Following the government’s announcement that contracting out of Defined Benefit schemes will be abolished as of April 2016, not only will both employees and employers be liable for increased National Insurance rates, but there could be further, financial implications for the members, too.

What is Contracting Out?

Since contracting out of Defined Contribution (DC) and personal pension schemes was abolished back in April 2012, the term ‘contracting out’ now generally refers to Defined Benefit (DB) schemes. Members of a contracted out DB scheme are no longer contributing towards their State Second Pension (S2P) and as such, both employees and employers pay slightly lower National Insurance (NI) rates, making it an attractive option for both parties. Additionally, in order to qualify as a ‘contracted out’ DB scheme, employers have to ensure that the benefits offered to members are at least equal to those offered under the S2P.

What has changed?

From April 2016 the Basic State Pension (BSP) and State Second Pension (S2P) will be replaced by a new, single-tier state pension from which it will not be possible to contract out. The changes will only apply to those people who are under the State Pension Age (SPA) in April 2016 and they will mean that both employers and employees of currently contracted out DB schemes will have to pay higher NI contribution rates, increasing their contributions by up to 41%, depending on their level of earnings. As a result of these changes, the government estimates it will collect approximately £5 billion in extra revenues, some of which will be put towards the funding of long-term care costs, which are also allegedly being funded by the extension of the freeze of the Inheritance Tax Threshold.

Impact and Future Challenges:

The principal impact of the abolition of contracting out will be the extra costs incurred for both employers and employees of currently contracted out DB schemes. However, depending on how each employer decides to cover these extra costs, significant further alterations could affect the employees. Employers now have the right, under the Pensions Bill, to amend their DB schemes through a statutory override without trustee consent, providing member contributions are not increased, or their benefits reduced, by more than the value of the employer’s lost NI rebate. The statutory override will apply to all DB schemes, with the exception of public sector pension schemes such as the NHS Pension Scheme, and the Civil Service Pension Scheme, for which the respective employers will be obliged to cover the extra NI contributions incurred.

For all other DB schemes, the statutory override could have a significant impact on the employees. While some employers might decide to cover the cost of the supplemental contributions, it seems far more likely they will seek to mitigate their losses by enforcing the statutory override and either increasing employee contributions, reducing employee benefits or, alternatively, closing their schemes to future accrual. In a recent survey carried out by Aon Hewitt, it was discovered that of the 91 organisations which took part, only one third have already considered how they might act on the abolition of contracting out, while half of those who had already studied their options were leaning towards closing their DB schemes to future accrual.