THE FIRST YEAR OF CONTRACTING-OUT D. G. JOHNSON

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1 THE FIRST YEAR OF CONTRACTING-OUT by D. G. JOHNSON (A paper discussed by the Society on 20th March, 1979) INTRODUCTION 1. THE new Earnings-Related State Pension Scheme was introduced, under the terms of the Social Security Pensions Act, 1975, on 6th April, The arrangements represented the product of more than fifteen years' efforts to establish a meaningful earnings-related supplement to the flat-rate basic State pension. Various proposals had been mooted, the first of which was probably the Graduated Pension Scheme, introduced in 1961, which was followed by the Crossman and Joseph schemes. The latter two schemes fell foul of changes of government and it was not until 1975 that the joint efforts of Barbara Castle and the late Brian O'Malley reached fruition in the Social Security Pensions Act The Earnings-Related State Pension Scheme embodied in the Social Security Pensions Act 1975 ultimately received the approval of all the major political parties. It provides an earnings-related pension over and above the flat-rate basic State pension for all employees except those who reach pensionable age (65 for men, 60 for women) in the fiscal year commencing 6th April 1978 or married women (or widows) who have opted to make National Insurance contributions at the reduced rate and, therefore, not participate for retirement benefits from the State Scheme. 3. In recognition of the levels of pension benefits provided through occupational pension schemes, provision was made under the terms of the Social Security Pensions Act 1975 for certain employments not to participate in the earnings-related State Pension Scheme so called 'contracting-out'. For a particular employment to be contracted-out it is necessary that the employees concerned are members of an occupational pension scheme which satisfies certain requirements. Briefly, a contracted-out occupational pension scheme must satisfy two broad tests. 181

2 182 D. G.JOHNSON 4. The first test is qualitative in nature in that the pension scheme must provide so-called 'Requisite Benefits'. Broadly, this means that the pension scheme must provide benefits related to earnings near retirement (or on a revalued basis) and that the pension accrual rate must not fall below l/80th for each year of contracted-out service. In addition, widows' benefits are to be provided on the basis of a pension accrual rate of not less than 1/160th for each year of contracted-out service. 5. The second test is of a quantitative nature. The contracted-out pension scheme must provide pension benefits following retirement or death no less favourable than would have been provided under the Earnings-Related State Pension Scheme had the employment not been contracted-out. These minimum levels of benefit are defined in the Social Security Pension Act 1975 as the Guaranteed Minimum Pension (GMP) and the Widow's Guaranteed Minimum Pension (WGMP). 6. If an employee is a member of an occupational pension scheme which is contracted-out of the Earnings-Related State Pension Scheme, he pays National Insurance contributions at a level lower than that which would have been payable had he not been contracted-out. Similarly, the National Insurance contributions payable by his employer are at the reduced contracted-out rate. The following is a summary of the rates of National Insurance contributions currently payable by both employees and employers: Employee Not Contracted-out Contracted-Out Employer Not Contracted-out Contracted-out Per cent of the band of earnings up to the Lower Earnings Limit Per cent of the band of earnings between the Lower and Upper Earnings Limits From 6th April, 1978 the Lower Earnings Limit has been per week and the Upper Earnings Limit per week. These levels are to be reviewed on 6th April each year. From 6th April, 1979 they will be increased to and respectively. 7. Married women (or widows) who have opted to make reduced rate contributions continue to make National Insurance contributions at the rate of 2% of earnings up to the Upper Earnings Limit.

3 THE FIRST YEAR OF CONTRACTING-OUT 183 Employment ceases to be contracted-out when an employee reaches pensionable age. Where an employee remains in employment beyond that age the employer is liable for National Insurance contributions at the non-contracted-out rate but the employee is not liable for contributions on any earnings received after pensionable age. THE CONTRACTING-OUT OPERATION 8. Clearly, if an employer was to achieve contracted-out status in respect of certain employments it would be necessary for a number of formal procedures to be completed. I do not propose to discuss these procedures in detail in this paper as they would in themselves constitute the subject of a paper. Briefly, however, the procedures involved included notification to the trustees of the appropriate pension scheme, the members concerned and, if appropriate, the respective insurance company and recognized trade unions. In many cases, it was of course necessary for benefit improvements to be introduced to ensure the pension scheme reached the levels required of a contracted-out pension scheme. 9. Having given these notifications and undertaken the appropriate consultations, application is made to authorities for the issue of a contracting-out certificate in respect of the appropriate employments. The responsibility for investigation of the application and issue of the contracting-out certificate rests with the Occupational Pensions Board. 10. In the months preceding 6th April, 1978 the Occupational Pensions Board (OPB) were under considerable pressure answering queries, approving drafts and formulating policies in connection with the contracting-out operation. It was estimated that in respect of some 65,000 occupational pension schemes about 15,000 contracting-out certificates would be issued. The OPB were aware of the probability that many employers would defer making application until as late as possible and issued a number of encouragements in an attempt to spread the flow of applications over as long a period as possible. However, only 4,000 applications for contracting-out certificates had been received by the end of 1977 and it was clear that the bulk of applications would be received during the first three months of 1978 a situation the OPB could not cope with under the existing arrangements. As a result, emergency procedures were introduced (referred to as 'Scheme Emergency' and 'OPB Emergency') whereby

