Employers: Countdown to the abolition of DB contracting-out

Introduction

As a consequence of the introduction of the new single-tier state pension, DB contracting-out will be abolished with effect from 6 April 2016. With only six months to go, below we set out the issues which sponsoring employers of affected schemes should have on their agendas.

Key points

Employers should:

decide whether and, if so, how to amend the scheme with effect from 6 April 2016 to deal with the loss of the National Insurance rebate
work with the scheme’s trustees to ascertain whether any rule changes are required to ensure that, on and from 6 April 2016, rules will continue to work as intended and / or that accrued contracted-out rights will be preserved
(if relevant) ensure the scheme will continue to qualify for use as an auto-enrolment vehicle
ensure benefit information for new and existing employees is reviewed and updated.

Loss of the rebate

Employers and members of schemes which are contracted-out on a DB basis currently pay reduced NICs (employer contributions are reduced by 3.4% and employee contributions by 1.4%). With effect from 6 April 2016, participating employers and their employees will pay NICs at the full rate.

Recognising that this additional cost will be a blow for sponsoring employers of the remaining open DB schemes, the Government has provided employers with a unilateral power to amend their schemes, in relation to some or all of the members, to take account of the increase in the employer’s NICs.

Statutory modification power

An employer may only use the statutory power to recoup the increase in its NICs by either adjusting members’ future pension accrual or future contributions. The modification power may not be used in a way which would, or might, adversely affect the subsisting rights of a scheme member, or a survivor of a scheme member.

In addition, employers may not use the power to make amendments which would remove a power to determine any matter from the hands of a scheme’s trustees. For example, this is intended to prevent an employer amending the scheme rules so that it is the employer, rather than the trustees, who consents to members taking early retirement.

The statutory modification power will be complicated to administer and deliberately restricts the changes that can be made using it. For this reason, employers may wish to explore alternatives, such as:

amendments to employees’ contracts
using the scheme’s amendment power.

First, employers need to determine whether they want to take action to address the increase in their NICs, rather than absorb the extra cost. Then, if action is required, they need to liaise with their advisers to agree the process and draw-up a timetable. Remember, it will be necessary to check employment contracts to ensure there are no specific benefit promises which would impede the required changes. If there are such promises, these cannot be overridden by a rule change and will need to be dealt with separately.

Benefit design

Integration with state benefits

Certain schemes were designed to integrate with state benefits. For example, state benefits may be taken into account through:

a deduction in pensionable salary
a deduction to a pension in payment
a bridging pension.

The DWP has confirmed that the value of the basic State Pension (“BSP”) will be published in an annual Uprating Order, as it will continue to be required for those pensioners who remain entitled to BSP under the current rules, ie those who retire on or before 5 April 2016. For this reason, the DWP has decided that a power to modify scheme rules to reflect the State pension reforms will not be needed.

Although there will continue to be a notional BSP, employers should consider whether the scheme rules dealing with any integrated benefits will apply as intended once the new single tier pension is introduced. We recommend asking the scheme actuary to advise on the additional cost (if any) of applying such rules after the change.

Reference Scheme Test (“RST”) underpin

Since 6 April 1997, schemes contracted-out on a DB basis must provide benefits which are at least as good as those which would be provided under the statutory “reference scheme”.

Certain DC schemes contain an RST underpin. This provides members with a guaranteed minimum level of benefit at retirement. The DWP has yet to determine how best to deal with preservation of the RST underpin (for service between 6 April 1997 and 5 April 2016) for schemes that have not hardwired it into their rules. It has decided, in the interim, to preserve the provisions relating to the RST until 6 April 2019. Employers should consider whether a rule change is required to remove or retain the underpin for service on and from 6 April 2016.

Plan ahead!

Employers must be careful to allow enough time to complete any changes.

For example, it may be necessary to obtain the agreement of the scheme’s trustees, the amendments may trigger a statutory requirement for the employer to consult with affected members for a minimum of 60 days (even where the statutory modification power is used) and / or the proposed changes may trigger the requirements of section 67 of the PA95 (protection of subsisting rights).

Auto-enrolment

Schemes which are contracted-out on a DB basis (and therefore meet the RST) automatically qualify for use as auto-enrolment vehicles. Once DB contracting-out is abolished, if such schemes wish to retain this status they will need to meet the “cost of accruals” test. This test varies according to the scheme’s definition of pensionable earnings and is intended to broadly represent the cost of providing the benefits of the RST.

Communications

The DWP has devised a “State Pension toolkit” which contains guidance, a video, fact sheets, info graphics and photo case studies to help employers to communicate the April 2016 changes to the State Pension. It is encouraging employers to download and use this information to help to explain the changes to their employees.

In addition, employers must ensure that joining information for new employees is updated in time for 6 April 2016.

Next steps

Employers should discuss and agree a plan of action. For further information and assistance, please speak to your usual Sackers’ contact.