UK pension tax reform: end of contracting-out

Key issues for employers and trustees

From 6 April 2016, defined benefit pension schemes will no longer be able to contract out of the State Second Pension (S2P). This is because of government reforms to the UK pension regime that have done away with S2P and replaced it with a single tier basic pension. This means defined benefit schemes that are currently contracted out will automatically cease to be contracted out from 6 April 2016. Defined contribution schemes lost their ability to contract out of S2P some time ago.

A key issue facing employers and members of defined benefit schemes is that as a result of these changes, NICs for employers in respect of each employee will increase by 3.4% of earnings. For employees NICs will increase by 1.4% of earnings. For an employer this could mean finding an extra £1,600 per employee a year. An employee will find themselves with £479 less in their pay packet over the year.

So what can be done about the increase in NICs? Employers who prefer not to absorb this additional cost can offset the increase in employer NICs from April 2016 either under the scheme amendment power (which may require trustee agreement/consultation depending on the specific rule) or by using a statutory override power (which does not require trustee consent or consultation) to reduce future accrual and/or increase member contributions, but only to the extent that it off-sets the increase in costs.

Key action points for employers:

• Assess cost impact of the changes
• Decide whether to make changes to the Scheme rules to off-set the cost of the changes
• If you decide to make the changes to the Scheme rules, consider with legal advice, whether you will use the statutory override or the scheme amendment power. 
• Depending on how the changes are to be made, consider with legal advice the timetable and any consultation requirements 
• Consider any communication with affected employees
• If the scheme is auto-enrolment compliant on the basis that it is contracted-out, then consider whether the scheme continues to be auto-enrolment compliant after the change.

Key action points for trustees:

• Liaise with the sponsoring employer on whether they intend to reduce benefit accrual and/or increase member contributions
• If so, discuss with the employer whether they will be using the amendment power or statutory override
• Consider with legal advice whether their rules reference state pension arrangements, as this may determine how the changes are effected
• Consider how the required protections for existing contracted-out rights will be properly operated by the scheme administrators
• Consider member communications about the changes including using the opportunity to update existing member booklets.