4 184 D. G. JOHNSON a contracting-out certificate could be issued notwithstanding that all the relevant procedures had not yet been completed (in particular the adoption of amendments to the rules governing the pension scheme) provided that basic notification and consultation had actually taken place. 11. In the event, the OPB proved worthy of the task and at the final count almost 23,000 contracting-out certificates were issued in respect of approximately 14,000 pension schemes. It is of interest to observe that out of the 14,000 pension schemes which received contracting-out certificates effective from 6th April, 1978, only 2,300 were wholly self-administered. As most of the insured pension schemes adopted standard documentation (including a standard interim amending deed), I shudder to consider whether the OPB could have coped had the insurance companies not pressed for the agreement and adoption of such standards. It is, however, misleading to split contracted-out pension schemes between self-administered and insured by virtue of the number of certificates issued. As might be expected, the self-administered pension schemes have, in the main, larger memberships and the split on a number of contracted-out members basis is more even. Unfortunately, no accurate statistics are available. 12. The major part of my day-to-day activity is in the sphere of self-administered pension schemes. This paper is therefore, of necessity, mainly concerned with self-administered pension schemes. However, I believe the majority of ground I propose to cover is common with insured pension schemes and so I trust will prove valuable to those readers who are not directly concerned with a contracted-out self-administered pension scheme. In addition, I hope my remarks will provoke an interesting discussion with those actuaries primarily concerned with insured pension arrangements. 13. The subject of my paper relates to the experience of pensions administrators and their advisers during the first twelve months of contracting-out and not to the period of intense activity preceding 6th April, I am not, therefore, primarily concerned with the procedures undertaken in connection with an application for a contracting-out certificate. However, I would mention in passing that applications for contracting-out certificates are still being received by the OPB although I understand new applications now number less than twenty per week. One area of continued activity arises as a result of the sale and purchase of subsidiaries of larger companies and the

5 THE FIRST YEAR OF CONTRACTING-OUT 185 resulting effect upon the relevant contracting-out certificates. I will refer to the procedures involved later. 14. The opposite to making election for a contracting-out certificate is, of course, its surrender. The OPB have now received many applications for surrender of contracting-out certificates but, as with new elections, this usually arises following the sale or purchase of a company. 15. To a considerable extent, the arrangements devised by the authorities to deal with the administration of the Earnings-Related State Pension Scheme (and contracting-out thereof) have not yet been fully tested. This primarily arises because the first earningsrelated pensions, or widows' pensions, will not fall due until after 5th April, Should an employee reach pensionable age and retire, or die prior to pensionable age, before 6th April, 1979, no earningsrelated pension is payable as this benefit ceases to accrue at the end of the fiscal year preceding the date of attainment of pensionable age or death. 16. To date, the majority of interaction between contracted-out pension schemes and the State have, therefore, taken place where a member withdraws from contracted-out employment as a result of leaving service (including early retirement). 17. The bible of the administrator of a contracted-out pension scheme on the subject of the procedures to be followed on termination of contracted-out employment is Department of Health and Social Security Leaflet NP29. I do not propose to set out in detail the contents of this leaflet but I would encourage the reader to refer carefully to this very useful document. Suffice it here to summarize the forms an administrator can complete in order to communicate with the DHSS. Paragraph references are to the appropriate sections of Leaflet NP29. Description Form Number Termination Notices RD550 CEP single notification (paragraph 32). RD550A CEP schedule (paragraph 32). RD551 GMP to be revalued at 5% compound per annum with payment of a LRP (paragraph 37). RD559 Cessation of Class INI contributions while abroad (paragraph 23). RD560 GMP to be revalued at a fixed rate, with no premium payable (paragraph 45). RD561 GMP with full revaluation i.e. revaluation by reference to section 21 orders (paragraph 46).

6 186 D. G. JOHNSON RD562 Transfer of accrued pension rights, including GMP rights (paragraph 47). RD564 Enquiry service request for calculation (paragraphs 72 and 73). Other Forms and Notifications RD569 Recommencement of contracted-out employment under a different employer using the same scheme (paragraphs 24 and 81). RD570 Buy-out of a GMP through an insurance company (paragraph 83). RD571 Specimen Notice of Delay relating to a particular case (paragraph 64). RD572 Specimen Notice of Delay relating to a class or classes of case (paragraph 64). RD573 Application for an extension of the time limits for notifying a termination of contracted-out employment, for making an election to pay a CEP, or for payment of a premium (paragraphs 26, 34 and 68). RD574 Increments to GMP (paragraph 76). TERMINATION OF CONTRACTED-OUT SERVICE 18. Serious misgivings were voiced by scheme administrators and their advisers as to the ability of the DHSS to deal quickly with the calculation of a Guaranteed Minimum Pension (GMP) or Contributions Equivalent Premium (CEP) (the premiums paid by an employer to reinstate a contracted-out employee fully into the State Scheme). Many scheme administrators have, in the past, taken pride in being able to set out for a member the options available to him as at the date he leaves the pension scheme before he actually leaves the Company. In most cases, these options would include a deferred pension, a transfer value and a refund of contributions. I am afraid that we must now accept that such days are past unless a computerized system is used to estimate GMP's and CEP's, or a considerable amount of time is expended with a manual system. The DHSS set out to provide a service for calculation of CEP's with a turn-round time of not more than three weeks. Initially, this timescale was met unless the forms supplied to the DHSS were in some way inconsistent or incorrect. However, as the number of withdrawals from contracted-out schemes has increased, I understand that the DHSS have fallen behind dramatically. At present the DHSS receive approximately 20,000 forms a week (which means about 1 million withdrawals a year) and they are experiencing a rejection rate in excess of 10% (mainly as a result of second-tier National Insurance contributions being incorrectly transferred to the appropriate RD form). No doubt as a direct consequence of this rejection rate, responsibility for which must in the main be attributed to scheme administrators, the turnround time is often two or three months.

