Irwin Mitchell | Pensions Update | Cessation of salary related contracting-out: Helping you to navigate the way ahead

Cessation of salary related contracting-out: Helping you to navigate the way ahead

Changes at a Glance

  • New single tier state pension. The additional earnings related element of the state pension state is withdrawn for members retiring from 6 April 2016. Employees’ entitlement to the new basic state pension will be adjusted (reduced) to take account of any years prior to 6 April 2016 during which the employee was in contracted out employment
  • More cost for employers and staff. Increase in NIC plus 3.4% (employer), 1.4% (employee). Employee on £40,000 pa.- employer pays an extra £1,162 pa while employee take home reduces by £486 pa. (2015/16 rates).
  • Existing Rights Preserved. Contracted rights up to 5 April 2016 are unaffected. NB that means GMP equalisation is still a retained risk and liability. Also there is a need to retain reference scheme compliant past benefits.
  • Overriding Power. A statutory power is available to reduce benefits to bring costs back in line. It’s use may be limited. Most who amend will use existing rules.
  • Action Required? Employers may want to review benefits and costs. Trustees will need to review their scheme documentation and administrative processes
  • Notify staff? For schemes currently contracted-out, the change in status should be disclosed. For other schemes no formal requirement if no changes planned but very advisable to let them know

On 6 April 2016 the earnings related element of the state pension will cease and with it the option available to employers of defined benefit schemes to contract-out. No urgent action is needed for schemes which have already ceased accrual. For any schemes currently contracted-out the National Insurance rebate will fall away from 6 April 2016 and employers and employees (in contracted-out employment as at 5 April 2016) will have to start paying the standard rate of National Insurance contributions. For employers this will mean an increase in respect of each contracted-out employee of 3.4% of earnings between the Lower Earnings Limit (£5,824 pa 2015/2016) and the Upper Accrual Point (£40,040 pa 2015/2016). For employees this will mean an increase in their National Insurance contributions of 1.4% of their earnings between the Lower Earnings Limit and the Upper Accrual Point.

Contracting-out may be gone but as is so often the case with changes to pensions, it cannot simply be forgotten. The changes to the state pension and the abolition of contracting-out have implications for defined benefit schemes (and potentially for schemes not contracted-out on a salary related basis) in a number of key areas.

With only about 6 weeks to go before 6 April 2016, employers and trustees need to review their pension schemes now to ensure they remain fit for purpose once contracting-out ceases to apply.

Is my pension scheme affected?

The changes will have an impact on more pension schemes that just those which are currently contracted-out.

If your scheme is:

  • a scheme that is open to further accrual and is currently contracted-out;
  • a scheme that is no longer contracted-out but has accrued post 97 contracted-out rights (sometimes referred to as section 9(2B) rights) from an earlier period of contracted-out employment - this would include a defined contribution scheme whose rules contain a post 97 contracted-out rights underpin for individual members;
  • a scheme (whether open or closed) that provides GMPs in respect of contracted-out employment before 6 April 1997;
  • a scheme which integrates with the state scheme in some way, for example if provision is made for a state scheme offset (i.e. either the salary definitions or pension entitlement in your rules refers to the state pension or national insurance rates) or a bridging pension;
  • a defined contribution scheme with contributions calculated by reference to state pensions

you may be affected by the abolition of contracting-out at 6 April 2016.

Even if you think your scheme is unaffected by this change, it would still be wise to review your scheme provisions now to ensure that there are no unexpected consequences under the scheme from 6 April 2016 when contracting-out ceases.

What do Employers need to do?

Increased costs

For any contracted-out schemes open to future accrual, pension provision will remain unchanged but employers will experience an increase in their payroll costs whilst members will see a reduction in their take home pay. You can choose to do nothing and simply absorb these additional costs. Alternatively you may decide to mitigate your additional costs by increasing member contributions or reducing future service benefit provision.

Any such changes can be made using the scheme power of amendment. Alternatively you can choose to make the change using the statutory overriding modification power which allows employers to amend the scheme rules to increase member contributions or reduce future scheme liabilities (e.g. the future accrual rate) without trustee consent but only to the extent to which the changes are required to offset the increase in the employer’s National Insurance contributions which results directly from the end of the contracting-out rebate.

