End of Contracting-Out in 2016 - What should Schemes be doing?

From April 2016, a single tier state pension will be introduced. This will replace the existing basic state pension and the earnings related state second pension. DB contracting-out will also end on 5 April 2016. Although schemes will automatically cease to be contracted-out, there are a number of issues that need to be considered before April 2016 and some actions that might need to be taken.

Reference Scheme Test (RST) Benefits

Although contracting-out is ending, schemes will not be wholly free of any restrictions in relation to formerly contracted-out benefits.

To protect RST benefits, there will be a restriction on amending schemes that were formerly contracted-out (exactly the same as the restriction in current legislation). The restriction prohibits amendments being made in relation to RST benefits unless the benefits for the member and for their widow, widower or surviving civil partner are at least equal to those that would have been provided before the alteration.

The current restrictions on the way in which RST benefits can be paid as a lump sum will also continue to apply.

GMPs

The requirements in relation to GMPs after April 2016 are more onerous. Many of the existing statutory provisions in relation to the shape of the benefit that needs to be provided will remain in place. A member will remain entitled to a GMP, calculated in the same way as currently and existing entitlements to widow and widower’s GMPs and restrictions on lump sums will also stay.

GMPs are revalued in line with average earnings while contracted-out employment continues and then the scheme can choose between average earnings and fixed rate revaluation (currently 4.75% a year). When contracting-out is abolished, GMPs will need to be revalued in line with average earnings until pensionable service ends (unless contracted-out service ended before the abolition date); only after that will the choice of average earnings and fixed rate revaluation apply. Schemes will need to check their administrative processes to ensure that they comply with the new regime.

The increase requirements in relation to GMPs (inflation up to 3%) will also remain. However, currently, where inflation is higher than 3%, the Government will increase state pension entitlement to reflect the excess. After the abolition of contracting-out, it appears that the Government will no longer pay these additional increases.

The Government has said that more guidance on conversion of GMPs will be forthcoming and that it continues to consider the issue of GMP equalisation.

Underpins

Where a DC scheme was contracted-out on an RST basis (so a DB underpin was provided), the situation is more complex.

As we interpret the legislation, the value of the RST underpin would need to be calculated based on salary at 5 April 2016. There is no statutory requirement to revalue the underpin, so over time, its value would generally be expected to fall. However, this is not the only interpretation of the relevant provisions and there have been some arguments that the value of the underpin should be linked to final pensionable salary. The Government is considering this issue further and has said: “the issue is more complex than we first thought and we need more time to develop a solution that will satisfy all parties… We will revisit this issue”. Further regulations are likely.

The provisions in the Pension Schemes Act 1993 setting out the features of the RST will remain in place until 2019 so rules referring to them will still work for a while. Schemes should check the wording of any RST underpin and whether the way it is drafted could mean that it will continue to accrue after April 2016 rather than falling away on the end of contracting-out.

Employer’s unilateral amendment power

The end of contracting-out will mean that affected members and employers will pay higher national insurance contributions. Legislation is therefore in place to give employers a unilateral power to increase member contributions and/or reduce future service benefits to offset this higher employer cost. The power exists for a limited time only and the relevant statutory provisions will be repealed from 2021.

Employers can use this power: “(a) to increase the employee contributions of the relevant members; [or] (b) to alter the future accrual of benefits for or in respect of them”. However, not all amendments will be within the scope of this power. For example an increase in normal retirement age may not be covered. The increase in contributions or reduction in accrual cannot be more than is necessary to cover the cost of the increased employer NI and regulations contain provisions about how this should be calculated.

Employers will also need to consider whether any amendments are listed changes for the purposes of the Consultation Regulations, in which case a minimum of 60 days of consultation will be required before implementation. There is no explicit exemption, but some changes may not affect member benefits and therefore may not be covered. We may hear more on this point as the Government has promised more on disclosure obligations on the end of contracting-out.

Consideration should also be given as to whether any amendment should be made under these provisions or using the scheme’s own amendment power. The Government clearly envisaged that the scheme’s amendment power would be used where possible.

Other issues to consider

Offsets: Definitions of “Pensionable Pay” may include an offset by reference to the Lower Earnings Limit (LEL) or basic state pension – the idea being that earnings below this level are pensioned through basic state pension and not the scheme. Thought needs to be given as to whether these provisions will continue to work as intended once the single tier state pension is introduced. Does what the scheme provides still reflect the intended benefit design?

Basic state pension: If rules refer to “basic state pension”, schemes should look at whether relevant provisions will work as intended after April 2016. Basic state pension as defined may no longer exist. However, the value of basic state pension will continue to be uprated for people reaching state pension age before 6 April 2016 – so there will be a “basic state pension” value that can be used (where the rules allow). DWP confirmed this month that there will be no statutory power to amend rules to deal with old references to basic state pension that no longer work.

GMP reconciliation: When a scheme ceases to be contracted-out, trustees must inform HMRC how they are going to deal with contracted-out liabilities. Generally as part of the process of ceasing to be contracted-out, schemes reconcile their GMP liabilities with data held by HMRC. HMRC have requested schemes to approach them as soon as possible to begin this reconciliation process. They will not accept submissions for reconciliation after 5 April 2016.

Bridging pensions and level pension options: Some schemes allow for pension to be adjusted so that a member’s total benefits, including their state pension, are equal before and after they reach State Pension Age. This calculation is likely to need adjusting when the higher, single tier state pension is introduced.

Information for employer: Regulations oblige trustees to provide employers with information they reasonably require to exercise the unilateral power of amendment. This does not remove any obligations trustees have under data protection legislation and they will need to consider how any such obligations can be complied with when supplying any requested information.

Automatic enrolment: Contracted-out schemes automatically meet the qualifying scheme requirements for automatic enrolment. Once contracting-out ends, schemes used for auto enrolment will still need to meet the qualifying scheme requirements. If future accrual is amended to reflect the end of contracting-out, thought will need to given as to whether the requirements are still satisfied.

Disclosure: The Government is considering what disclosure will be required to members on the cessation of contracting-out, but clearly some communications will be needed and employers should be prepared for this.

Other things to be aware of...

The Chancellor announced a number of changes in the Budget that will affect occupational pension schemes:

• From 6 April 2016, there will be a tapered annual allowance for high earners – reducing from £40,000 to £10,000. Broadly speaking, for every £2 of income an individual has over £150,000 there will be a £1 reduction in the annual allowance.
• All existing pension input periods (PIPs) ended on 8 July 2015. All members have a new PIP starting on 9 July 2015 and ending on 5 April 2016. After that, PIPs will be aligned with the tax year. There are transitional rules for valuing accrual to April 2016, allocating DB benefit accrual between PIPs and determining the available annual allowance.
• Certain lump sum death benefits (mainly where paid after age 75) attract a tax charge of 45%. It is intended that where such lump sums are paid on or after 6 April 2016, they will be taxed at the recipient’s marginal rate.
• Further details on the Government’s proposals for a secondary annuity market will be provided in the Autumn and implementation will be delayed until 2017.
• The Government has launched a consultation looking at whether the way in which pensions are taxed and contributions and investment returns receive tax relief remains the most appropriate way of doing things. Consultation closes in September but whether it will lead to any changes remains to be seen. The Government acknowledges that the result of the consultation may well be that there is no better alternative than the current system.

If you have any comments on this publication, just e-mail us at pensions@cms-cmck.com.