7 THE FIRST YEAR OF CONTRACTING-OUT A contracted-out pension scheme must make provision for payment of the appropriate GMP, in pension form, from pensionable age unless the total pension is trivial and can then be commuted into a lump sum payment. This restriction can have significant consequences where a member of a contracted-out pension scheme withdraws from service, or retires on pension prior to pensionable age. In the past, a member might have been freely able to exchange part of his pension for a tax-free lump sum (subject to Inland Revenue limitations) or surrender a portion of his own pension to provide a prospective pension, following his death, for his widow or a dependant. Such options may now be substantially restricted by virtue of the requirement to pay a minimum of the GMP, appropriately revalued, in pension form. Perhaps of even greater consequence is that where previously a member might have been able to retire in normal health before the pension scheme's normal pension age and receive a smaller pension, it is now unlikely that such arrangements can continue as the GMP element of the pension becomes more significant. One alternative is, of course, to provide a pension of two levels. A relatively modest level during the period of early retirement up to pensionable age, with an uplift to the level of the revalued GMP at that age. Unfortunately, if the GMP constitutes the major part of the total pension benefit it is unlikely such an arrangement will work satisfactorily as the initial level of the pension might be unreasonably low. 20. When a member withdraws from a contracted-out pension scheme, action must be taken to preserve the GMP. In its simplest form this action can simply be the payment of a Contributions Equivalent Premium (CEP) to the state scheme to extinguish the GMP liability and reinstate the member in the State Scheme for the period he was previously contracted-out. A CEP cannot, however, be paid under all circumstances and often the Scheme administrator may wish, on grounds of cost or efficiency, to preserve the GMP by some other method. 21. In order to protect the value of the preserved GMP against the effects of inflation, the Scheme administrator must apply revaluation to the GMP between the date a member leaves the contracted-out pension scheme and his attainment of pensionable age. There are three methods of revaluation currently available to a contracted-out pension scheme. A pension scheme can only apply one method to leavers at any one time and changes in the method of revaluation to

8 188 D. G. JOHNSON be adopted must be reported to the Occupational Pensions Board. The three methods available are as follows: (a) In accordance with orders made under Section 21 of the Social Security Pensions Act 1975 during the period from the date of withdrawal to the end of the fiscal year preceding pensionable age or death if earlier (this is effectively revaluation in line with increases in national average earnings during the period in question); or (b) by 5% per annum compound for each complete fiscal year between the date of withdrawal and the attainment of pensionable age or earlier death (or the revaluation under (a) above if less). In such cases, a premium (Limited Revaluation Premium) is payable, which will provide further revaluation if necessary, so that the total revaluation does not fall below that described in (a); or (c) in accordance with such rate as regulations made under Section 45(1) (b) of the Social Security Pensions Act 1975 (which at the present time means 8½% per annum compound for each complete fiscal year between the date of withdrawal and the attainment of pensionable age, or earlier death). 22. In addition, the employer must make a decision on the policy to be adopted towards the payment of Contributions Equivalent Premiums. An employer may pay a CEP in respect of an employee who: (a) leaves contracted-out employment before reaching the scheme's normal pension age for him, or, if earlier, the end of the fiscal year preceding the attainment of pensionable age, and (b) has completed less than five years' contracted-out service, and (c) has not qualified for preservation of pension rights under the Social Security Act 1973, and (d) the termination is due to death, where there is a widow, and (e) the pension scheme has not ceased to be contracted-out, and if) the employer so elects. 23. The employer need not make CEP's for all early leavers with less than five years' contracted-out service who have not qualified for preservation of pension rights provided he does not discriminate

