The end of the contracting-out era

25 / 05 / 2016

Last month saw the end of contracting-out, a creature which was introduced in 1978 to enable employers to integrate their scheme benefits with those offered by the State. It is clear that the impact of the end of contracting-out will affect employers and members to different extents. Here we provide a recap of the factors which employers and trustees should have been considering in the run up to 6 April 2016.

State pension offset

Many schemes which were contracted-out provide for a State pension offset (i.e. an offset of some or all of the individual’s basic State pension against the benefits provided by the scheme).  Where a scheme remains open to accrual the Scheme Rules should have been carefully checked to ensure that any State pension offset will continue to apply in respect of future pension.  Much of this will depend on the specific wording in the scheme’s governing documents.  An important point to note is that whilst the basic State pension has been “replaced” by the single tier State pension, a basic State pension figure will continue to be published for many years (albeit not indefinitely).  Important points to consider here are (i) whether the State pension offset will continue to work as intended for so long as the basic State pension figure continues to be published; and (ii) what happens when the basic State pension figure ceases to be published?  We have helped a number of schemes amend their rules to safeguard them against members becoming entitled to a windfall in benefits and increased cost to the Scheme as a result of the offset ceasing to be applicable.

Revaluation

The law requires GMPs to be revalued in line with national average earnings for so long as a member remains in contracted-out service with a scheme.  Normal practice is then to switch to fixed revaluation until the date at which the pension commences payment.  Scheme rules often only permit a switch at the time the member ceases to be in contracted-out service.  Since the end of contracting-out, no members are in contracted-out service.  Schemes have therefore had to consider whether they need to make any amendments to their scheme rules to enable fixed rate revaluation to be applied upon a member ceasing to be in pensionable service on or after 6 April 2016.

National Insurance Contributions (NICs)

The main advantage of being contracted-out of the State second pension was the reduced rate of NICS payable by the employer and the scheme members (a saving of 3.4% on band earnings for employers, and 1.4% for employees).  However, following the end of contracting-out that saving will no long be available.

Employer NICs: The impact of the increased national insurance contributions should have been assessed and managed by employers.  Some employers have taken advantage of the statutory override which was granted to them to pass the cost of the additional national insurance contributions on to members either by increasing member contributions for future service and/or reducing accrual rates for future service.  Where the employer has decided to take such action appropriate dialogue should have been entered into with the trustees and the members.

Some employers have taken the opportunity to make more significant changes to their benefit structure with a view to managing future costs, such steps generally fall outside the scope of the statutory override and have required compliance with the scheme’s own amendment power and the statutory consultation requirements.

Other employers have used this change as an appropriate opportunity to introduce salary sacrifice.  This is one method of helping to mitigate the increase in NIC cost to an employer.

Employee NICs: Furthermore, members should have been informed of the additional national insurance contribution that they will be obliged to pay.

Contracting-out certificates

Upon closing to accrual schemes were previously required to surrender their contracting-out certificates to HMRC.  This requirement will still need to be complied with by any schemes that closed to accrual before 6 April 2016.  However any scheme closing to accrual from 6 April 2016 onwards will not be required to take further action with regards to their contracting-out certificate as all contracting-out certificates for scheme open to accrual on 6 April 2016 are deemed to be surrendered.

Contracting-out may have ended, but we suspect it will continue to cause confusion for many schemes and members alike for many years to come.  If you are unsure about whether you have taken all necessary steps please do contact us!

Further Information

For further information on the topics raised in this article, please contact a member of the Pensions & Employee Benefits Team.