On 14 January 2013 the DWP published a White Paper entitled "The single-tier pension: a simple foundation for saving". This was followed on 18 January 2013 by the publication of the draft Pensions Bill. The White Paper and the draft Bill outline proposals to reform the State pension into a single-tier pension, with the existing State Second Pension being abolished.

Occupational pension schemes will no longer be able to be "contracted-out" of the State Second Pension. This will lead to increased National Insurance contributions for those who are currently "contracted-out". The DWP has proposed measures to alleviate the impact of this.

Trustees and employers of all occupational pension schemes should consider the potential impact to see whether the changes will affect them.

1. The single-tier state pension

The single-tier pension will, for future pensioners, replace the current basic State Pension and State Second Pension with a flat-rate pension that is set above the basic level of means-tested support (currently £142.70 per week). The White Paper assumes a starting level of £144 per week, which will be uprated at least in line with the growth in average earnings. The starting level and uprating policy will be set shortly before implementation.

The Government plans to implement the single-tier pension in 2017 at the earliest, to provide employers and schemes with time "to ensure a smooth end to contracting out", given the financial and administrative implications. Transitional arrangements will protect the position of those who have a pre-implementation National Insurance contribution record exceeding the single-tier pension.

Comment

All schemes (whether contracted out or not) should check their trust deed and rules to identify any possible impact of the change. Some schemes impose a State pension offset to integrate the scheme with the State scheme. An offset might operate in relation to the calculation of benefits, contributions or bridging pensions (see 4 below for more detail in relation to bridging pensions).

Although the basic State Pension will continue to exist for those who are too old to qualify for the new State Pension, scheme rules should be examined to ensure the offset will continue to operate as before in conjunction with the change.  

2. Abolition of contracting-out

A key element of the single-tier pension reform is the closure of the State Second Pension. Contracting out of the State Second Pension for defined benefit schemes – giving up entitlement to State benefits in return for a broadly similar occupational pension and payment of a lower National Insurance rate for employer and employee – will therefore come to an end.

For employers of contracted out members, the end of contracting out will have immediate cost and administrative implications. Most significantly, these employers will have to pay the same rate of National Insurance as all other employers - an increase in respect of each contracted-out employee of 3.4% of earnings between the Lower Earnings Limit (LEL) and Upper Accrual Point (UAP).

Meanwhile, all active members in contracted out employment immediately before the abolition will cease to be eligible for the contribution ‘contracted-out rebate’ and will start to pay full National Insurance contributions - an increase in the rate of their National Insurance contributions equivalent to 1.4 per cent of their earnings (between the LEL and the UAP).

To compensate for the loss of the rebate, the draft Pensions Bill introduces provisions which would enable private sector employers to change their scheme design – without trustee consent – to adjust members' future accrual or pension contributions. The draft Bill specifies that the power may not be used in a way that would adversely affect a member's subsisting rights – i.e. benefits already accrued cannot be adjusted, only benefits for future service.

The modification powers will exist for only a limited period (five years) and changes will be allowed only to the extent that they offset the cost of additional employer National Insurance contributions, not employees' National Insurance contributions. The detail of the changes which are to be permitted has not yet been finalised. The Government has said that it will work with the pensions industry, employers and member representatives to determine "exactly what type of change should be allowed and what safeguards will be needed". Draft regulations are expected to follow.

Comment

Many employers will welcome the proposed power to make changes without trustee consent but it is difficult to comment fully on the scope and usefulness of the power as we do not yet have all the details of how it will operate.

The Government has said that the power may be used only in a way that would offset the cost of the additional employer National Insurance contributions, but it is unclear how this would operate in practice. For example, should the employer decide to increase member contributions, different members may end up paying different rates of contributions; employer National Insurance contributions are payable only in respect of earnings between the LEL and the UAP, but member contributions to pension schemes are generally based on pensionable earnings which may be in excess of the UAP. It is therefore not as simple as simply increasing all members' contributions into the scheme by 3.4%.

Employers may wish to begin considering whether they will want to take advantage of the new power to make any benefit design changes. Employers may wish to consider making such changes at the same time as other changes, for example in respect of GMP equalisation or conversion (which would need to be made using the usual amendment power and would therefore generally require trustee agreement).

Even if trustee consent is not required, the change should be considered by employers in the same way as any other change to members' benefits or contributions. Employers should act in good faith and will be required to consult affected members in accordance with the usual pensions consultation legislation. There will be no requirement to consult on ending contracting out, given that this will occur automatically and be outside the employer's control.