9 THE FIRST YEAR OF CONTRACTING-OUT 189 between different employees other than on grounds of length of service. For example, an employer might decide to pay CEP's for employees who leave with, say, less than three years' contracted-out service but the scheme must then preserve the GMP rights of all employees with three years' service or more. Discrimination is not, however, prohibited where: (i) pension rights are transferred to another contracted-out scheme, or (ii) a married woman or a widow has elected to pay reduced-rate National Insurance contributions, or (iii) a condition of Inland Revenue approval of the scheme (e.g. the salary limit) prevents a refund of the employee's contributions, or (iv) an employee exercises an option under scheme rules to have his pension rights preserved even though the qualifying conditions of the Social Security Act 1973 are not satisfied. 24. The choices facing the scheme administrator with regard to the method of GMP revaluation and the CEP period to be adopted are not always easy ones to make. An important factor in the decisions made is the policy adopted by the trustees towards so called 'franking'. There are a number of ways in which the GMP guarantee in respect of contracted-out employment can apply, for example: (a) The GMP can be considered as an overriding guarantee over the total benefits (relating to both pre-6th April, 1978 and post-6th April, 1978) payable out of the pension scheme, or {b) the GMP can be considered as a guarantee on the level of benefits payable from the pension scheme in respect of post 6th April, 1978 service only, pre-6th April, 1978 benefits being payable in addition to the GMP, or (c) the GMP can be considered as a guarantee on the level of benefits payable from the pension scheme in respect of post-6th April, 1978 service only and in addition should a member leave service prior to pensionable age, revaluation increments on the accrued GMP should be paid in addition to the deferred benefit calculated as at the date of withdrawal. There are, of course, several variations in the broad alternatives given here. Example (a) represents total franking of the GMP against all pension benefits payable out of the scheme, example (b) represents

10 190 D. G. JOHNSON franking against post-6th April, 1978 benefits only, and examples (c) exhibits no franking whatsoever. 25. The scheme administrator will have been advised to consider the relative merits of each of the three methods of revaluation described in paragraph 21 above. One can consider the advantages and disadvantages of each method as follows: Full Revaluation (Section 21 orders) v. Fixed 8½% In most cases by adopting full revaluation a pension scheme would be exposed to the risk of possible high rates of inflation which could only be reduced for the future by the rather drastic solution of the scheme ceasing to be contracted-out. This argument suggests adoption of revaluation at the fixed rate of 8½% per annum. However, if a pension scheme already grants contractual increases to deferred pensions before retirement in line with inflation it should probably opt for full revaluation as otherwise it runs the risk of being required to provide even greater benefits should inflation average less than 8½% per annum. If discretionary increases in deferred pensions are granted at similar levels the argument still applies although with less force. 5% plus Limited Revaluation Premium v. Full Revaluation The arguments are similar to those above in the comparison between full revaluation and fixed revaluation at 8½% per annum. Normally, 5% revaluation plus the LRP would be favoured unless deferred pensions are usually increased in deferment in line with inflation. 8½% v 5% plus Limited Revaluation Premium Generally speaking, payment to the State of a Limited Revaluation Premium represents good value for money if most members who leave service do so at young ages. The major factors acting in favour of a young average age for such leavers are generally high turnover of members and a young membership in general. Other factors can militate against a young average age for leavers, such as a high number of early retirement pensions, a scheme Normal Pension Age earlier than pensionable age, a policy to pay CEP's in respect of most

11 THE FIRST YEAR OF CONTRACTING-OUT 191 short service leavers or a high proportion of women (which has a similar effect to an increase in the scheme's average age). Although an LRP may represent good value when compared with the prospective revaluations now taken over by the State Scheme, if franking is applied in the pension scheme the scale deferred pension might exceed the GMP revalued (up to pensionable age at 8½% per annum) in which case payment of an LRP would be an unnecessary expense. The factors which operate for and against the adoption of fixed 8½% revaluation are tabulated below: In favour of 8½% revaluation (in the short term) (1) Franking of pre- 6th April, 1978 benefits In favour of8½% revaluation (1) High level pension benefit scale (2) Deferred pension usually calculated on scale more generous than accrued pension (1) (2) (3) (4) Against 8½% revaluation Minimum level of benefit scale Revaluation of GMP provided over and above scale benefit (i.e. no franking) Gross earnings substantially exceed salary for pension purposes Most members take a refund of pre- 6th April, 1978 contributions 26. Having decided upon which method of revaluation to adopt when a withdrawing member leaves contracted-out employment and a CEP is not paid, the question arises, when should a CEP be paid? This decision is not independent of the method of GMP revaluation adopted. A comparison with the cost of preserving a GMP (on the basis of current deferred annuity rates) suggests the following guidelines: Method of GMP Revaluation adopted Full Revaluation: Fixed 8½% revaluation: Pay CEP's wherever possible on grounds of administrative convenience. Pay CEP's wherever possible on grounds of relative costs and administrative convenience.

