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Is Your DB Scheme Design Ready for a Post Contracting-out World?

As Seneca once said, “Whatever begins, also ends” and so it is with UK state pension provision.

The first earnings related element of state pension was introduced in 1961 and, despite a number of revisions, has formed part of state pension provision ever since. However on 6 April 2016 all this changes with introduction of the new single tier state pension. The earnings related element of the state pension will be no more and with it the option available to employers of defined benefit (DB) schemes to contract-out will automatically come to an end.

Since its introduction in 1978 contracting-out has been an attractive option for employers of DB schemes whereby in exchange for providing a minimum pension under the scheme in place of the earnings related element of the state pension, both employers and employees have enjoyed a rebate on their National Insurance contributions.

Contracting-out may be gone but as is so often the case with changes to pensions, sadly it cannot simply be forgotten. The changes to the state pension and the abolition of contracting-out have implications for DB schemes in the following key areas:

Increased National Insurance Contributions

From 6 April 2016 the National Insurance rebate falls away 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, which for employers will mean an increase in respect of each contracted-out employee of 3.4% of earnings between the Lower Earnings Limit (£5,824pa 2015/2016) and the Upper Accrual Point (£40,040pa 2015/2016) and for employees an increase in their National Insurance contributions of 1.4% of their earnings between the Lower Earnings Limit and the Upper Accrual Point.

For any schemes open to future accrual, scheme 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. Employers could choose to do nothing and simply absorb these additional costs. The Government however recognises that many employers of contracted-out schemes will deem it unreasonable to be asked to bear the cost of paying higher National Insurance contributions whilst maintaining the same level of benefits under their scheme, and as a result will want to consider ways to reduce future pension costs.

Whilst the Government expects that in most cases the employer and trustees will work together to determine how the scheme provisions should be amended to mitigate the impact of the increase in National Insurance contributions and will affect the agreed changes using the scheme’s power of amendment, it acknowledges that this may not always be possible. Since scheme amendment powers do not generally allow employers to unilaterally amend their scheme provisions, the Government has introduced legislation giving employers (who cannot or choose not to make changes using the scheme amendment power) a limited statutory power to amend their schemes as a result of the abolition of contracting-out without the need for trustee consent.

To give employers sufficient time to consider and implement any changes they may consider necessary, the overriding power came into force in April 2015, although any rule amendments made in exercise of the power cannot take effect until 6 April 2016.

The overriding modification power will remain in force until 5 April 2021 and allows employers to amend the scheme rules to increase member contributions or reduce 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.

Where an employer (or in the case of a multi-employer scheme, the principal employer or such other person nominated to act on behalf of all the employers) wishes to exercise the overriding modification power it should also bear in mind that:

  • amendments can only be made in respect of future service, the power cannot be used in any way which would or might adversely affect subsisting rights
  • amendments can be made in relation to both current and future members
  • amendments are prohibited if they would remove a power to determine any matter from the trustees (e.g. removing a trustee consent requirement in relation to an early retirement provision)
  • the employer will be required to appoint an actuary (who should not be the Scheme actuary) to certify that the proposed amendments comply with the statutory requirements
  • the overriding power can be used to amend a scheme in relation to the same members on more than one occasion
  • the trustees are required to provide any information reasonably requested by the employer in connection with the exercise of the power (trustees can therefore refuse to supply membership data which they consider to be in excess of that necessary to enable the actuary to certify the proposed amendment)
  • scheme contributions made by salary sacrifice are not covered by the overriding modification power as they are expected to be contractual arrangements
  • the power cannot be used in relation to public sector schemes or in respect of employees of former nationalised industries whose benefits are protected by privatisation legislation.

Amendments which fail to comply with the statutory requirements will be deemed void.

Trustees 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. The trustees will need 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.

When the overriding modification power was being consulted upon concerns were raised that employers might “double dip” by making changes with the trustees under their scheme power of amendment to take account of increased costs due to the abolition of contracting-out, and then seeking to make further changes using the statutory override. The Department of Work and Pensions has therefore suggested that trustees should obtain the employer's written consent, when making any changes to recoup their increase in National Insurance costs under the scheme’s amendment power, to the effect that they will not subsequently use the statutory override power.

Future administration of contracted-out benefits

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.

Whilst many schemes are already making use of the HMRC’s GMP reconciliation service, trustees will need to ensure that post 5 April 2016 their 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 their scheme rules which cease to be a statutory restriction and could therefore be removed or relaxed under the scheme.

The contracting-out provisions in 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 a rule amendments made in accordance with the scheme power of amendment.

Integrated Scheme Design

Some schemes (both contracted-in and contracted-out arrangements) 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 a scheme operates any form of integration within their benefit design, the employer and trustees will need to review the on-going suitability of the 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.

Additional Issues

Employer consultation: Where member contributions are to be increased or benefit accrual reduced, the proposals will be treated as listed changes under the employer consultation regulations regardless of whether the rule changes are intended to be made using the scheme power of amendment or the statutory overriding modification power. As a result prior to amending the scheme rules, the employer will need to enter into a 60 day consultation process with affected members.

Employers are also advised to review the pension terms in staff contracts of employment to ensure that any proposed changes do not require the alteration of any contractual promises.

Member communications: Members of DB contracted-out schemes will need to be advised about the abolition of contracting-out, the impact this has on their national insurance contributions and accrued scheme benefits and any changes which are being introduced to reflect the increased employer costs. Equally for contracted-in schemes 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. Scheme booklets will also need to be updated.

The bigger picture: Where an employer reviews the scheme provisions with a view to mitigating the cost of additional National Insurance contributions, it may 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.

Such an exercise will not of course be covered by the statutory modification power and will require detailed consideration by both the employer and the trustees. The trustees too may consider that the extent of the rule amendments required to reflect employer requested changes 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.


6 April 2016 is only 6 months away, employers of DB contracted-out schemes (or those with a contracted-in scheme with an integrated scheme design) who have not already begun to do so, need to take steps now to:

  • consider (with actuarial input) what changes (if any) should be made to their scheme to mitigate the costs of their additional National Insurance contributions
  • discuss and agree the proposals with the trustees with a view to amending the scheme using the scheme power of amendment
  • if trustee agreement cannot be obtained and/or the scheme amendment power cannot be exercised, appoint an actuary and use the statutory override route to affect the scheme changes
  • ascertain whether the change requires a consultation exercise with staff
  • put in place a timetable to ensure the rule amendments are in place to coincide with the abolition of contracting-out.

For further information about the new single tier pension and the abolition of contracting-out and for any assistance in amending your pension scheme rules and member literature in light of the changes please contact the Pensions Team at Irwin Mitchell.

Key Contact

Kate Byers