Defined Benefit (DB) contracting out will end on 6 April 2016. From this date, employers and employees will need to start paying the standard rate of National Insurance Contributions (NICs). This will not be an insignificant extra cost to employers of open DB Schemes. 

The current state pension system is made up of three elements:

  • Basic State Pension (BSP)
  • Additional State Pension (now known as S2P)
  • Pension Credit

Since 1978, it has been possible for employers to “contract out” of the additional state pension by providing an occupational pension which meets certain statutory requirements. The aim was that employees of a contracted out scheme would receive a pension which was broadly equivalent to the additional state pension. In return, employers paid reduced rates of NIC of 3.4% and employees paid a reduced rate of 1.4%.

Why the change?

From 6 April 2016 the current pension regime will be replaced by a flat rate pension, meaning the option of contracting out of the additional state pension will no longer be possible.

What has changed?

Provisions within the Pensions Act 2014 have been introduced to enable the employer to recoup the increased NICs. The employer has a unilateral power to amend its schemes in order to take account of the increased contributions.

Pensions Act 2014

There are two main functions of the new legislation:

  1. Protection of accrued contracted out rights – section 12E of the Pension Schemes Act 1993 (the PSA) will ensure a contracted out scheme must broadly continue to meet the statutory requirements that used to apply to guaranteed minimum pensions.
  2. Employer override – section 24 & Schedule 14 of the PSA allows employers to amend scheme benefits to the extent that they offset the cost of the additional employer NICs which will be payable after 6 April 2016.

Employer override details

  • Employers will not need the consent of scheme trustees in order to use the employer override.
  • The power can only be used to affect future benefits and cannot adversely affect member’s accrued rights.
  • Actuarial certification will be required confirming the changes comply with statutory requirements.
  • The override power will be repealed five years after it comes into effect.
  • The modification power can amend a scheme in relation to the same members on more than one occasion within the period.
  • Trustees are to convey any relevant information to the employer for the purpose of using the amendment power.
  • An employer can increase member’s contributions or alter accrual rates, but an employer cannot do the following:
    • Increase member contributions beyond the increase in the employer’s NICs
    • Reduce Member’s benefits by more than the annual increase in the employer’s NICs
    • Use the power so any increase in contributions and decrease in benefits is more than the annual increase in the employer’s NICs
  • “Listed Change” communication requirements will still apply e.g. increase retirement age, stop or amend future accrual, increase member contributions.

Impact of the changes

Employers will need to consider the increased costs of the changes and assess how best to deal with them. There are a number of options available to employers, such as reducing member’s benefits, increasing member contributions, putting in place salary sacrifice arrangements or ceasing accrual under the scheme.

The changes could even also impact schemes with no active members. Depending on the format of the benefit calculations (reference could be made to the basic state pension) the benefits members are entitled to could become difficult to establish.

Contracted out liabilities can be reconciled using HMRC services until 2018, at this point HMRC will contact members who are not yet of state pension age advising them of their contracted out membership. Importantly after this date HMRC will assume its figures are correct and it will be hard to challenge.