12 192 D. G. JOHNSON 5% revaluation plus LRP with: (1) Main turnover at Average age of leaver less than young ages: 35 acts against payment of CEP (2) Main turnover with Favours payment of CEP on grounds short-service members of administration expenses From the above it is apparent that CEP's should be paid whenever possible except where the normal method of revaluation is 5% per annum (with an LRP) and the bulk of the member turnover is at the younger ages. In such cases it is possible to determine the period 'n' during which it is advantageous to pay CEP's by reference to the average age of scheme leavers. The following is a summary of the effective V being the period of years of contracted-out service which is the watershed for payment of a CEP as opposed to preservation of the GMP: Average Age of Leavers Having chosen a method of GMP revaluation and a policy with regard to payment of CEP's, the scheme administrator is faced with a further choice should he retain the preserved GMP within his own pension scheme or should he take advantage of one of the contracts available from certain insurance companies and secure the GMP outside of the pension scheme. Such an option is of course only available if fixed or limited rate revaluation is adopted an insurance company will not accept responsibility for revaluation in line with Section 21 orders. The main aims behind a decision to secure with an insurance company the GMP of a member who leaves without becoming entitled to an immediate pension are: (i) to relieve the pension scheme of the administration involved in preserving (and ultimately paying) the GMP (and possibly any excess of deferred pension over and above the GMP), and (ii) to change the responsible paying authority from the pension scheme to an insurance company. The contracts offered by individual insurance companies have their own special characteristics but in the main they will: (a) deal with the annuitant direct when a benefit becomes payable; V 1 2 5

13 THE FIRST YEAR OF CONTRACTING-OUT 193 (b) issue policies on an individual member basis; (c) place a lower limit on the number of leavers (on a monthly or annual basis) who must be covered by the arrangements; (d) accommodate either 8½% or 5% revaluation; (e) provide for securing additional member or widow's benefits where scale benefits to be secured exceed the GMP. A sample of the premiums quoted by two companies referred to as Company A and Company B are set out below, separately for each of 8½% fixed revaluation and 5% revaluation, plus LRP: 8½% Fixed Rate Revaluation (Age next G.M.P. at Date of Exit birthday at 10 per annum 100 per annum date of exit) Company A Company B Company A Company B Males Females ,760 1, ,505 1, , , Thus, Company B's rates are seen to be more competitive at the younger ages and for the larger GMP, whereas Company A's rates are preferable for older members with smaller GMP's.* (Age next birthday at date of exit) Males Females Company A % Revaluation G.M.P.at Date of Exit 10 per annum 100 per annum Company B Company A Company B

14 194 D. G. JOHNSON * The LRP must be added to all the above premiums. Company A's rates are cheaper for the older members and in particular the smaller GMP's (particularly for females). Company B's rates are cheaper for younger members and larger GMP's (particularly for males). Naturally, an insurance company will not allow selection against itself and so in deciding which office to arrange a contract with the scheme administrator (in conjunction with his advisers) must determine the likely ages of the withdrawing members and the levels of their respective GMP's. 28. Over the last few years the options available to members of pension schemes who leave service without becoming entitled to an immediate pension have been subject to a number of changes in legislation and Inland Revenue practice. The maze of restrictions on options makes it virtually impossible to explain, in simple terms, the choices open to a withdrawing member if the scheme wished to take maximum advantage of the flexibility offered. On facing page is an example of a decision tree which appears in the explanatory booklet of a typical contracted-out pension scheme. OPTIONS 1. You are entitled to a refund of all your contributions less your share of the Contributions Equivalent Premium (CEP) and less tax on the balance. In paying the CEP to the State you are bought back into the State Scheme for contracted-out service and you have no further rights due from the XYZ Scheme. 2. You are entitled to a Guaranteed Minimum Pension (GMP) preserved by the XYZ Scheme plus a refund (after tax) of your contributions remaining after deducting your share of the cost of preserving the GMP. A CEP is not permitted. 3. You are entitled to a refund of any pre-april, 1975 contributions (after tax) plus a deferred pension for post-april 1975 membership calculated as laid down in the XYZ Scheme Rules, but subject to a minimum of your revalued GMP. A CEP is not permitted. 4. You are entitled to a deferred pension as set out in the XYZ Scheme Rules for the whole period of scheme membership, subject to a minimum of your revalued GMP. A CEP is not permitted. 5. You are entitled to a deferred pension as set out in the XYZ Scheme Rules for pre-6th April, 1978 service and a CEP paid to the State Scheme for post-6th April, 1978 service.

15 THE FIRST YEAR OF CONTRACTING-OUT 195

16 196 D. G. JOHNSON 6. You are entitled to a deferred pension as set out in the XYZ Scheme Rules subject to a minimum of your revalued GMP. 7. You are entitled to a refund of your contributions (after tax) for membership before 6th April, 1978 which must include some pre-6th April, 1975 contributions, plus a deferred pension for post-6th April, 1978 membership calculated as laid down in the XYZ Scheme Rules subject to a minimum of your revalued GMP. A CEP is not permitted. 8. You are entitled to a transfer of your benefits (including liability for accrued GMP, plus future revaluation) to your new employer's contracted-out scheme with your new employer's consent. NOTES (a) Those married women and widows who opted to pay the reduced liability contributions prior to May, 1977 will not be subject to the Contributions Equivalent Premium Rules or the Deferred Pension Transfer Value after five years Contracted-Out Service Rule. They will not have a GMP which, therefore, cannot be revalued. (b) A refund of contributions here permissible may be delayed until verification by the DHSS of the CEP amount. Clearly, a very complicated structure of options and the table takes no account of the recent Inland Revenue relaxation with regard to the ' 5,000 Rule'. One point which is worth mentioning here is that the DHSS have no means to check whether payment of a CEP or an LRP (or some other method of preservation of GMP) is an acceptable option in accordance with any particular pension scheme's rules-. Rightly so, they consider it the responsibility of the scheme administrator to confirm that the scheme is operating within the terms of its rules and any undertakings given by the Trustees to the Inland Revenue. A consequence of this decision is that the DHSS will accept a CEP even though the member might have qualified for preservation under the Social Security Act 1973 (and, therefore, a CEP ought not to be paid), similarly they might accept simultaneously a termination notice for one member confirming that the GMP will be preserved on the fixed 8}% per annum revaluation basis and another termination notice in respect of a different member of the same pension scheme for whom an LRP is paid.

