Currently, the state pension has two components – the basic state pension and an additional earnings-related top-up (called the state second pension). Where an employer provides membership of an occupational pension scheme that meets certain minimum requirements, they can contract members out of earning the state second pension. In return, employers and members pay lower National Insurance contributions (“NICs”) than the standard rates.
From April 2016, a new single tier state pension is being introduced, which will no longer be separated into basic and additional pension components. As there will no longer be a separate state second pension, contracting-out will cease to be an option, and employers and employees will start to pay standard rate NICs.
Contracted-out pension rights accrued prior to April 2016, including guaranteed minimum pensions (“GMPs”), will remain in existence and subject to rules that are broadly equivalent to those that apply currently to contracted-out rights. However, the position under scheme rules will need to be checked to avoid any unintended changes.
Issues arising for schemes
The abolition of contracting-out creates a number of issues for schemes, in particular for those schemes which are currently contracted-out and remain open to benefit accrual. If they have not already, trustees and employers should start considering what actions they need to take as a result. Rule amendments may be necessary for some purposes.
Rule amendments that may be necessary
GMP revaluation for members remaining in pension- able service following abolition
Currently, the contracting-out legislation provides that while a member remains in contracted-out service, his or her accrued GMP must be revalued each year by the rate specified in an order made for that year under s148 Social Security Administration Act 1992. (This is known as “s148 revaluation”.) However, where a member ceases contracted-out service prior to GMP age, the scheme has a choice: it can either continue to apply s148 revaluation or it can switch to revaluation by a fixed annual percentage which will remain unchanged until the member’s GMP starts (known as “fixed rate revaluation”).
From 6 April 2016, the contracting-out legislation will be changed for members whose contracted-out service ends on that date solely because contracting-out is being abolished, but who remain active members of the scheme. For them:
- legislation will require s148 revaluation to continue until the member actually leaves pensionable service, and
- any switch to fixed rate revaluation can occur only when the member’s pensionable service ends.
This change to the law creates a potential problem for schemes if:
- they are contracted-out;
- on 6 April 2016 they still have active members with accrued GMPs;
- they revalue deferred members’ GMPs on the fixed rate basis; and
- their rules reflect the current statutory require- ments about when fixed rate revaluation starts. (In our experience, most schemes’ rules do.)
This is because, in those cases, the scheme rules will effectively provide for those members’ GMPs to be revalued on the fixed rate basis starting from 6 April 2016 (because that is when their contracted-out service ends), while legislation will require the same GMPs to be revalued on the s148 basis until the member eventually leaves pensionable service. In effect, there could be double-counting for the period from 6 April 2016 until the member leaves pension- able service, with members being entitled to whichever of fixed rate revaluation and s148 revaluation gives them the bigger benefit.
Schemes in that position should therefore amend their rules to ensure that the rules reflect only the new statutory provisions for those members who leave service after 6 April 2016 to avoid giving those members an unintended windfall.
Some schemes may be able to make those amendments using their own amendment power, but others will not. All schemes are therefore being given a new statutory power, exercisable by trustees, from 6 April 2016 to change their rules to ensure that only the new statutory GMP revaluation rules apply to members leaving service on or after 6 April 2016. The power will be exercisable by trustee resolution, and must be exercised no later than 5 April 2017. But if amend- ments are made by then, they can operate with retrospective effect from 6 April 2016: in other words, trustees of affected schemes will have a year to align the relevant scheme rules with the new legislation and stop the double-counting issue arising.
State pension offsets
Some scheme rules provide for pensions paid to members retiring before state pension age to be reduced by some fraction of the basic state pension at state pension age. Others include a definition of pensionable earnings that applies a deduction based on some element of the state pension.
Despite the forthcoming changes to the state pension, legislation will still define the basic state pension as pre-April 2016 retirees will continue to receive one. Scheme rules in that form will still have a clear meaning so long as the reduction or offset is defined by reference to the statutory concept alone.
However, some schemes go further than that and define the amount of the reduction/offset by reference to the basic/additional state pension that the specific member actually receives. These relatively rare schemes will have an issue for members who reach state pension age after 5 April 2016, because those members will receive the new single tier pension, possibly leaving it unclear how the relevant benefit should be calculated. Schemes in this position may wish to take advice on how their rules will operate after 5 April 2016 and on whether they should be amended to hardcode an agreed deduction or to adjust the definition of the amount to be offset appropriately.
(Scheme rules that refer to the reference scheme test
Some schemes’ rules contain a so-called reference scheme underpin, in other words a rule saying that some (or all) benefits will be no less than would have been provided by the notional “reference scheme” described in s12B Pension Schemes Act 1993. Although s12B is being repealed, legislation says that it will continue to have effect indefinitely in relation to schemes which contain a reference scheme underpin and in relation to the period of contracted-out employment.
