Government simplifies state pensions at a price

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1 Page 1 of 5 News Alert 2013/02 15 January 2013 Government simplifies state pensions at a price At a glance The Coalition Government has set out its plan to combine the various current elements of state pension into a single-tier pension for those reaching State Pension Age (SPA) from April 2017 at the earliest. At the same time contracting out will be abolished, meaning higher National Insurance Contributions (NICs) for employees currently contracted-out and their employers. Key Actions Employers If contracted-out decide how to deal with increased employer NICs perhaps through reducing benefit accrual or more wider-reaching changes to the benefit provision/ member contributions. If the rules refer implicitly or explicitly to state pension terms (for example to a Basic State Pension offset), assess the impact of the introduction of the single-tier pension and determine whether rule adjustments need to and can be made. Trustees Review pension scheme rules to check whether they are impacted by the state pension changes and the end of contracting out. Scheme manager Check any references to State provision in scheme communications. Decide upon a communication strategy with scheme members. Assess the preparatory work required in the run up to the state pension changes and the end of contracting out.

2 Page 2 of 5 The Detail The Coalition Government unveiled its long-awaited plan to create a single-tier state pension in a White Paper published on 14 January This follows its equally longawaited Green Paper on the subject published in April 2011 which set out the key elements of what is now to go ahead. The White Paper outlines how the various current elements of state pension including the flat Basic State Pension ( BSP ), the earnings-related State Second Pension ( S2P ) and the means-tested Pension Credit will be combined into a single-tier state pension for those reaching State Pension Age (SPA) from April 2017 at the earliest. Contracting out on a salary-related basis will end at the same time. Those whose SPA falls before the transition date will be unaffected by these changes, retaining their State Pension entitlements as the system currently stands. As the single tier pension is being delivered against a background of economic austerity it is no surprise that it has been designed to cost no more than the current system overall. In fact, although in the early years it will cost more (but the Government will be receiving significantly increased NICs), by 2040 it is projected to cost less than the current system. SPA will be formally reviewed every five years with the object of ensuring that people maintain the same proportion of adult life receiving the State pension. The outcome of the first review will be published by 7 May Should a decision be taken to raise SPA (presumably speeding up the increase from 67 to 68 or introducing an increase from 68 to 69) the Government intends that a 10 year notice period is given. The Single-Tier Pension The single-tier pension will be set above the basic level of means-tested support (currently per week for a single pensioner) the precise level dependent on fiscal conditions around implementation. Consequently the guaranteed element of the State Pension Credit will be far less needed than at present. The White Paper proceeds on the assumption that the single-tier pension will be set at 144 per week in today s earnings terms. This significant increase to the current BSP of per week is being financed to a large degree through the single-tier pension subsuming S2P and the savings element of the pension credit, both of which come to an end at the transition date, as well as the increased NIC inflow. The initial method for pension increases has yet to be decided and future decisions on increases will rest with future Governments, but the increase must be at least in line with average earnings.

3 Page 3 of 5 The number of years of NICs or equivalent credits required for a full single-tier pension will increase from 30 to 35 years and the minimum contribution record to qualify for any single tier pension will be between 7 and 10 years. The single-tier pension will be an individual qualification, so spouses will not be able to inherit or derive rights to this State pension from their partner s NICs record. Impact on individuals of the transition to the Single-Tier State Pension One of the most controversial aspects of the reform is the method under which account will be taken of the NIC record at transition of those reaching SPA after this date. The Government intends to translate such a record into a single tier starting amount called the foundation amount taking the greater of what would have been accrued under the new system had it been in force and what has accrued under the current system. The first calculation has a deduction if the member has any contracted out service and the second calculation includes benefits earned under SERPS / S2P. This foundation amount is then compared against the full single-tier pension. So those who are midcareer who have been contracted in and on good earnings and who have the prospect of all this continuing will see a significant reduction in their expectations. The few that have a foundation amount greater than the single tier pension (such as those towards the end of their career with a good level of SERPS / S2P accrual) will have the excess protected but only in line with prices. It appears that some of the biggest winners will be the self-employed, who have traditionally not built up S2P benefits, and those who have lower earnings but have a good NIC contribution record quite often women with caring responsibilities. Impact for pension schemes Pension schemes will need to check that any reference to a State benefit in the rules (for example, applying a BSP offset to pensionable salary) remains appropriate. To the extent that the scheme design is intended to allow for state benefits when considering members total income in retirement, the scheme design might need to be reconsidered. Currently contracted out employees and their employers will see their NICs increase as they move to the contracted in rate. As private sector employers are unlikely to be willing to shoulder the increased NICs they will need to make a decision about scheme design. The Government is hopeful that employers will retain existing schemes but modify their future accrual and/or increase member contributions. But there is nothing to stop many scheme sponsors from deciding on much more radical action such as switching to a money purchase scheme, provided the level of contributions at least satisfies the minimum required to be used for auto-enrolment. There is a fear that there will be another round of closures of long-standing and good quality occupational schemes.

4 Page 4 of 5 Members of public sector pension schemes stand to benefit from these reforms, although they will have to pay an additional 1.4% in NICs for the privilege. This is because the Government is committed to the recent reforms to public service pensions enduring for 25 years, so public sector employers will not be able to pass on the increased cost of NICs by reducing benefits or further increasing member contributions. Public sector schemes account for around 5.3 million of the nearly 7 million active members of contracted out defined benefit schemes. For those schemes with restrictive amendment rules the Government intends to allow, for a limited period only, changes to be made, but only to the extent that they offset the additional employer NICs. There are certain knock-on effects associated with schemes being forced to cease contracting out that will need to be dealt with nearer the time, including performing complex anti-franking calculations and checking the scheme meets the relevant test scheme standard for auto-enrolment (if the scheme is being used for this purpose). Implementation The Government intends to publish a draft Pensions Bill on 18 January setting out the legislation for these reforms there may be much devil in the detail. The Bill will undergo pre-legislative scrutiny before starting its passage proper through Parliament. Comment Automatic enrolment made changes to the partially means-tested state pension system essential, as otherwise millions of lower-earners would have received very poor value for their automatically-enrolled pension contributions. Making the pension flat-rate at the proposed level effectively solves that problem, and in turn makes contracting out an outdated concept that has to be removed. Given that, the Government s proposals are sensible and necessary. However, it does seem that once again it will be middle- and higher-earners having their benefit expectations reduced to fund the additional support for lower-earners. There is also a real risk that in the absence of alternative good quality risk-sharing designs on which the Government has very recently started the ball rolling, the need to review contracted out schemes in the run up to April 2017 could lead to a further round of private sector closures and their replacement with inferior schemes. Given that the simplified state pension will only ever deliver a modest amount, a good workplace pension is more vital than ever to ensure that individuals receive a meaningful income in their retirement. It would be a shame if this well-intended reform only widens the gap between public and private sector pension provision.

5 Page 5 of 5 This News Alert should not be relied upon for detailed advice or taken as an authoritative statement of the law. If you would like any assistance or further information on the contents of this News Alert, please contact David Everett or the partner who normally advises you at LCP on +44 (0) or by enquiries@lcp.uk.com