17 THE FIRST YEAR OF CONTRACTING-OUT As an alternative to securing the GMP of a withdrawing member in his own pension scheme or by buying out with the State or an insurance company, subject to the consent of the employee, the option is available to transfer responsibility for the GMP to the member's new employer's pension scheme, provided this scheme is contracted-out and prepared to accept the responsibility for payment of the GMP. Under such circumstances, the ceding pension scheme completes form RD562 and forwards it to the DHSS. When a GMP is transferred in this way the effect is the same as if the employee had completed all his contracted-out employment with the new employer, in particular the earnings factors appropriate to the accrued GMP are subject to full revaluation (i.e. limited or fixed-rate revaluation does not apply). 30. A number of contracted-out pension scheme managers have expressed the opinion that responsibility for an accrued GMP should not be accepted as part of an incoming transfer payment. I am concerned that some managers might adopt such a 'blanket policy' without having considered fully the implications of transferability of GMP's. 31. When a member brings a transfer payment into a self-administered pension scheme he is normally offered a period of additional pensionable service which provides pension benefits equal in value to the transfer value received. The additional period of pensionable service is likely to be calculated by means of an actuarial basis which makes allowance for expected future salary increases and interest earnings on the invested transfer value in such a way that no financial strain should be placed on the receiving scheme following acceptance of the transfer payment. If the 'past service pension' (by which I mean the additional pension secured by the transfer payment, on the basis of salary at the date of joining the receiving scheme) exceeds the accrued GMP then no financial strain will be placed upon the receiving scheme by accepting the GMP liability, provided a member's salary increases at a rate not less than the increase in national average earnings, which would be highly likely if the member is in an employment where salary increases on account of promotion are anticipated. To the extent that the past-service pension exceeds the accrued GMP there is a margin whereby increases in national average earnings can exceed those received by the member without any financial strain being placed upon the pension scheme by virtue of acceptance of the GMP.

18 198 D. G. JOHNSON 32. Furthermore, if a comparison is made of the incoming transfer value with the Accrued Rights Premium (ARP) relative to the GMP protection can be afforded should the receiving scheme cease to be contracted-out shortly after the transfer payment has been received. In addition, the ARP gives an indication of the present value of the GMP accepted and, therefore, if the transfer value exceeds the ARP by a reasonable margin, no financial strain should be encountered by accepting the GMP. 33. Of a general nature it is, I believe, worthy of consideration that if it becomes established practice between contracted-out pension schemes to transfer and accept responsibility for GMP's there will be a 'swings and roundabouts' effect and no pension scheme should end up with a disproportionate level of GMP liability. In view of the considerable increase in member awareness of the value of their pension rights there is an 'employee relations' aspect to the policy adopted towards acceptance or non-acceptance of GMP liability following change of employment. If the receiving pension scheme is not prepared (or unable) to accept the GMP responsibility the ceding scheme might be unwilling to pay any transfer payment, in which case the options available to the withdrawing employee are likely to be a refund of his own contributions (less the Certified Amount and the -tax liability) which is unlikely to be financially advantageous, or a deferred pension, which apart from the GMP element, may well not be increased before retirement. 34. Two tests, therefore, suggest themselves when considering acceptance of a GMP as part of a transfer payment. If the proposed transfer passes both tests, I consider it perfectly reasonable to accept the GMP liability. The tests are: (1) Does the total transfer payment exceed the ARP by at least 25%? (2) Does the 'past-service pension' exceed the accrued GMP? Scheme administrators will be aware that the Occupational Pensions Board are currently investigating transferability of pension rights. It would be unfortunate if a general reluctance among scheme administrators and their advisers to investigate carefully the case for and against transferability of GMP's resulted in the OPB recommending further legislation to achieve this object. It is relevant to mention here that most public-sector pension schemes freely transfer and accept GMP's, often as a consequence of membership of the public-sector transfer club.

