State pension consultation: Sackers’ Comments

Background

In its consultation paper, “A state pension for the 21st century”, the DWP has proposed two options for reform:

• Option one: faster flat rating of S2P; and
• Option two: the introduction of a single tier flat rate pension

In this response:

• The two options
  
• Impact of ending contracting-out
  

The two options

Legislation is already in place to morph S2P into a flat rate structure by the early 2030s.  Option one involves accelerating the pace of reform so that this is achieved by 2020.

Option two is more radical.  It would see the BSP and S2P combined into one single tier state pension which would be available to all, subject to a minimum qualification of seven years of National Insurance (NI) contributions or credits.

Under option one, contracting-out would continue, although the value of the NI rebate would fall over time.  Under option two contracting-out for DB schemes would end immediately.

The consultation also seeks views on introducing a “more automatic mechanism” to consider and / or implement future changes to state pension age to take account of increasing longevity.

Impact of ending contracting-out

The potential withdrawal of the ability to contract-out of S2P is a major issue for many of our clients.

At the moment if an employee contracts out of S2P both they and their employer pay reduced NI contributions.  In return the DB scheme must provide a guaranteed level of benefits (assessed by the “reference scheme test”).  If a decision is taken by Government to close S2P and end contracting-out, NI contributions will increase proportionately but the DB scheme design will remain intact.

Legislation has required schemes to write into scheme rules what contracted-out benefits must be provided.  It was the schemes choice how to do this.  But making changes to benefit structures to remove the rights to contracted-out benefits can be complicated.  As well as the potential for restrictions on the power of amendment which may prevent changes, there are statutory restrictions on changes to past service benefits.  Under section 67 of the Pensions Act 1995, it is not possible to amend a DB scheme to reduce a member’s subsisting rights (broadly the pension benefits they have accrued to the date of the change) without the member’s consent.

This could be the final straw for many struggling employers for whom the reduction in NI contributions is a vital source of extra cash which enables them to provide pension benefits to their employees.  Against a background of increasing pension costs related to longevity and the current economic climate, it may mean that they will now choose to close their schemes to all members.  Anecdotally, we understand this additional burden makes it increasingly likely that some employers who have not already closed their schemes to new joiners and / or future accrual will do so as a direct result of this change.

In the consultation, the Government comments that:

“In theory, scheme rules could be changed to reduce the benefits payable and hence reduce the contributions that employers are required to make, so that there is no impact on employers from the loss of the National Insurance rebate.  However, it may be difficult for some schemes to do this in practice and the Government would wish to support a balance being struck between the need to ensure provision is sustainable and that it provides good value for members.”

We would ask the Government to consider providing schemes with a statutory override to section 67 to allow them to make such changes.  In addition, a power to allow modifications under section 68 would be helpful for those schemes which contain restrictions in their governing documentation which prevent any reduction in scheme benefits, past and / or future.

In either case, we presume the Government will consult further on how the end of DB contracting-out will be achieved.  In order to minimise the impact on employers, there should be sufficient time for them to adjust to the changes.  Questions which will need to be addressed include:

• what will happen to accrued contracted-out benefits, particularly GMPs?  Will they be grandfathered or will they automatically become ordinary scheme benefits?
• If such benefits will be grandfathered, will it be possible to convert them into ordinary scheme benefits (as is possible with GMPs)?

The Government should also take into account the fact that employers are facing a number of challenges in relation to their pension schemes; not least the changes to the annual and lifetime allowances and the introduction of the auto-enrolment duty from 2012.  It would be preferable for these changes to be given time to bed-down before yet more are introduced.

We stress the need for clarity when making changes to contracting-out legislation.  This is already a complicated area.

Pressure is also on employers for two other reasons related to NI contributions:

• their NI contributions increased by 1% from April 2011;
• as a result of the Quinquennial Review, contracted-out NI rebates are changing.  NI contributions are currently reduced by a total of 5.3% (1.6% for members and 3.7% for employers), this reduction will drop to a total of 4.8% (1.4% for members and 3.4% for employers) after 6 April 2012.