September 2011
In brief
• Contracting out on a DC basis
is to be abolished from 6 April
2012.
• All restrictions surrounding
protected rights benefits will be
removed from the same date.
Next steps
• Sponsoring employers need to
consider the implications for
DC scheme design.
• Trustees need to inform
members about the change,
and should also discuss any
necessary scheme changes
with their sponsoring
employer.
Abolition of defined contribution
contracting out
On 6 April 2012, contracting out on a defined contribution (DC) basis will be
abolished, and all restrictions surrounding protected rights benefits will
disappear. These changes have a number of implications for DC schemes,
their sponsoring employers and trustees.
Background
Contracting out on a DC basis is where employees and sponsors pay reduced national
insurance (NI) contributions (i.e. rebates of NI contributions are made) in exchange for
giving up accrual of the earnings-related second state pension (S2P). The contracted-out
scheme has to invest the rebates on behalf of the employee. The current rebates mean
that employees pay 1.4% lower NI contributions and employers pay 1.6% lower NI
contributions. In addition, HM Revenue and Customs (HMRC) pay further ‘rebates’ into
the scheme. The invested rebates are known as protected rights and currently have
restrictions attached to them, especially with regards to the pension that is bought
at retirement.
Contracting out on a DC basis first became possible in 1988, but, in 2005, the Pensions
Commission recommended that it be removed, due to a combination of the difficulties in
setting the NI rebates at an appropriate level, the complexity created by contracting out
and the lack of member understanding. The previous Government adopted this proposal;
it put the necessary legislation in place and set an abolition date of 6 April 2012. The
Coalition Government subsequently confirmed that it would proceed as planned.
As well as abolishing DC contracting out for the future, all restrictions governing existing
protected rights will be removed from the same date, meaning that protected rights can
be treated in the same way as all other scheme benefits.
What does this mean for DC scheme design?
With effect from 6 April 2012, NI contributions will revert to standard rates and the
rebates from HMRC will cease. This means that contributions into DC schemes will
reduce, with a corresponding reduction in the rate at which funds accumulate, resulting
in smaller annuities at retirement. However, members will accrue additional benefits
under S2P which may or may not be greater than the reduction in benefits accrued
within the DC scheme.
Employers may therefore wish to review contribution rates in order to ensure that target
benefit levels remain appropriate. Employers may also wish to combine this with any
review needed due to the new employer duties coming into force in October 2012.
What will happen to protected rights?
Currently there are a number of rules applying to protected rights; for example, the
annuity bought with protected rights funds must include an attaching survivor’s pension
of at least 50% of the member’s pension. These requirements will disappear from 6 April
2012, providing welcome flexibility for members.
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However, where scheme rules have incorporated the protected
rights requirements (rather than simply referring to the relevant
legislation), trustees will need to change the rules in order to
take advantage of this simplification.
The Department for Work and Pensions (DWP) has recently
published draft regulations that would provide a modification
power to enable trustees to amend scheme rules in this way
without needing to consider ‘section 67’ issues, but there will
only be a three year window (before 6 April 2015) to do this
and the proposed power might not be sufficient to amend the
wording relating to protected rights in all scheme rules.
Employers and trustees will therefore need to review their rules
in order to understand what changes, if any, are required.
Implications for scheme administration
There will be a number of simplifications for scheme
administration, the most significant of which is that there
will no longer be a need to track protected rights separately,
simplifying record-keeping and the processing of benefits. In
addition, the requirement to inform HMRC when a member
leaves service, dies, retires or transfers will disappear.
There is no requirement to surrender a contracting-out
certificate; instead certificates will cease to have effect from
6 April 2012, and the normal requirements for member notice
periods and cessation procedures upon surrender of a
contracting-out certificate will not be needed.
Trustees should therefore be considering now how they wish to
proceed. Trustees may also wish to consider including additional
information in their communications, for example to explain why
there is no longer any mention of protected rights on annual
benefit statements.
Trustees should also review other member communications, for
example scheme booklets, to ensure they are appropriate post
6 April 2012. In general, however, member communications
should be more straightforward after the abolition, since
protected rights have always been difficult to explain and have
often been a source for confusion.
Transfers between schemes
There have been issues in the past with transfers between
schemes that are contracted out and those that are not, as any
protected rights have to be left in the original scheme. There
should be fewer of these so-called partial transfers following the
abolition of DC contracting out.
The DWP also confirmed earlier this year that transfers from
contracted-out defined benefit (DB) schemes into DC schemes
will still be permitted, subject to certain safeguards (e.g. trustees
will need to explain in writing to members about the rights being
given up and members will need to consent in writing), and the
contracted-out portion of the transfer will simply become a
DC pot in the same way as the non-contracted-out portion
of the transfer.
There will be a three year transitional period (6 April 2012 to
5 April 2015) to allow for:
What about defined benefit schemes contracted-out
on a DC basis?
• the payment of the final year’s rebates (i.e. the 2011/12 tax
year), since these are normally received some time after the
end of the tax year; and
For DB schemes which are contracted out on a DC basis, the
situation is more complicated. Options available to sponsoring
employers include increasing contributions to replace the rebates
previously paid in, to reduce benefits, or to contract out on a
salary-related basis. However, this is a complex area and
employers and trustees with such schemes should speak to
their advisers.
• the late payment or recovery of recalculated rebates due to
adjustments to individuals’ NI records.
After this period, HMRC will no longer track protected rights,
so trustees may wish to ask their administrators to carry out
an exercise to ensure that all records are correct in advance of
this date, since the opportunity for corrections at a later date
will be limited.
Communicating with members
Trustees must inform members that the scheme is no longer
contracted out within one month of 6 April 2012. In addition,
trustees will have a period of four months to inform members of
the effect of the abolition of protected rights on the additional
state pension and on accrued scheme benefits. Alternatively,
trustees can provide all this information within the year leading
up to the abolition date, which gives schemes the opportunity
to send the information out as part of another communication,
for example the annual benefit statement.
Where can I get further information?
For specific advice, please get in touch with
Will Wolfenden on 0118 977 2277 or by email to
[email protected]. Alternatively,
speak to your usual Punter Southall contact.
This briefing note is provided for general information only and is based on our understanding
of the position as at the date shown. It should not be relied upon as advice on your specific
circumstances. ©2011 Punter Southall Group
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