19 THE FIRST YEAR OF CONTRACTING-OUT complete this section of the review by mentioning briefly three problem areas encountered following withdrawal from contractedout employment and the solutions evolved by the DHSS. Maternity Leave The difficulty encountered relates to whether the six weeks' maternity pay period counted as contracted-in or contracted-out employment. Originally the DHSS ruled that whether the maternity pay period was contracted-in or contracted-out employment depended upon whether or not the woman intended to return to employment after confinement. However, after having taken legal advice the DHSS decided that the maternity pay period was actually a continuation of the woman's employment. Consequently, if a woman was in contracted-out employment when she left because of pregnancy, contracted-out rate contributions should be paid on maternity pay, irrespective of whether she has indicated that she intends to return to work or not. Retrospective Pay Awards The difficulty arises where a termination notice has been forwarded to the DHSS and a retrospective pay award or bonus is paid to the ex-employee. The administrator did not know whether a supplementary termination notice was required. The DHSS have decided that payments of earnings made after an employee has left contracted-out employment should attract contracted-out rate contributions. Where payments are not made before an employee leaves service (e.g. holiday pay, lying-on pay, etc.) but can be determined in advance the contributions to be made on these earnings should be reflected in the termination notice sent to the DHSS. Where payments cannot be forecast in advance of the date of leaving (e.g. retrospective pay awards, wage dividends, bonuses, etc.) the amount paid should be treated as if earned in one week and one week's contracted-out rate contributions paid. Where the termination notice has already been sent to the DHSS and a premium paid, or a GMP statement received, by the time the retrospective payment is made, there is no requirement to inform the DHSS of the additional contracted-out-rate contributions paid, or send in a supplementary termination notice. This arrangement applies whether the retrospective payment is made in the same tax year as that in which the employee left service or in a later year.

20 200 D. G. JOHNSON The Earnings-Related State Pension and, if appropriate, the GMP liability will of course reflect the full National Insurance contributions paid, including those based upon the retrospective pay award. Polygamous Marriages Some scheme administrators were puzzled as to whether a GMP was payable to the widow of a polygamous marriage. The DHSS have confirmed that the provisions of the Social Security and Family Allowances (Polygamous Marriages) Regulations 1975 SI 1975 No. 561 have'the effect of rendering a marriage invalid for Social Security purposes if it is polygamous at the relevant time, for example, at the date of the confinement when maternity benefit is claimed or at the date of death of the husband when widows' benefit is claimed. It, therefore, follows that if a man was polygamously married on the day he died, widow's benefit would not be paid by the State Scheme to any of his wives. Consequently, a contracted-out pension scheme need not pay a widow's GMP to any of the wives under such circumstances. The provisions may, of course, be overridden by the provisions of a particular pension scheme's rules. VARIATION, SURRENDER AND CANCELLATION OF CONTRACTING-OUT CERTIFICATES 36. As might be expected, it was not long after the issue of the first contracting-out certificates that the OPB was confronted with requests for information as to the procedure to be followed to vary a contracting-out certificate. In most cases, the proposed variation arises as a result of the sale or purchase of a subsidiary. The procedures to be completed were summarized in Joint Office Memorandum no. 52. Broadly speaking, this Memorandum provides for notice of intention to vary the certificate to be issued to all relevant employees, to recognized trade unions, the trustees and the insurance company (if any). In addition, consultations must be held with all recognized trade unions. The period of the notice should normally be for at least three months but the OPB can approve a shorter period (although usually not less than one month) if prior to the issue of the notice the employer obtains agreement from both the OPB and recognized trade unions.

21 THE FIRST YEAR OF CONTRACTING-OUT As practice developed, it became clear that many of the variations requested to the contracting-out certificate did not involve any change of pension scheme for the employees concerned nor were their requisite benefits affected. In such cases, the formal notice and consultation procedures did not appear to be appropriate. Happily, Regulations took effect early in 1979 which enabled the OPB to adopt a more flexible approach under certain circumstances to variations of contracting-out certificates. The new arrangements, which are described fully in Joint Office Memorandum no. 57, apply in particular: (a) in a temporary situation, where a subsidiary company is sold to an unassociated company, or where a business or part of a business is sold or is split to form a new business or businesses, and the SFO approve arrangements for the employees to remain in the old pension scheme while new long-term arrangements are made for them, or (b) in a situation, which is likely to be more permanent, where: (i) there is a change in the structure of a company or group of companies; or (ii) with a group of companies in business association it is desired to change the type of contracting-out certificate from a number of "single employer" certificates to one holding company, or vice versa. 38. Provided that the OPB are satisfied that: (a) the employees in employments covered by the election will continue to qualify for requisite benefits under the scheme of which they are members at the time the election takes effect, and (b) the rights of those employees to requisite benefits under the scheme will be unaffected; and (c) the employment of those employees will continue to be contracted-out by reference to that same scheme, the OPB will not require compliance with the usual formal notification and consultation procedures but accept a 'notice of explanation' which has been sent to the appropriate employees, recognized trade unions, scheme administrator and trustees. Such relaxation in procedures will greatly assist scheme administrators in dealing with sales and purchases of subsidiaries and company reconstructions. It should be noted that the new relaxed arrangements do not cover

