Abolition of DB contracting-out: Countdown to April 2016

Introduction

Alongside the introduction of a new single tier state pension, contracting-out on a DB basis will come to an end with effect from 6 April 2016.  In preparation for this, regulations to preserve certain contracted-out rights have been finalised and laid before Parliament.

In this Alert

• Key points
• Background
• Why is DB contracting-out being abolished?
• New rules for existing contracted-out benefits
• Scheme benefits linked to the Basic State Pension
• Government guidance
• Next steps

Key points

• Although contracting-out on a DB basis will come to an end from 6 April 2016, the majority of contracted-out rights accrued before that date are to be preserved.
• A transitional period will run for three years to allow schemes to deal with practical issues arising from the abolition of contracting-out.
• An Uprating Order will continue to be published annually for the basic state pension (BSP), which will help schemes that have integrated it into their benefit structure.

Background

The current state pension system comprises the BSP, the additional state pension which is linked to earnings pension (commonly known as S2P but formerly SERPS), and the pension credit (a means tested benefit).

It is possible for employers to “contract out” of the additional State pension by providing an occupational pension which meets certain statutory requirements (these have changed over the years).  The aim of these requirements is to ensure that employees will become eligible to receive a pension in their contracted-out scheme which is broadly equivalent to the additional state pension to which they would otherwise have been entitled.

In return for the employer providing a pension which meets the statutory minimum, both the employer and the employee pay reduced rates of NICs.  Employer contributions are currently reduced by 3.4% and employee contributions by 1.4%.

Why is DB contracting-out being abolished?

With effect from 6 April 2016, the Government intends to replace the current state pension system with a flat rate single-tier pension (see our Alert for details).  A key consequence of this is that employers will cease to have the option to contract their employees out of the additional state pension on a salary-related basis.  DB contracting-out will therefore also cease to exist from the same date.

One of the most significant implications of the abolition of DB contracting-out is that both employers and employees will need to start paying the standard rate of NICs.  Regulations are already in place to provide employers with a limited, but unilateral, power to amend their schemes in relation to some or all members, to take account of the increase in employer’s NICs.  However, any changes to scheme rules made under this power cannot take effect until 6 April 2016.

For more details on the new power, see our Alert on the unilateral amendment power.

New rules for existing contracted-out benefits

Unlike contracted-out DC benefits (where protected rights were converted into ordinary scheme benefits), on the abolition of DB contracting-out, contracted-out rights accrued before 6 April 2016 will be retained within schemes and will remain subject to the same statutory requirements as before.  These include certain restrictions on the alteration of contracted-out rights.

To achieve this, The Occupational Pension Schemes (Schemes that were Contracted-out) Regulations 2015 set out rules applicable to schemes that were contracted-out on a DB basis immediately before 6 April 2016.  Such schemes will need to continue to comply with these rules on and from that date, in respect of accrued contracted-out benefits.

Guaranteed Minimum Pensions and Section 9(2B) rights

The regulations supplement provisions in the Pensions Act 2014 which will, broadly, require former DB contracted-out schemes to continue to meet the legislative requirements in relation to both GMPs and Section 9(2B) rights.  Among other things, they provide for:

• the protection of benefits for surviving spouses and civil partners
• revaluation, including protection for individuals whose contracted-out employment ended before 6 April 2016 but who remain active members of their schemes
• the payment of lump sums
• suspension and forfeiture in specified circumstances
• (in the case of GMPs) conversion into other benefits.

Restoring State Scheme rights

Where a scheme is winding-up underfunded, members can currently have their additional state pension rights restored under a process known as “deemed buyback”.  The regulations provide that deemed buyback will only apply where the scheme was being wound up before 6 April 2016.

Contributions Equivalent Premiums

An employee with more than three months but less than two years’ qualifying service will be entitled to either a cash transfer sum or a refund of their employee contributions.  A person with less than three months’ pensionable service will generally only be entitled to a refund of their contributions.  In some circumstances, early leavers’ rights to the additional state pension can be reinstated so that they are treated as if they had never contracted-out.

The regulations will allow this facility to continue.

Scheme benefits linked to the Basic State Pension

Many workplace pension schemes operate a structure in which contributions, or part of the benefit, are linked to the BSP (for example, in the form of “bridging” or “clawback” pensions).

The BSP will be replaced by the new single tier state pension for people reaching state pension age on and after 6 April 2016.  The value of the BSP, however, remains for people reaching state pension age before 6 April 2016. The DWP have therefore confirmed that they will continue to publish the annual Uprating Order specifying the BSP following its abolition.

Schemes will continue to be able to refer to this amount where the BSP is part of a scheme’s benefit structure.

Government guidance

The DWP and HMRC are currently working together on guidance for pension scheme administrators / trustees of contracted-out DB schemes.  HMRC will also be working with stakeholders to update its guidance manual for publication in early 2016.

In the meantime, the DWP has published a factsheet on the new state pension transition and contracting-out which sets out:

• how contracted-out amounts will be treated in the new state pension
• how revaluation will work for GMPs
• the effect on uprating of the ending of the additional state pension.

Next steps

A three year transitional period will run until 6 April 2019 to enable trustees and HMRC to carry out essential tasks in relation to any period of contracted-out employment before 6 April 2016, such as those relating to the issue, variation and surrender of contracting-out certificates.  However, trustees must send an “expression of interest” to use HMRC’s GMP reconciliation service before 5 April 2016.

One issue identified during the DWP’s consultation was how Reference Scheme Test underpin schemes should be preserved.  Due to the complexity of this issue, it will be the subject of further review by the DWP.

The DWP has also said that it intends to consult later in 2015 on further consequential changes to the legislation, including regulations that will deal with contracted-out benefits on transfers.