Proposed changes to future accrual rates or to increasing member contributions will be treated as a listed change under the employer consultation regulations and as such will require a 60 day consultation exercise with affected staff before the pension scheme rules can be amended. For changes taking effect from 6 April 2016 an employee consultation exercise would need to have begun no later than 5 February 2016.

In addition when making any changes to future service pension provision, you should be mindful of any implied duty of good faith with regard to previous pension promises made to staff. Employees' contracts of employment will also need to be considered to assess whether (and the extent to which) these contain any contractual obligations with regard to pension provision. Similarly, employers with unionised workforces will need to consider any agreements in place with regard to a proposal to change future service pension provision.

If, as an employer, you do not currently operate a salary sacrifice arrangement, you may also wish to consider introducing one in order to reduce the impact for both yourself and the employees of the increase in National Insurance contributions from 6 April 2106. Bear in mind of course that further changes might result from the 2016 budget announcement on 16 March.

The bigger picture

If you intend to review the scheme provisions with a view to mitigating the cost of additional National Insurance contributions, you may also wish to take the opportunity to review more fully the scheme design and funding liabilities. Changes which might be considered alongside an increase in member contributions or a reduction in future accrual might include:

  • capping future pensionable salary increases
  • increasing the scheme normal retirement date or linking it to state pension age
  • introducing salary sacrifice arrangements for member contributions
  • adjusting existing basic state pension or lower earnings limit deductions to salary or benefit calculations
  • closing the scheme to future accrual.

This wider exercise will not be covered by the statutory modification power and will require detailed consideration by both the employer and the trustees and will need to comply with the terms of the scheme’s power of amendment and, to the extent required, the employer consultation requirements.

Where wider amendments are proposed the trustees may consider that the extent of the rule amendments together with the changes needed to reflect the post April 2016 contracting-out administrative requirements mean a consolidated trust deed and rules should be put in place so as to reduce the risk of any misinterpretation of the revised scheme provisions.

Auto-enrolment compliance

From 6 April 2016, it will no longer be possible for a scheme to use its contracted-out status to meet the auto-enrolment obligations of the employer.

Employers who currently rely upon the scheme’s contracted-out status in order to meet the quality requirements under the automatic enrolment legislation need to take action now to demonstrate that the scheme will continue to meet the quality requirements once contracting-out is abolished and make any changes necessary to their certification process to ensure continued compliance from 6 April 2016.

Deferring Changes until after April 2016

If you do not take any action to alter your scheme design before 6 April 2016, this will not prevent you from making changes at a later date (you can use statutory overriding modification power until at least 2020 and the scheme amending power at any time), however you should be aware that any changes you seek to introduce are unlikely to be able to have backdated effect, and will apply only to future service.

What do Trustees need to do?

Employer proposals

Trustees of contracted-out schemes who have not yet discussed the cessation of contracting-out with the sponsoring employer should ask it now how it is proposing to address the abolition of contracting-out.

Increased member contributions

Trustees of schemes which are currently contracted-out should note that where an employer uses the overriding power to alter contribution rates these do not automatically feed through to the schedule of contributions, nor does the power enable an employer to vary the debts it owes to the scheme without trustee agreement. You will need therefore to react to any changes considering the relevant scheme funding documentation and consider whether the schedule of contributions needs to be revised in light of the change.

Accrued contracted-out rights

Notwithstanding that schemes can no longer be contracted-out, the contracted-out rights relating to Guaranteed Minimum Pensions and post 97 contracted-out rights accrued prior to 6 April 2016 and many of the rules relating to them will remain in force.

If your scheme is currently contracted-out or has been contracted-out in the past and has any accrued post 97 contracted-out rights and/or GMPs, as trustees, you will need to ensure that post 5 April 2016 your scheme rules reflect the on-going statutory requirements for accrued contracted-out benefits and that these benefits are administered accordingly. Account should also be taken of any pre 6 April 2016 restrictions and requirements applicable to contracted–out benefits included within the scheme rules which cease to be a statutory restriction and could therefore be removed or relaxed under the scheme.

The contracting-out provisions in your scheme rules will need to be reviewed and will almost certainly need to be amended to reflect the post April 2016 position. These changes are not covered by the overriding modification power and will need to be affected by means of rule amendments made in accordance with the scheme power of amendment.