22 202 D. G. JOHNSON surrender or cancellation of contracting-out certificates and in such cases the formal notification and consultation procedures continue to apply. SCHEME DOCUMENTATION 39. Once an employer had reached his decision on whether or not he would contract his employees out of the Earnings-Related State Pension Scheme, it was usually necessary to work very quickly if the appropriate procedures were to be completed in time for the contracting-out certificate to be issued before 6th April, For every existing pension scheme which was to be used as a vehicle for contracting-out it was necessary to make a number of amendments to the rules in order to comply with the requirements of the Social Security Pension Act 1975 in many cases the amendments required were very substantial. Clearly it was the exception where time was available to agree definitive rule amendments with the OPB so that the revised Definitive Deed and Rules could be executed prior to the date the election for a contracting-out certificate was made. In most cases an Interim Deed procedure was adopted with the undertaking that definitive amendments could be made within twenty-four months we are now at least twelve months into those twenty-four. 40. Over the last twelve months scheme administrators have been actively employed in drafting rule amendments which are acceptable to the OPB for the purposes of contracting-out. The OPB have insisted that amendments are made on an individual basis and they are not prepared to accept the style of overriding undertakings which were embodied in the interim contracting-out deeds. It has, however, been my experience that when a draft set of amendments are submitted to them the OPB are very helpful in indicating precisely where they consider the amendments are inadequate and suggesting alternatives. It may be helpful to list the main areas where amendments are necessary. I must stress that the list is far from exhaustive and each pension scheme will have its own peculiarities: (a) incorporation of a definitive rule on GMP's; (b) redrafting of the winding-up provisions to incorporate a revised set of priority liabilities; (c) revision of the rule relating to commutation of pension ('on a basis certified as reasonable by an actuary'), qualification to the commutation of trivial pensions provisions, etc;

23 THE FIRST YEAR OF CONTRACTING-OUT 203 (d) amendments to the rule relating to transfer payments to refer to the GMP only being transferable to another contracted-out scheme; (e) provisions to ensure payment of requisite benefits, particularly to widows following death after early retirement; (f) revision of definition of widow (i.e. wife at both date of death and date of leaving service is no longer acceptable); (g) revision of early retirement reductions (i.e. reduction of not more than 6% for each year of early retirement or on a basis which has been certified as reasonable by an actuary); (h) age disparity reduction in widow's pension to be limited to 2½% for each year in excess of ten; (i) various trustee discretions to be made subject to consent of the OPB (in particular those which affect requisite benefits). COMPUTERIZED ADMINISTRATION 41. Even without the Social Security Pension Act 1975, the demands upon the administration system of a pension scheme have been increasing steadily over the last decade. Growing awareness amongst employees of the value of their pension benefits have led to demands for annual benefit statements. Personnel departments have observed that the pension scheme records can provide a useful database and managers have begun to take advantage of the statistics collected through the pension fund for future planning exercise. Add to this the routine form-filling which is a consequence of contractingout and the additional requirements of the actuary for his valuation data and we can start to appreciate the reasons for the growth in the number of self-administered pension schemes which make use of a computer in their administration system. 42. It is of course possible to administer any pension scheme without recourse to a computer prior to 1960 National Insurance records were maintained successfully on manual ledger by an army of clerks! However, in a modern pension scheme it is clearly not cost efficient to neglect the opportunities made available by computers. A number of the very large pension schemes have developed their own computerized administration systems, some with considerable success. However, the complexities involved often deterred introduction of a full administration system. 43. During the last two or three years the introduction of the

24 204 D. G. JOHNSON Earnings-Related State Pension Scheme has spurred on the production of computer packages which can provide a basic administration system for virtually every pension scheme. Bearing in mind the workload which such a system takes off the shoulders of the Pensions Department, the packages are very reasonably priced. For a pension scheme with 5,000 members, say, the annual rental of a package works out at about 1 per member, less than the total costs of employing a full-time pensions clerk. 44. The package will maintain a pension master file which will record all relevant personal details in respect of active members, including contribution history, salary history, service history and all Social Security Pension Act 1975 details. In addition, similar records will be available for current pensioners, widows, dependants and deferred pensioners. The computer system will probably be capable of producing (via a link with the Company payroll) all relevant DHSS forms appropriate to leaving members a considerable advantage in itself. In addition, the system may provide valuation data in a form directly compatible with the actuary's requirements, contribution accounting to assist the pension scheme's auditors, diary reports (e.g. impending retirements), statistical summaries, benefit statements and benefit calculations. 45. As computer packages are available for use on the Company's own computer or on a bureau basis, it seems to me that virtually every self-administered pension scheme can derive considerable benefit from them in terms of increased efficiency and accuracy. I believe the advantages of these systems will become even more obvious once the Earnings-Related State Pension Scheme becomes fully operational when earnings-related pensions (and GMP's) become payable. CONCLUSIONS 46. In this paper, I have attempted to give a brief account of some of my observations during the first twelve months of contracting-out. Many aspects have not been covered as I have attempted to restrict the paper to a readable length, but perhaps some areas I have not referred to can be covered by discussion. I conclude with a quotation and a list. The quotation is from the Secretary of State for Social Services in September, 1974: "Terms for contracting-out of the State Scheme are as simple as they can be made...".