It's the final countdown . . . to the end of contracting out

There has been so much going on in the world of pensions lately that employers could perhaps, be forgiven for letting the forthcoming end of contracting-out for Defined Benefit (DB) schemes slip under their radar. Yet with less than six months remaining, some employers could be sleepwalking into higher pension costs.

What are you waiting for?

When the New State Pension is introduced in April 2016, the option for DB schemes to contract-out of the State Second Pension (S2P) will come to an end. Employers and employees will face increased National Insurance (NI) costs as a result. However, sponsors do have options to mitigate these costs.

Surprisingly, a recent survey by Barnett Waddingham of 74 contracted-out pension schemes with members currently accruing DB pensions shows that almost 1 in 3 employers have yet to decide on a course of action.

Single Tier State Pensions

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Employers are required to consult members, for at least 60 days, on any proposed changes to benefits or employee contribution rates. Those undecided employers have little time left if they would like to offset the increased cost from April.

One way, or another

The approach taken by employers to mitigate the increased costs will broadly fall under four options, outlined below.

  • do nothing and absorb extra NI Cost
  • make minor changes to the scheme benefit structure from April 2016
  • increase employee contribution rates to offset the extra NI cost
  • conduct a fundamental review of the scheme benefit structure

Which option a sponsor will choose will depend on many factors including its financial position and the number of members still accruing benefits. Our survey shows that while the majority of those who have decided on a course of action have chosen simply to absorb the extra cost, a significant proportion have taken the opportunity to conduct a fundamental review of the scheme’s benefit structure.

"When the New State Pension is introduced in April 2016, the option for DB schemes to contract-out of the State Second Pension (S2P) will come to an end"

We undertook a similar survey earlier this year. The picture has clearly moved on since then, with few now considering a small change to benefits or contribution rates. The options at either end of the scale, to do nothing or undertake a fundamental review, have been growing in popularity.

Indeed, many companies may find a full review of benefits more attractive at present as falling prospects for investment returns threaten to increase the cost of funding DB pensions still further.

Back for an encore?

There are a number of other consequences of these reforms which employers may have to consider, even if an employer chooses to make no changes to the benefit structure or member contribution rate:

  • some employers may look to offset part of the increased NI costs by introducing a salary sacrifice arrangement for member contributions
  • employees will need to be advised of the increase in their own national insurance contributions
  • employers will need to ensure that their ‘contracted-in’ scheme continues to function as a ‘qualifying scheme’ for the purposes of automatic enrolment after April 2016
  • schedules of contributions and scheme rules may need to be reviewed

If you are one of those employers that have yet to consider the impact of the end of contracting-out on your DB scheme, can you really afford to wait any longer?