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The end of DC contracting-out: Will you be ready?

The Government is abolishing contracting out of the State Second Pension (S2P) on a defined contribution (DC) basis from 6 April 2012. From that date, anyone contracted out of S2P on a DC basis will automatically be brought back into S2P.

It also means that a person's accrued protected rights (i.e. contracted-out DC benefits) will cease to have any special significance, and will be no different from any other DC benefits.

What does this mean for affected employers? 

The main consequence for employers is an increase in their National Insurance Contributions (NIC) bill. Unless a decision is taken to contract-out on a salary-related basis in future, both the employer and his employees will have to pay NICs at the full standard rate. This is instead of the reduced rate currently payable in respect of an employee who is contracted out on a DC basis.

The increase in NICs is in theory off-set by the fact that neither the employee nor the employer will any longer be required to pay ‘minimum payment’ contributions into the pension scheme. These are of course equivalent to the NI reduction. However, in many cases, the minimum payment obligation is part and parcel of the agreed contribution rate, so if there is to be a reduction, it may well require a scheme amendment (possibly necessitating trustee consent), and must be preceded by at least 60 days consultation with the members affected. It should also be noted that the age-related rebate (payable to the scheme by the state) will also cease, so members' benefits will be further reduced.

It should also be borne in mind that the employer will in due course have to enrol its employees into a qualifying pension scheme, with minimum contributions payable by both. It may be wise to consider how the two events will interact with each other. Automatic enrolment is due to begin from October 2012 with employers being phased in by size (largest first) from this date.

Those employers who have defined benefit (DB) schemes with a DC contracted-out underpin will find that the amount they have to pay into the scheme will increase once the rebates finish.

Some employers may want to continue paying reduced NICs, and will consider switching to a salary-related basis for contracting out. This in itself raises all sorts of issues, many of which are related to the reason why so many employers are closing their DB schemes. It will also involve an election, and one month's notice to the employees (increasing to three months if any independent trade union requires it).

What does this mean for affected trustees?

Where scheme rules expressly set out the contracting-out requirements, they will need to be amended. Trustees will be given power by regulation to modify their schemes so that all references to protected rights in the scheme rules can be removed. This will operate for a three year window, i.e. until 5 April 2015. They may of course also use any amendment power they already have, although it is likely to involve the employer.

Trustees may be approached by employers with restructuring proposals, possibly involving the payment of reduced contributions. Any such that require their consent will need to be considered with care.

Trustees should make sure their scheme records are up to date and accurate before abolition. Up to now, HMRC have kept details of an individual’s contracted-out DC scheme membership, so schemes have been able to check the accuracy of the information they hold against HMRC records. However, once protected rights have gone, the accuracy of HMRC’s records will decline over time. Trustees should therefore take advantage of the situation while they still can.

Trustees will have one month from 6 April to inform members that the scheme is no longer contracted-out, and four months to inform members of the consequences (i.e. the removal of protected rights and basis for future accrual of scheme benefits).

The scheme booklet may need to be reviewed and revised.

A three year transitional window will allow for the recovery and adjustment of NI rebates arising before 6 April 2012.

Take action

Whether you are an employer or a trustee, if you have not already done so, you should contact your advisers to work out how to deal with the abolition of DC contracting-out. In particular, if consultation procedures are involved, these should be started no later than the end of January.

We would be happy to discuss your particular circumstances, and answer any queries you may have.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at January 2012. Specific advice should be sought for specific cases; we cannot be held responsible for any action (or decision not to take action) made in reliance upon the content of this publication.

TLT LLP is a limited liability partnership registered in England & Wales number OC 308658 whose registered office is at One Redcliff Street, Bristol BS1 6TP England. A list of members (all of whom are solicitors or lawyers) can be inspected by visiting the People section of this website. TLT LLP is authorised and regulated by the Solicitors Regulation Authority under number 406297.

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