Malcolm McLean: Get ready for contracting-out fallout


Bringing in big changes to pensions is often not quite as easy as it first seems. Rarely is it possible to make a complete break with the past in setting the direction for the future, and there are usually complicated transitional stages to get through before the old is fully replaced by the new.

That is certainly the case with the introduction of the new single-tier state pension next year and, with it, the ending of contracting-out. It is coming as a big surprise to many when they learn deductions for past periods of contracting-out of state earnings relate pension schemes and state second pensions have to be made from the starting figure for their new pension in 2016.

This is, of course, not quite as bad as it sounds. It is effectively a one-off deduction from the notional starting amount and many of those some years away from actually reaching their state pension age should be able to make good most, if not all, of the deduction by continuing in work and making National Insurance contributions. This will build their final pension entitlement back up to the full single-tier rate.

However, it is without doubt all very confusing for the average person and becomes almost incomprehensible if and when they try to find out how the deduction itself (the rebate derived amount) has been calculated. You must be not far off a genius to understand it.

The abolition of contracting-out also brings with it further problems for defined benefit pension schemes. From 6 April 2016, those employers still running these types of scheme in both the private and the public sectors will lose their NI rebates and face increases in their own and their employees’ NI contributions. As such, these employers will need to consider how they are going to cope with the extra costs that will hit them from the increased NI bills.

The amounts involved will depend on the earnings level of individual employees, with the biggest impact of course falling on employers with large numbers of staff on their payroll. For example, on a £30,000 salary an employee will pay an extra £338 and the employer £822 a year. On a £40,000 salary the employee pays £478 and the employer £1,162. For an employer with more than 1,000 staff, the increase in annual NI could easily exceed £1m – hardly something to be dismissed as inconsequential.

This raises a number of questions as to what it might mean for the future of DB pension provision. Many employers have already closed down their final salary schemes on the grounds that they were already too expensive for them to support. Now some that have so far persevered with their schemes may decide that they cannot simply go on and accept this further cost falling upon them.

Essentially, an employer in the private sector has three options in this situation. One, they can grit their teeth and agree to absorb the cost. Two, they can amend the scheme rules to reduce the pension benefits accrued by the members. Three, they can increase the DB contributions required of the members.

Things are even more difficult for employers in the public sector. The last government, in revising the terms of the public sector pension schemes, agreed that they would not require any further major changes to members’ terms and conditions for many years hence. This means that most, if not all, public sector employers will have no option but to find large, offsetting savings from their overall funding budgets, which inevitably means making cuts in their staffing levels or other services elsewhere.

This all represents a considerable challenge for scheme sponsors to grapple with and we shall no doubt find out next April where the casualties are and what this signals for the future of DB pension provision more widely.

Contracting-out may be coming to an end but legacy issues from it may have a significant impact on us all for some time to come.

Malcolm McLean is senior consultant Barnett Waddingham