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Contracting-out and two-tier state pension abolished: what should you be doing now?

On 6 April 2016, contracting-out for defined benefit (DB) pension schemes was abolished. In this note, we highlight some points arising from this that are relevant for trustees and employers with a DB scheme that was previously contracted-out.

Background

Before last week, DB pension schemes were permitted to contract-out of the state second pension by guaranteeing their members certain minimum benefits and, in return, both employers and members paid reduced National Insurance contributions (NICs). 

The government has abolished the two-tier state pension and replaced it with a single-tier state pension. As part of this, contracting-out has also been abolished. All DB schemes that were contracted-out ceased to be contracted-out on 6 April 2016.

Issues for employers

The headline issue for employers is the additional cost resulting from increased NICs where a scheme ceased to be contracted-out on 6 April 2016. There will be an immediate cost impact and, depending on the size of the workforce that was previously in contracted-out employment, this may be significant.  

Legislation has introduced a modification power which can be used by employers to make changes to benefits provided to members under their pension scheme in order to offset their increased costs. The modification power is limited to changes to achieve this objective only and cannot be used to create a windfall for the employer or to make other amendments to the pension scheme that may be required as a consequence of the abolition of contracting-out. There are statutory requirements that need to be satisfied in order for the modification power to be effective, including the requirement for an actuary's certificate.  

As an alternative, it may be possible to amend the scheme rules to the same effect under the scheme's amendment power, depending on the terms of that power.  

Consultation with affected members is likely to be required where scheme benefit changes are proposed. Employment law advice may also be required on whether affected employees have a contractual right to existing benefits. 

Employers should, if they have not already, contact scheme members to communicate how the abolition of contracting-out affects them and ensure that HR departments are briefed on how to respond to member queries over the coming months, as members see reduced levels of take-home pay due to them paying a higher rate of NICs.

Employers would also benefit from considering the effects that the higher state pension age (moving from 65 to 68) may have on their human resourcing plans, any bridging pensions provided under their pension scheme (if applicable) and scheme liabilities. 

If your pension scheme is used for auto-enrolment purposes, you must check that the scheme meets the quality requirements under auto-enrolment legislation from 6 April 2016. Before that date, your DB contracted-out scheme did not need to be certified as meeting the quality requirements for auto-enrolment, but that has now changed.

Issues for Trustees

For all schemes (whether open or closed to accrual), we recommend that a legal review of the scheme's governing documentation is carried out to ensure that the abolition of contracting-out does not have any inadvertent, adverse effects on the scheme. Issues may arise, for example, where the scheme benefit design provides an underpin to benefits based on the "reference scheme test" or where there is a basic state pension offset to benefits. Such provisions may no longer be effective from 6 April 2016, when the reference scheme test and the basic state pension ceased to exist. This may adversely affect members' benefits or result in increased scheme liabilities. Rule amendments may be necessary to clarify areas of concern and to ensure that scheme liabilities are not increased. All references to statute and contracting-out in scheme rules should also be updated in line with current legislation. 

There is a technical but important issue, as a result of the abolition of contracting-out, that is relevant for schemes that are open to accrual and use the fixed rate revaluation (FRR) basis for revaluing members' guaranteed minimum pensions (GMPs). Depending on how scheme rules are drafted, if trustees do nothing it is possible that from 6 April 2016: 

  • the GMP revaluation method used will have to be the better of statutory FRR and revaluation under the scheme rules; and
  • some schemes may have lost the option to choose FRR for the revaluation of GMPs.  

A statutory modification power has been introduced, from 6 April 2016, that trustees can use to amend scheme rules by resolution to provide for the new statutory FRR and to preserve their ability to choose FRR. Trustees have until 6 April 2017 to make such a modification. Alternatively, it may be possible to make rule amendments to the same effect under the scheme's amendment power, depending on the terms of that power. This would provide trustees with certainty as to how GMPs are to be revalued after 6 April 2016.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at April 2016. Specific advice should be sought for specific cases. For more information see our terms & conditions.

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