An update on the changing landscape and what you, as an employer, could be doing.
By the time you read this, there will have been countless articles in the press about how much ‘better off’ or ‘worse off’ various sections of society will be as a result of the proposed move to a flat rate state pension from the present two-tier system of basic (‘old age’) pension and the state second pension (still known to many people as the state earnings related pension scheme (SERPS) which it replaced). It is not therefore the purpose of this article to consider the financial impact on individuals but instead to identify issues that employers will face during the transitional period.
The technical information is included in the Department for Work and Pensions (DWP) white paper The single-tier pension: a simple foundation for saving, which was issued on 15 January. Naturally, there are some areas that would benefit from clarification and there is always the possibility that things could change in the various committee stages when a Bill is considered. However, the Government has consulted widely with employers and those in the pensions industry, so significant changes would now seem unlikely.
Those of us who remember the introduction of the SERPS in 1978 (which – as is usual for pensions – followed enabling legislation two years previously) may recall that the initial national insurance (NI) rebate of 8.5% for contracting-out was always going to be reviewed at 5-year intervals and that this rebate would reduce over time. Today’s contracted-out rebate (only available to defined benefit schemes) has fallen to 4.8% of earnings between the lower earnings limit (£5,564 in 2012/13) and the upper accrual point (£40,040 in 2012/13) made up as 3.4% (employer) and 1.4% (member).
The great majority of employers who established defined benefit (usually ‘final salary’) pension schemes for their staff took advantage of the NI rebate available to schemes of a certain ‘quality’, by contracting their members out of SERPS and subsequently the state second pension. The ‘quality’ test did not apply at outset but let’s not confuse the issue!
“Double Whammy”
In the General Election of 1992, the Conservative party coined the phrase “double whammy” as an attack on the Labour party. It referred to a perceived outcome, if the latter won, as being (1) more taxes and (2) higher prices. The loss of contracted-out status for a defined benefit scheme is indeed a double whammy. The employer is faced with a 3.4% increase in NI contributions (tax, by another name) and may well have previously agreed adverse scheme or contribution changes with members. Any proposal to further reduce future benefits or to increase contributions will do little to motivate the workforce. Members will also see a 1.4% increase in their own NI contributions.
The Government has said that it does not intend to introduce a single-tier state pension (resulting in the demise of contracting-out) until at least 2017 by which time all employers will be caught up in ‘auto-enrolment’ - the interim (5% total contribution) phase, effective from October 2017.
Most employers today have limited financial resources and will find it difficult to afford such a dramatic increase in pension contributions. So what are the options?
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Pass on the whole 3.4% increase (applied to the relevant earnings) to members.
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Reduce future benefits – adopt a lesser benefit structure or defined contribution plan?
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A combination of these.
The Government intends to allow employers to impose an increase in member contributions regardless of any powers that trustees might otherwise have. This is relevant to all schemes other than public-sector or ‘protected’ schemes. Bearing in mind that employees will have their own increase in NI contributions (1.4%) to worry about, is it realistic to pass on a further 3.4%? Probably not; members have often shared funding rate increases in recent years and to pass on a further 4.8% of a band of earnings (a combination of direct NI contributions and increased pension contributions) could well be ‘the straw that breaks the camel’s back’.
If an employer cannot afford the additional 3.4% and if passing on the entire cost of the increased NI contributions to the member (as higher pension contributions) would be unacceptable, the most practical options would be to reduce future accrual, possibly in its entirety. There are very few schemes today that accept new entrants but to close a scheme to this group without also reducing or ceasing future accrual will not address the problem of higher NI contributions.
Auto-enrolment will be in its interim phase (5% total contribution) by October 2017, so assuming some kind of defined contribution arrangement will be established if future accrual ceases, it will be important to take into account how (or if) it is to be part of your auto-enrolment solution.
Further complications
Once a scheme ceases to be contracted-out, each member’s NI record will need to be validated. Experience gained from winding-up pension schemes shows that this can be a tortuous process, with discussion needing to be held between sponsoring employers and the relevant section of HMRC. At present, HMRC has no experience of gathering this kind of information on such a grand scale. The DWP has indicated that HMRC is looking into how ‘Real Time Information’ might be used to facilitate this process but we remain sceptical as to how it could be used to reliably collect such long-term historical information.
What could you be doing?
Working on the premise that a reduction in benefits is more likely to be imposed than a further increase in member contributions (beyond the 1.4% increase in NI contributions that members will pick up in any event) there are a few actions that employers might wish to take or issues to consider, as follows.
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Explain your anticipated new predicament, preparing members for a future solution.
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If members agreed to pay higher contributions following your last actuarial valuation, they might not be too keen to continue with this if a cut in future benefits is planned, even though it will probably not be implemented before 2017.
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Consider a lesser defined structure (including career average revalued earnings) or a defined contribution option.
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Prepare a paper for your board, explaining the impending changes and possible solutions, taking into account auto-enrolment requirements.
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Present your paper to the board, having a realistic implementation timetable in mind.
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Initiate consultation with staff, once a viable solution has been identified.
All of the above will need to be tempered with the caveat that this is only a white paper and there is for amendment, although significant changes are not expected.
Smith & Williamson has considerable experience in helping employers to address pension issues, communicating with boards of directors and members, designing consultation material, staff presentations and 1:1 meetings.
Rather like pensions simplification in 2006, the proposed single-tier pension is supposed to be ‘a simple foundation for saving’ … we shall see!
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.