On 6 April 2016, the Pensions Act 2014 (and related regulations) will effect the introduction of the single-tier state pension and, with it, the abolition of contracting out on a defined benefit basis. The abolition of contracting out will present challenges for many trustees and employers.

All schemes will need to consider the implications of the new regime in relation to their scheme rules. While contracted-out and formerly contracted-out schemes need to be live to the issues surrounding the abolition of contracting out, all schemes (including schemes that have never been contracted out) should consider how their benefit design interacts with the current state pension regime and whether any  such interaction is still appropriate in the ‘new world’ of the single-tier state pension.

Those employers with “open” contracted-out schemes will also need to decide on the action to be taken to address any additional costs arising from the increase in National Insurance Contributions (NICs).

Schemes with accrued contracted-out rights on 6 April 2016

Following the abolition, accrued contracted-out rights (both GMPs in respect of pre-6 April 1997 contracted-out service and section 9(2B) rights in respect of post-5 April 1997 contracted-out service) will be subject to various protections. Broadly, this means that whilst contracted-out rights will no longer build up from 6 April 2016, contracted-out rights  which have accrued at that date will  be preserved. This is in contrast to the approach taken to the abolition of contracting out on a defined contribution basis in 2012, when protected rights’ status fell away.

The key protections relate to:

  • amendments to scheme rules which will impact upon accrued contracted-out rights;
  • the requirement to revalue GMPs; and
  • the provision of survivors’ benefits. 

In many instances the protections will replicate much of the framework currently in place (subject to some modifications). Some provisions which were to be repealed from 6 April 2016 will be preserved to allow necessary tasks to be undertaken by schemes in respect of accrued contracted-out rights. In most cases, provisions are preserved for three years but, in some cases, they are preserved indefinitely. The preserved provisions concern the certification of contracted-out schemes, national insurance rebates and state scheme premiums, and HMRC supervision of contracted-out schemes, amongst others.

Power to amend

During the consultation on the protections, there were calls for the introduction of a power to allow trustees (with the consent of the employer) to modify scheme rules which make reference to the basic state pension or which are otherwise integrated with the state pension regime (for example, through the provision of bridging pensions). The Government has stated that such a power will not be introduced. It reasoned that it would not be needed because the basic state pension will continue to be uprated each year for those who reached state pension age before 6 April 2016 and this uprated figure will continue to be published.

The Government’s response appears to be overly simplistic and does not take into consideration the many different ways in which scheme rules integrate with the state pension regime. It also leaves most employers and trustees looking to their scheme amendment power if they wish to make changes in response to state pension reform, where they will also be subject to legislative restrictions under section 67 of the Pensions Act 1995 and the pensions consultation requirements. 

Further consultation

The current legislation is not the end of the story. Many issues identified as part of the Government’s consultation have yet to be resolved. The Government has therefore indicated that there is to be further consultation regarding changes to legislation to address these issues, including:

  • the transfer of contracted-out rights between formerly contracted-out schemes;
  • potential changes to the power to alter scheme rules in relation to section 9(2B) rights; and
  • clarifying the notification and/or consultation requirements to be undertaken by employers ahead of the abolition of contracting out.

It is expected that these consultation(s) will be published in late 2015.

Open Contracted-out schemes

From 6 April 2016, there will be immediate cost implications for both active members and employers of  contracted-out schemes that are open to future accrual. This additional cost takes the form of increased NICs, currently 3.4% of relevant earnings for employers and 1.4% of relevant earnings for employees.

In recognition of the additional financial cost for employers, the Government has introduced a statutory power which will allow employers to amend schemes to take account of some, or all, of the increase in the employer’s NICs without the consent of scheme trustees. The power may be used in respect of members impacted by the abolition of contracting out to increase member contributions and/or to alter the future accrual of benefits. It may  be used to amend a scheme on more than one occasion.

However, any amendment(s) will at all times be subject to the protections set out in legislation including:

  • a restriction that the power cannot be used to make amendment(s) where the impact would be to recover more than the annual increase in the employer’s NICs;
  • the power cannot be used to make amendment(s) which become effective before the abolition date (that is, 6 April 2016) and it cannot be used to make amendment(s) retrospectively;
  • the power may not be used for certain groups, including ‘protected persons’ from the electricity, railway and coal industries (the legislation also allows for the Government to introduce further exceptions through regulations); and
  • in order to strike a balance between the overriding nature of the power and the protection of members, employers will be required to consult with members before making the change(s) because increases to member contributions and reductions in benefit accrual are both ‘listed changes’ under the pensions consultation legislation. 

Next steps

Employers wishing to use the power to mitigate an increase in NICs from 6 April 2016 should already be taking action. They will need to understand whether the power is available in respect of their affected members and the amendments that are open to  them to make, having taken legal and actuarial advice as necessary. It should be noted that the power will not be available indefinitely, but will remain in place for five years, until 5 April 2021 (unless extended further by the Government).

To the extent the power is not available or employers wish to make changes to ensure that their schemes continue to integrate with state pension benefits in the way that was intended, they will need to comply with any conditions and restrictions set out in the  scheme’s amendment power and under legislation, which may also require trustee agreement to any proposed  changes.

As employers will also need to factor in time to consult with affected members for at least 60 days before making a ‘listed change’, employers should put a plan of action in place as soon as possible.