The Pensions Act 2007 reforms the State Second Pension (S2P) so that, eventually, it will become a simple flat-rate top-up to the basic state pension by 2030. Although the changes were originally scheduled to take place in 2012, the Government now intends to implement legislation to introduce the changes with effect from 6 April 2009. Where occupational schemes have a benefit structure which is linked to state pensions, action may be necessary to avoid an inadvertent change to benefits under the rules of some contracted-out schemes, depending on how they are expressed.

From 6 April 2009, the calculation basis of the S2P will be changed. S2P accrual after this date will be based on earnings between the Lower Earnings Limit (LEL) and the new Upper Accrual Point (UAP) which is fixed at £40,040, rather than the Upper Earnings Limit (UEL) as currently, which rises annually and which will be £43,888 for 2009/10. National Insurance (NI) contributions paid on earnings between the UAP and the UEL will no longer attract contracted-out rebates from 6 April 2009.

The consequences for contracted-out schemes include:

  • from 2009/10, NI contribution rebates will be based only on earnings up to the UAP, although NI contributions themselves will continue to be based on earnings up to the UEL; and
  • the Reference Scheme Test (for contracted-out salary-related schemes) will become easier to satisfy over time as it will be based on earnings between the LEL and the UAP, and the differential between these two figures will gradually decrease in real terms.

Schemes which provide pension benefits which are integrated with state scheme benefits may need to take action to avoid inadvertent changes to their benefit levels after 6 April 2009.  

For example:  

  • where a scheme targets a level of benefits minus the state benefit actually received, as the S2P is reduced, the employer's share of benefit provision would increase, increasing scheme costs for the employer;  
  • where a scheme deducts an amount for the state pension that is based on earnings between the LEL and the UEL, then the increase in the UEL resulting from the 2007 budget will reduce scheme benefits and thus also costs for the sponsoring employer. However, the deducted amount will no longer reflect the S2P unless the rules are updated so that the state pension calculation is made based on earnings between LEL and UAP; and  
  • where contributions are defined in the scheme rules in relation to the UEL, this may need to be amended prior to the implementation date to avoid problems with reduced NI rebates and s67 certification.  

Comment: we are advising trustees and employers of contracted-out final salary schemes in which there is ongoing benefit accrual to review their rules before 6 April 2009 when the changes take effect. They should also check whether an allowance has been made for the UAP in the employer's payroll system.