contracted-out rights will continue to be administered correctly. 
  • Communications: check whether any updates are needed to scheme literature, including in relation to the way that increases to GMPs are described. 
  • GMP reconciliation: reconcile GMP data with HMRC.

Additional issues for schemes that are open to accrual  

  • Benefit design issues: employers should consider whether any amendments will be made to scheme benefits to offset their increased National Insurance costs.
  • Rule amendments: check the scheme rules to see whether any amendments are needed in relation to provisions which are drafted to apply when contracted-out employment ends, and to ensure that any Reference Scheme Test underpin will not continue to accrue.
  • Communications: employers should communicate with members about the change to their National Insurance contributions, and trustees will need to comply with requirements under the Disclosure Regulations. 
  • Automatic enrolment: if the scheme is being used to fulfil automatic enrolment requirements, employers should check that one of the alternative quality requirements is met.

Benefit design issues

Offsetting increased National Insurance costs

The end of contracting-out will mean increased National Insurance contributions for employers and employees of schemes that are open to accrual. Employers that sponsor such schemes may therefore want to make changes to the benefit design in order to offset their increased costs. As well as the possibility of using the scheme amendment power to make such changes, a statutory modification power is available which employers can use without trustee consent to increase employee contributions and/or reduce future accrual to the extent needed to offset their increased cost. The DWP anticipates that the statutory power will be used only where employers and trustees are unable to reach agreement about how to mitigate for the increased cost. 

As with any benefit change, employers will need to consider issues such as complying with statutory consultation obligations and the requirements of the amendment power used, for example, there are strict criteria to meet when using the statutory power including actuarial certification. Employers that are intending to make benefit changes may well already have commenced, or even completed, the steps needed to make changes. However, changes could be made after 6 April 2016 (the statutory power of amendment is available for five years) and therefore even if employers have not yet considered this issue, they may want to do so now.

Benefits by reference to State Pension

For all schemes (even those that have never been contracted-out), employers and trustees should consider whether any benefits are calculated by reference to the existing State Pension legislation. For example:  

  • sometimes scheme pensions are "integrated" with the State Pension by requiring an amount equal to the current basic State Pension to be deducted from pensionable earnings, and
  • some schemes provide bridging pensions meaning that a higher pension is paid until the member reaches State Pension age, at which point a deduction is made. This higher amount and corresponding deduction may be defined by reference to the current basic State Pension.

For members who reach State Pension age before 6 April 2016, the existing State Pension system will continue to apply. The Government will therefore continue to publish an uprated figure for the basic State Pension each year. Rules which refer to basic State Pension should therefore continue to work and achieve their intended purpose for these members. 

However, members who reach State Pension age on or after 6 April 2016 will receive the new single-tier State Pension, not the basic State Pension. The impact for schemes will depend on how exactly their rules are drafted. 

Employers and trustees should consider seeking advice about: (i) whether it will still be possible to operate their rules for members who reach State Pension age on or after 6 April 2016; and (ii) even if it is still possible to operate the rules (for example, because the basic State Pension figure will still be published annually), whether they will continue to achieve their intended purpose, and what the cost implications will be in light of the State Pension changes. Any changes to benefits which employers decide to make to reflect the new State Pension will be subject to the usual considerations such as whether legislation prevents the amendments applying to accrued benefits and whether members need to be consulted.

It is worth noting that there is further legislation to come in relation to bridging pensions because amendments need to be made to the tax legislation. These amendments are expected to be in the Finance Bill and regulations made under it.

More generally in relation to bridging pensions, in light of provisions in the Pensions Act 2014 which bring forward the increase in State Pension age to 67, employers and trustees may also want to consider whether the age under the rules at which bridging pensions cease to be paid remains appropriate.

Rule amendments and administering accrued rights 

Even though contracting-out is being abolished, accrued contracted-out rights will be preserved and will continue to be subject to statutory restrictions. Some new legislation has been made in relation to the treatment of contracted-out rights which mirrors the existing legislation in many respects although there are also some differences. Depending on what the scheme rules say about interpretation, it may be that cross-references in the rules to the existing legislation can simply be read as referring to the new legislation. The extent of rule amendments may also be limited by the fact that the new legislation states that certain statutory provisions on GMPs override any conflicting scheme rules. 