The position in relation to service from 6 April 2016 is less clear, and whether the underpin continues to apply to that service may not be obvious, and is likely to depend in any case on exactly how the scheme rules are worded.
Another issue which may not be clear is whether the earnings to be taken into account in applying the reference scheme underpin are to be calculated as at the point when pensionable service ends, or as at the point when contracting-out ends on 6 April 2016. The contracting-out legislation itself does not require the test to be applied as at the point pensionable service ends, so – subject to the scheme’s amendment power – it may be possible to amend scheme rules so that the underpin applies by reference to salary when contract- ing-out ends.
Schemes with a reference scheme underpin rule should consider whether they wish to amend their rules before 6 April 2016 in order to achieve clarity on how the underpin will work going forwards.
Employer amendments to the scheme
Employers sponsoring schemes that were contracted- out until April 2016 have a statutory power to amend their scheme unilaterally to offset the cost of the increased employer NICs by:
- reducing future benefit accrual; or
- increasing member contributions; or
- a mixture of both.
The statutory power overrides any consent require- ments in the scheme documentation and any restrictions that would otherwise prevent such amendments being made. It cannot be used to make changes that are greater than is required to recoup the increased employer NICs liability.
Schemes which remain open to accrual will need to establish what changes, if any, the scheme employer wishes to make to recoup the increase in NICs. Some employers may wish to make changes using the scheme amendment power rather than the statutory power, which would usually require trustee consent.
Transfers of contracted-out rights that include a GMP
Current contracting-out legislation generally requires schemes to apply the same GMP revaluation rate for all deferred members. However, there is an exception where a scheme accepts a transfer-in of contracted- out rights that include a GMP, the scheme can choose to apply the same revaluation rate as was applied to the benefits under the transferring scheme (even if the receiving scheme applies a different rate to other members’ GMPs).
However, the legislative provisions that create this exception are replaced from 6 April 2016 by a new provision that only applies to transfers to a scheme which was contracted-out at the time of the transfer. Therefore, as no schemes will be contracted-out from 6 April 2016, schemes will no longer be able to con- tinue to apply the GMP revaluation rate used by the transferring scheme for post-5 April 2016 transfers-in of contracted-out rights that include a GMP.
Unfortunately, there is no way of resolving this issue schemes will need to update their processes accord- ingly unless the legislation is changed. This point has been raised with the Government, but there is no information as yet about whether the Government is likely to correct the position.
Commutation of GMPs
Under current contracting-out legislation, a GMP can be paid as a lump sum in certain circumstances, including where it would qualify as one of various specified commutation lump sums for tax purposes. However, this option is available before the member reaches GMP age only if:
- the scheme uses the fixed rate method to revalue GMPs in deferment; and
- for the purpose of deciding whether the member’s benefits are within HMRC trivial commutation limits, the scheme assumes that the member’s current pension includes the GMP that the member would get with fixed rate revaluation all the way up to GMP age.
The legislation that will apply from 6 April 2016 seeks to replicate these provisions, but it omits the wording that says that the notional revaluation requirement applies only for the purpose of testing the member’s pension against trivial commutation limits. This will make it easier for members to argue in future that the notional revaluation requirement should also be factored in when determining the lump sums actually paid out on trivial commutation, increasing the lump sums to which they are entitled.
We doubt that the Government meant this minor change to the wording to affect the meaning of the regulations one way or the other, but we are awaiting clarification from the Government. In the mean time, where schemes offer a trivial commutation option before GMP age and currently assume that notional revaluation is required only in applying the HMRC tests, they may wish to consider whether to adopt different factors in light of the changed statutory wording, or whether to stick with their past approach despite the rather higher risk that a court will decide against it.
Schemes holding GMPs are encouraged to reconcile the data that they hold on members’ GMP entitlements with HMRC’s records in order to avoid disputes later. To do this, schemes must register with HMRC’s Scheme Reconciliation Service by 5 April 2016. There will often be discrepancies between the scheme’s data and that held by HMRC. The question then arises as to how far schemes must go to reconcile their data with HMRC’s records.
The theoretical legal position is that trustees are obliged to pay the benefits determined by the scheme rules and legislation. On the face of it, with full scheme records, it should be possible to establish what the right benefit is, and to reconcile scheme data with HMRC’s data on that basis. Schemes cannot, as a matter of law, just decide to pay incorrect benefits.
In some cases, the scheme’s data will be correct, while in others, HMRC’s records will be accurate. If no reconciliation exercise is carried out therefore, members may well receive conflicting information on their GMP entitlements which may in turn lead to disputes.
Notifying members of the cessation of contracting-out
Schemes are required to notify members if the scheme ceases to be contracted-out within three months of the cessation date. Schemes that are currently con- tracted-out and remain open to accrual should therefore ensure that they notify their active members of the cessation of contracting-out by 5 July 2016.