As part of the seemingly never-ending raft of pensions reform, the flat-rate state pension has been introduced to replace the current basic state pension and earnings-related state second pension (S2P) system. A major consequence of this is the abolition of contracting-out for contracted-out salary-related (COSR) schemes from 6 April next year. The impact of this is far-reaching, and employers and trustees need to take steps now to ensure that their schemes are ready.
Contracting-Out – The basics
Currently, where an employer operates an occupational pension scheme, that employer can contract out of S2P, reducing the National Insurance Contributions (NICs) payable by employer and employee and providing alternative benefits through the scheme which meet certain minimum requirements.
This system is being replaced from 6 April 2016 by a single-tier flat-rate pension, under which S2P will be abolished. This means it will no longer be possible for employers to contract out of S2P.
The implications for your scheme
The most obvious issue which the abolition of contracting-out will raise for employers is the cost implications for employers and members alike. However, employers and trustees should also be alive to other issues. For example:
- Does the scheme have any benefits calculated by reference to S2P?
- What will the impact be on compliance with auto-enrolment obligations?
- How will the scheme deal with the reconciliation of Guaranteed Minimum Pensions (GMPs)?
Employers and trustees should consider the steps required to ensure their scheme is prepared.
One of the main reasons for contracting-out is the cost benefits to employers and members. In exchange for the promise of certain minimum scheme benefits, employers and members pay lower NICs. These NIC rebates cease and full NICs become payable once contracting-out is abolished.
Employers need to consider the impact of this change on their liabilities – it will become more expensive to provide the same benefits to members. Options include reducing scheme benefits, closing to future accrual or absorbing the extra cost associated with this change. This may involve scheme amendments or consultation exercises, and companies therefore need to act fast to obtain advice in enough time to allow changes to be made before 6 April.
In addition, members of COSR schemes will be required to start paying additional NICs to receive the same benefits from their schemes. These amounts may be significant to some members, and trustees should take appropriate steps to inform them of the impact of the abolition of contracting-out on them.
Some COSR schemes offer benefits which are linked or refer in some way to the current state pension system. Employers and trustees should consider instructing a review of their scheme rules and administrative practices to identify any issues which need to be resolved prior to the abolition of contracting out.
Currently, employers can comply with their auto-enrolment obligations in respect of existing COSR scheme members by showing that the scheme satisfies the Reference Scheme Test (RST). From 6 April, it will not be possible for a scheme’s contracted out status to be used in this way. Employers will therefore need to establish another method to show their scheme meets the auto-enrolment quality requirements in advance of next April.
Following the abolition of contracting-out, COSR schemes will be in a position to reconcile their GMP records with HMRC. This reconciliation ensures that schemes and HMRC hold identical records and can reveal important issues which impact on the level of benefits payable to members.
However, schemes which need to reconcile GMPs should act fast. From December 2018, schemes will be required to use HMRC’s GMP figures with no recourse for reconciliation of any discrepancies. In addition, any scheme wishing to use HMRC’s Scheme Reconciliation Service must make a request, at the latest, by April 2016.
Take steps now to avoid issues later…
The changes to the state pension system will affect all COSR schemes, with decisions being required of trustees and employers to ensure their schemes are prepared to deal with the abolition of contracting-out. Our advice is to act sooner rather than later – changes to the operation of any pension scheme take time, which is fast running out before contracting-out is no more…
This post was contributed by Sarah Jenkins. For more information, email email@example.com.
 By the Pensions Act 2014, which received Royal Assent on 14 May 2014.
 Contracted out employees and employers receive a rebate on NICs of 4.8% of band earnings (split 3.4% to employers and 1.4% to employees), with band earnings being those earnings between the Lower Earnings Limit (currently £112 per week) and the Upper Accrual Point (currently £770 per week).
 There is an obligation under the Occupational and Personal Pension Schemes (Disclosure of Information) Regulations 2013 to notify members of any material changes to their basic scheme information within three months of the change. The Department for Work and Pensions is of the view that the cessation of contracted out employment is such a material change.