However, all schemes with contracted-out rights should check their rules to see whether any amendments are needed as the position will depend on the way the rules are drafted. Even if amendments are required, it may be that there is no urgency to make them and that they can be picked up in the next deed of amendment or rules consolidation but we would suggest that at least an initial review is completed now to ascertain whether this is the case.

Schemes that are open to accrual will also need to check for any rules currently drafted to apply when contracted-out employment ends. Such rules may need to be changed before 6 April 2016 in order to ensure that they are not triggered by the abolition of contracting-out. 

A key example of rules drafted in this way is provisions on revaluation of GMPs for early leavers. In summary, the current position is that revaluation of GMPs occurs during contracted-out service in line with earnings (section 148 orders) but once members leave contracted-out employment, the scheme can use fixed rate revaluation instead. Changes are being made to the contracting-out legislation so that the relevant point at which fixed rate revaluation can be used will not be 6 April 2016 when contracting-out ends but will be when the member leaves pensionable service (although the existing position is saved for those who left contracted-out employment before 6 April 2016). This means that revaluation rules referring to the date contracted-out employment ends will not fit with the legislation for those who cease to contract out on 6 April 2016 and could result in revaluation not operating as the employer and trustees intend. However, regulations have been published this week (coming into force on 6 April 2016) which contain a statutory power so that trustees can, by resolution, modify the scheme to provide for fixed rate revaluation from the date that the member leaves pensionable service. The power is available until 5 April 2017 and amendments can be backdated, although not to a date before 6 April 2016. 

Other rules that may currently be drafted to apply when contracting-out ends and may therefore need to be amended include those relating to anti-franking and obtaining HMRC approval when a scheme ceases to contract-out. In addition, for post-5 April 1997 contracted-out rights, schemes should check whether the Reference Scheme Test is hardwired into the rules as an underpin to benefits and, if so, consider whether any amendments are needed to ensure that the underpin does not continue to accrue. 

Communications

Employers of schemes that are open to accrual should let their affected employees know that the end of contracting-out will mean increased National Insurance contributions and therefore a change to their take home pay. Under the Disclosure Regulations trustees have an obligation to provide information when there are material changes to certain "basic information" about the scheme. This list of "basic information" includes whether the employment is contracted-out and therefore trustees will be required by the Disclosure Regulations to inform those affected that this is no longer the case.

For all schemes with contracted-out benefits a general review of scheme literature should be completed to check for any out of date references to contracting-out or the State Pension. One area to look out for in particular relates to GMP increases. The issue is complex but, in summary, relates to the fact that scheme literature may refer to increases on pre-6 April 1988 GMPs and post-5 April 1988 increases in excess of 3% being paid through the State Pension. However, this will not be the case for those reaching State Pension age on or after 6 April 2016, (and indeed may not be the case for all members who reach State Pension age before that date), and it is important that such references are updated in order to mitigate the risk of complaints from members that the scheme has provided misleading information.

GMP reconciliation

All schemes with contracted-out benefits should consider whether any steps need to be taken to ensure that the scheme's contracted-out records match those of HMRC. To assist with this, HMRC is offering a Scheme Reconciliation Service to administrators and trustees but expressions of interest to use the Service must be registered before 5 April 2016. If schemes do not register before this date or do register but do not submit queries through the Service, HMRC will assume that they are content with the accuracy of their data. If schemes do not complete a reconciliation process, risks include that they will not be paying the correct GMPs and could at some later point discover that benefits have been underpaid or overpaid which could be time consuming and complex to rectify. 

Automatic enrolment

Schemes can currently meet the quality requirement to be used to fulfil the employer's automatic enrolment duties by virtue of being contracted-out, but from 6 April 2016 the scheme will instead have to meet one of the alternative quality requirements (the test scheme standard or the cost of future accruals test). If employers of schemes that are open to accrual are currently using that scheme to comply with any of their automatic enrolment duties, they should seek advice on whether the scheme will meet one of the alternative requirements and what steps need to be taken in relation to this.

Areas waiting further developments

It is also worth employers and trustees being aware that the DWP intends to revisit some areas of the legislation at a later date including commutation of GMPs and the alteration of post-5 April 1997 contracted-out rights.