There has been much discussion surrounding the impact of the abolition of contracting-out on defined benefit (DB) schemes, with many expressing concerns around the increased costs and administration burdens to the employers of such schemes.
Contracting-out is the process by which an employer provides a pension arrangement for employees which replaces all, or part, of the additional State Pension. Individuals and employers in such instances benefit by paying lower National Insurance contributions (NICs). The introduction of the single tier State Pension, with effect from 5 April 2016, will bring an end to contracting-out. This will have important consequences for employers, employees and trustees of DB schemes which are currently contracted-out.
In response to this, the Department for Work and Pensions (DWP) has recently produced guidance fact sheets those affected on the impact of this upcoming abolition.
It is estimated that there are currently 2,500 private sector employers who offer open salary related contracted-out schemes and who will, therefore, be affected. The new guidance available to employers focuses on the practical consequences, for example that they will pay standard NICs from April 2016 rather than the contracted-out rate. This will mean an increase of 3.4% of relevant earnings in respect of each contracted-out employee, which is a large difference in overall terms.
It is important to note here that employers may make changes to their workplace pension scheme to help offset the end of the National Insurance rebate. The new guidance includes an explanation of the statutory override that employers will have, which will allow employers to amend scheme rules, subsequent to the abolition of contracting-out, without trustee consent to reduce scheme costs in order to offset the increase in NICs. However, employers must not increase employee contributions or reduce employees’ benefits by a greater value than the amount of their lost National Insurance rebate.
The guidance recommends that employers now seek advice in order to explore their options.
Employees who pay into a salary-related workplace pension scheme may be contracted-out.
Upon abolition of contracting-out there will be a new single tier State Pension for people reaching State Pension age on or after this date (6 April 2016). The change in the State Pension is intended to help individuals better understand what they will get from their State Pension so that they can plan adequately for their retirement.
Similarly to employers, as a result of abolition, employees who are currently contracted-out will have to pay full rate NICs. This means an increase equivalent to 1.4% of relevant earnings, meaning they will pay the same rate that is paid by other employees.
The guidance to trustees explains the change in NICs and the statutory override mentioned above, along with the impact that abolition will have on members’ benefits and the fact that HMRC will cease to hold information about which schemes hold GMPs and other contracted-out rights for scheme members.
Trustees should be encouraged to make plans to identify the impact of the abolition of contracting-out on their scheme as early as possible and use HMRC’s GMP reconciliation service to ensure that the scheme’s records are correct.