How DB schemes can offset end of contracting-out costs

As a consequence of the abolition of the state second pension, defined benefit contracting-out also ends on April 5 2016.

For schemes currently contracted out and open to accrual, this means that both members and employers will pay higher standard rate (class 1) national insurance contributions.

For members, this represents an increase to 12 per cent from 10.6 per cent of earnings between the lower earnings limit set at £5,824 a year and the upper accrual point of £40,040. 

Take-home pay will be reduced by the additional 1.4 per cent NI.

For employers, this represents an increase to 13.8 per cent from 10.4 per cent of earnings within the same banding and could equate to up to £1,163 per employee, per year.

Although NI will increase, there is no automatic reduction to the level of benefits that a scheme provides. On the face of it, the cost of providing DB accrual will increase. 

Offsetting NI costs

For members, there is nothing they can do about the reduction to take-home pay, and trustees should communicate with the membership to explain the changes.

For employers, there are ways that the increased NI costs can be mitigated.

The legal framework is complex and employers considering benefit changes in connection with the abolition of contracting-out should seek legal advice

Legislation has been brought in to give employers a unilateral power to either increase member pension contributions or reduce future service benefits under their pension schemes, or a combination of the two, to offset the 3.4 per cent increase in employer NI. 

The statutory power is for a limited time only and will not be available after April 5 2021. But any increase in member contributions or reduction in accrual cannot be more than is necessary to cover the cost of the increased employer NI. 

The comparison between the increase in employer NI and the value of the proposed scheme changes needs to be calculated by an actuary appointed by the employer. 

It seems that calculations of the level of member contribution increase or reduction in accrual should be done on an aggregate basis – rather than a member-by-member basis – meaning it is possible that changes made using the statutory unilateral power could result in some members being worse off than others. 

The Department for Work and Pensions’ view is that an amendment made using this power will constitute a ‘listed change’ for the purposes of the consultation regulations, so employers will have to undertake a consultation exercise before going ahead.

Scheme amendment

The government does not expect employers to use the statutory power automatically, only where it has no other choice, although the legislation does not reflect this policy and simply gives an employer the unilateral power. 

An alternative for employers is they look to make rule amendments to benefit provision using their scheme’s amendment power. 

This may require trustee consent and be subject to other conditions depending on the terms of the amendment power. 

Changes need not be limited to increased member contributions and/or reduced future benefits, and could include increases to retirement age or a cessation of accrual.

The changes need not be an actuarial match to the value of the NI increase.

The legal framework is complex and employers considering benefit changes in connection with the abolition of contracting-out should seek legal advice. 

They will want to consider the wider implications of any proposed changes, including consultation processes, employment aspects – for example contractual commitments or salary sacrifice arrangements – and communications. 

Johanna Clarke is senior associate and Keith Webster is partner at CMS Cameron McKenna