It is unclear whether employers will be able to take advantage of the new power in respect of Protected Persons (see below) or where employees have contractual agreements outside the trust deed and rules in relation to benefits or contributions. In the absence of clarity, it is expected that such promises would need to be changed in the same way as any other change to contractual terms, even if the employer unilaterally amended the scheme rules, as the employer could otherwise face a claim for breach of contract.

Under the draft Bill, the power may be exercised only if an actuary has certified that the proposed amendments comply with the requirements of relevant statutory regulations. It is expected that this will in particular cover the requirement that the change is only used to offset the employer's increased National Insurance contributions (see above). However, given the potential for uncertainty as to how this will operate in practice, it remains to be seen how willing actuaries will be to give such certificates.

Employers may use the new power in relation to the same members of a scheme on only one occasion. This means they must get it right first time. If they use the power and subsequently realise they did not go quite far enough, or a mistake was made, it will not be possible for the employer to exercise the power a second time.

Regulations will in due course be introduced in respect of multi-employer schemes, and schemes with different categories of member.

Finally, it should be noted that HMRC may struggle to find the resources to reconcile quickly all of the National Insurance records following the abolition of contracting out. This may impact on schemes which are going through the process of winding up and need to reconcile their member records before this process can be completed. HMRC is aware of this issue.

3. Protected Persons in formerly nationalised industries

In some industries which were formerly nationalised (specifically rail, coal and electricity), there is limited scope to change scheme rules to change benefits or increase member contributions for older members due to legislation at the time of privatisation in the early 1990s. Essentially, employees who were employed by the State at the time of privatisation and who have subsequently remained with the same employer or its successor, are Protected Persons. Protected Persons Regulations prevent employers from reducing the pension provisions of these employees (although in the case of coal and electricity, some changes can be made if a majority of the members agree). Following the abolition of contracting out, employers will face the additional cost of paying full-rate National Insurance contributions without being able to make a corresponding change to the benefits or contributions of the Protected Persons.

On 18 January 2013, the Government began consultation on whether it is fair and appropriate to override the Protected Persons Regulations for employers who wish to take advantage of the new power discussed above in relation to future benefits or member contributions. Consultation is due to end on 14 March 2013.

Comment

It remains to be seen whether the Government will allow the Protected Persons Regulations to be overridden for the first time since privatisation. Employees may feel that the Government would be breaching promises made at the time of privatisation. On the other hand, the Government recognises that if it does not override the Protected Persons Regulations, employers would have to pay increased National Insurance contributions without being able to make adjustments to mitigate the increased cost.

If the Protection legislation is overriden, the 'shared cost' contribution basis of certain privatised schemes may mean that employers would seek to reduce benefits rather than increase member contributions.  

4. Bringing forward the increase in the State Pension age to 67

State Pension age is to rise gradually from age 66 to 67 between 2026 and 2028. Provisions are contained in the Pensions Bill to effect this. The Government will carry out a review of the State Pension age every five years, with the first review taking place in the next Parliament. Future increases to State Pension age are not expected to apply to persons who are already close to their current State Pension age.

Comment

Schemes will need to consider the implications for their rules of the forthcoming changes to State Pension age. In particular, this is relevant for those schemes with automatic or optional bridging pensions payable on early retirement (sometimes known as a level pension option, or temporary pension).

Currently, under the Finance Act 2004, bridging pensions must cease to be paid by age 65. The draft Finance Bill 2013 (published on 11 December - for our bulletin click here) aims to remedy this by removing the reference to age 65 and instead allowing schemes to choose whether the bridging pension will be paid until the current State Pension age or the amended, higher State Pension age.  

5. Guaranteed minimum pensions (GMPs)

The Government states in the White Paper that it considered options to simplify GMP legislation but decided that at present it is not possible to make any further significant reforms without interfering with employees’ property rights. GMP conversion legislation was introduced in 2009.

Comment

The Government has passed up the opportunity to simplify GMP legislation presumably because it was too difficult (arguably why the simplification of the legislation was needed!). However further legislation on equalisation for the effects of unequal GMPs still appears to be in prospect (see our bulletin here).

6. Timetable

The draft Pensions Bill was published on 18 January 2013 and submitted to the Work and Pensions Select Committee for pre-legislative scrutiny.

The Department for Work and Pensions is not running a formal consultation on the draft Bill but any comments on the draft legislation received by 22 March 2013 will be considered. In particular, it is expected that comments will be welcomed in relation to the scope of the new employer power of amendment.

The Select Committee is expected to publish a report following its scrutiny (currently expected to be completed by the end of the current session in April), and this will be considered by the Government before introducing the Bill as soon as is practicable thereafter.