GMP Reconciliation

In addition if any entitlement to GMP exists under your scheme and no action has been taken yet to reconcile the scheme’s GMP records with those held by HMRC, immediate consideration should be given to making use of the HMRC’s GMP reconciliation service.

GMP reconciliation is important because of the need not only to ensure that the total amount of pension is correct but also to ensure that the correct cash is paid and the correct revaluation and increases are applied.

Using the reconciliation service offers your scheme a one-off opportunity to improve its data, helps you comply with the Pension Regulator’s guidance on record-keeping, and to improve the fitness of your data for future liability management or de-risking exercises.

GMP Equalisation

Both the rate at which GMPs accrue and the date from which they are paid differ between men and women. The Department for Work and Pensions however require GMPs to be equalised (although to date have not specified exactly how this should be achieved).

If you have not equalised your GMPs (and few schemes have done so) you should be aware that the abolition of contracting-out does not remove this requirement. If your administrators are undertaking a GMP reconciliation exercise for you, you may wish to ask them whether this would be an opportune time to consider how best to achieve GMP equalisation.

Administration services and agreements

For Trustees of schemes with post 97 contracted-out rights and/or GMPs, checks should be undertaken with the scheme administrators to assess whether the abolition of contracting-out will give rise to any particular administration issues and whether or not these are within scope of the existing administration agreement or whether any changes to the services and fees specifications need to be negotiated.

Matters of detail with regard to the way in which contracted-out rights accrued prior to 6 April 2016 are to be calculated and administered in future will need to be agreed with scheme administrators. The Trustees will need to be satisfied that contracted-out accrued rights comply with the post April 2016 statutory requirements, that revaluation is applied using an agreed statutory option and that provision in excess of the statutory provisions is made only to the extent to which the employer and trustees have agreed they should apply.

Integrated Scheme design

Whether your scheme is contracted-in or contracted-out it may have been designed to take into account the income upon which employees pay National Insurance contributions and the state pension to which scheme members will become entitled on retirement. As a result the scheme design may include offsets equal to the lower earnings limit or basic state pension on salary definitions or pension entitlements or may include bridging pension provisions.

Where your scheme operates any form of integration within their benefit design, you will need to work with the employer to review the on-going suitability of these provisions in light of the changes to the state pension.

Changes made as a result of an integrated scheme design are not included within the statutory modification power and so any proposed rule changes will need to be agreed between the employer and trustees and made in accordance with the scheme’s own power of amendment.

What do scheme members need to be told?

Although there is no statutory requirement to notify members of the changes to the state pension scheme from 6 April 2016, there is a requirement to disclose the change in the scheme’s status that will occur as a result of the abolition of contracting-out to members in contracted-out employment. In addition any related scheme changes are also likely to be subject to the disclosure requirements and trustees will need to comply with their disclosure obligations to advise members of those changes.

If your scheme is contracted-in with integrated benefits, members will need to be advised of any rule changes made in light of the introduction of the single tier state pension.

Where any rule changes are being introduced the employer will need to communicate with members before adopting those changes if a consultation exercise is required.

Notwithstanding the lack of a statutory requirement, as a matter of good practice, employers and trustees may wish to notify members of the changes to the state scheme, the entitlement rules to the new single tier pension, the impact the abolition of contracting-out has on their national insurance contributions and accrued scheme benefits in, for example, a scheme newsletter or annual report.

A communication exercise may help to manage members’ expectations particularly as employees either in contracted-out employment now or who have previously been in contracted-out employment are likely to receive a lower amount of single tier pension on reaching state pension age than the £155 per week rate widely publicised in the press. Communicating now may help to reduce staff concerns directed at HR departments or the trustees in future.

In the longer term all scheme booklets will also need to be reviewed and updated to reflect the changes to the state scheme, contracting-out and any related scheme changes.

If having read this you are concerned that you have not taken all the action you need to in relation to your pension scheme to future proof it against the abolition of contracting-out we will be happy to undertake a fixed fee review of your pension scheme documentation to identify any areas where you need to act.

For further information please contact:

Martin Jenkins - National Head of Pensions -
Andrew Ashley Taylor - Partner -
Nigel Bolton - Partner -
Penny Cogher - Partner -
Kate Byers - Head of Pension Documents -

Key Contact

Kate Byers