For the best part of 50 years, employees and employers of defined benefit (DB) schemes have been able to contract out of the additional state pension.
For employees, this has meant paying a lower rate of national insurance contributions (NICs) and building up less state pension in exchange for an equivalent benefit from their private scheme. Contracting out has been popular with employers too because of the NIC savings involved for them.
From 6 April 2016, contracting out for DB scheme employers and members will be abolished. The driver of this happening is the state pension reforms. The Pensions Act 2014 introduces a brand new single-tier pension which will replace the old two-tier system.
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It will no longer be possible for members of private schemes to contract out of the second tier state pension. There will no longer be one.
The change will have a significant impact on active members of open DB schemes and their sponsoring employers. There will be no more NI rebates and employers will face a 3.4% hike in NICs for each contracted-out employee.
Employers will not like facing yet another additional financial burden associated with their DB scheme. But what can they do about it?
Option one is to do nothing, which is unlikely to be popular.
Option two could be to cut back future pension benefits. Most employers will want to offset the increase in NICs by reducing liabilities elsewhere, most obviously by cutting future benefits.
However, option three for employers is to increase member contributions.Some employers may prefer this because they can send a message to staff that benefits remain unchanged. The cost to the member may be increasing but that is because of a government enforced change.
To soften the blow on employers, the government is introducing a unilateral power for them to amend their schemes to reduce benefits or increase contributions. Full legal detail will be set out in regulations which we are expecting to be published imminently. However, the power will be limited in scope, it will certainly not help employers considering option four.
And this option four could be to close schemes to future accrual. Inevitably, some employers will decide enough is enough and pull the plug on their DB scheme. Of course full closure is not easy to achieve and can involve protracted consultation and/or negotiation with trustees and employees or employee representatives.
Any changes will represent a communication challenge and are likely to require a 60 day consultation with members. So the time to start planning is now.
Fuat Sami is a partner at law firm Sackers.