Defined benefit (DB) contracting-out will end in April 2016. All schemes, whether currently contracted-out, once contracted-out or (even) never contracted-out need to consider how they might be affected. While there are more issues for schemes open to accrual, the changes are relevant to closed schemes too. Are you ready for the changes? Our experts take a closer look at what the end of DB contracting out means for trustees and employers.
What is a defined benefit contracted out scheme?
The state pension currently consists of two parts - the basic state pension and the state second pension. Many defined benefit occupational pension schemes have "contracted out" of the state second pension. This means that members accrue a minimum level of benefits within their employer's scheme instead of building up a state second pension. Employers and active members pay lower National insurance (NI) contributions as a result (via a rebate). The rebate is based on a proportion of earnings - 3.4% for employers and 1.4% for active members.
Some pension schemes, whether contracted-out or not, have created benefit structures which seek to integrate with the state system in some way.
What is changing in April 2016?
From 6 April 2016, the basic state pension and state second pension will be replaced by a new single tier state pension. As there will no longer be a state second pension, it will no longer be possible for DB occupational pension schemes to contract out of the state second pension. Employers and active members of such schemes will lose their NI rebates and have to pay standard NI contributions going forwards. The change to the state system will impact on the way the rules of occupational schemes integrate with it. Employers and trustees need to consider how the end of DB contracting out will affect their scheme and how it might operate in the future.
Do I really need to worry about this now?
Yes. Although April 2016 might seem like a long way away, there are a number of actions that trustees and employers need to take. It is important to start planning now.
What can employers do about their increased NI costs?
For schemes open to accrual, employers have been given a "statutory override" which allows them to increase member contributions and/or reduce future service benefits to mitigate their increased NI costs.
Trustee consent is not required but members must be consulted over any such changes. An actuary must certify that the value of the proposed amendments does not exceed the increase in the employer's NI costs. The legislation sets out what assumptions the actuary uses and how it carries out the calculations. Trustees are required to give the employer any information it reasonably requests in connection with the use of its power.
Employers with open defined benefit schemes have a number of options for dealing with the increase in their NI costs:
- Absorb them;
- Increase member contributions;
- Reduce future service benefits; or
- Close the scheme to future accrual (the employer will need a business case for this)
Is there anything else employers and trustees need to think about?
Many occupational pension schemes were designed to interact with the state pension. For example the scheme rules may provide for state scheme offsets to apply to a member's pension by reference to the basic state pension, state second pension or lower earnings limit. Or members (including of closed schemes) could be paid a bridging pension linked to the state scheme. Contributions to schemes may be based on earnings which take into account the state system.
How will these rules work in light of the new single tier state pension? The answer will depend on the precise drafting of your scheme rules. We recommend that you take legal advice. Does the pension scheme (as now interpreted) still achieve its objective? If not, is a rule amendment needed? Employers are likely to need to liaise with trustees over any changes to the scheme rules.
Many schemes (including closed schemes) will need to review their Guaranteed Minimum Pension (GMP) Model Rules and consider how to apply revaluation of GMPs going forward.
If your DB scheme is being used as a qualifying scheme for automatic enrolment purposes, you will need to check whether it still meets the relevant criteria. All DB contracted-out schemes currently satisfy the quality requirement. When DB contracting out ceases they will need to meet either the test scheme standard or a new cost of accruals test.
HMRC's scheme reconciliation service
HMRC's scheme reconciliation service allows pension schemes to reconcile their membership and GMP data against HMRC records. The deadline for registering for this service in respect of each individual scheme is April 2016 so if you haven't already registered, you need to do so soon. The reconciliation process is likely to reveal discrepancies, with the most problematic relating to member overpayments. Trustees will need to decide whether or not to seek recovery of any such overpayments.
HMRC is publishing a number of "countdown bulletins" to help schemes and employers prepare for the end of DB contracting-out. You can access these bulletins here.