The end of an era MAY DB pension scheme closure of contracting-out. Life in UK pensions never stands still. Cessation view

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1 MAY 2014 [ PMI T E C H N I C A L n e w s [ The end of an era DB pension scheme closure of contracting-out Life in UK pensions never stands still The world of pension schemes in the UK is never static or lacking in controversy, and with recent announcements about the future of the State Pension, and how this integrates with defined benefit (DB) pension schemes, we are yet again placed into another arena of significant work needed to be completed within tight timescales. The following represents the view of the proposed changes from the perspective of a Cessation Specialist Angela Moran and a bulk buy-out consultant Adrian Marshall. They explain what will happen to contracted-out DB schemes and what everyone concerned with them needs to consider. Cessation view What is happening and when? In January 2013, the Government announced plans to reform the State Pension system, by changing it into a single-tier pension for future pensioners. The new single-tier pension will come into payment with effect from 6 April 2016 and will affect those who reach State Pension Age on or after this date. The introduction of the single-tier State Pension will mean that DB schemes will no longer be able to contract-out and all schemes will cease to contract-out. What is meant by contracting-out? With effect from April 1978, the UK government introduced the State Earnings Related Pension Scheme (SERPS) which subsequently became the State Second Pension (S2P) in April The purpose of SERPS/S2P was to provide employees who paid full Class 1 National Insurance Contributions with an additional earnings related pension, to be paid in addition to their Basic State Pension. Prior to April 1997, DB pension arrangements were able to contract-out of SERPS on a Guaranteed Minimum Pension (GMP) basis, meaning that both the employer and scheme members paid National Insurance Contributions at a lower rate than would otherwise have applied. In exchange, scheme members became entitled to receive a GMP from the scheme. A member s GMP is broadly equivalent to the amount of SERPS that they would have accrued had they not been contracted-out. After April 1997, GMP ceased to accrue and DB arrangements that were actuarially certified to provide a minimum level of benefit could elect to contract-out on a Reference Scheme Test (RST) basis. Alternatively it was possible to contract-out on a money purchase basis in which an underpin to scheme benefits was provided by National Insurance rebates received from the Government. In January 2013, the Government announced its intention to introduce a Single Tier State Pension and as a result the S2P will no longer accrue from April 2016 and, in turn, DB pension arrangements will cease to contract-out from this date. Her Majesty s Revenue & Customs (HMRC) safeguards and maintains individual National Insurance accounts and therefore holds details of GMPs and contracted-out service for members who have contracted-out of SERPS/S2P.

2 Who will be affected? It is estimated that there are approximately 4,500 schemes still contracted-out nationally which include 1.6 million contracted-out active members of private sector DB schemes and 5.3 million active members of public sector DB schemes. 1 What changes will the abolition of contracting-out have on employers and scheme members? Employers and scheme members will cease to qualify for a lower rate of National Insurance Contributions. What changes will the abolition of contracting-out have on scheme administration? At present, for schemes which have not yet ceased to contract-out, HMRC issues statements informing pension schemes of the GMPs that should be put into payment as and when they fall due. Under the current system, administrators are able to query and resolve any discrepancies that are identified between HMRC s records and those held by the scheme. HMRC has to be informed of any changes to the contracted-out liabilities, for example, if a member transfers their benefits to a different pension arrangement. With effect from April 2018, HMRC has confirmed that it will significantly scale back the service that it offers and, as a result, will neither track where GMPs are held nor issue statements when benefits fall due. Instead, it is intended that, in December 2018, all members of these schemes will be issued with individual statements confirming: n they hold contracted-out benefits n the period during which those benefits were accrued n the pension scheme in which the benefits are held There will not be any information regarding the amount of these benefits within these statements. There will be very little scope to query GMPs and contracted-out liabilities with HMRC after April What is a contracted-out liability reconciliation? Broadly speaking, this is the comparison of the membership and the liabilities held by HMRC with those held by the trustees/ pension administrators on their scheme records. These include: n Early Leavers - Members under State Pension Age n Pensioners - Members who have attained State Pension Age n Widow(er)s - Deceased members for whom there is a surviving spouse or civil partner at date of death Types of reconciliation Traditionally there are two types of reconciliation which can be undertaken on behalf of the trustees 1. A membership only reconciliation this will investigate the membership only and the exceptions to be agreed are: a. Those members for whom the scheme believes that a liability is held but HMRC does not, and b. Those members for whom HMRC believes that a liability is held but the scheme does not 2. A full reconciliation - in addition to 1, this will take into account such variables as member surname, contracted-out start date, contracted-out termination date, total GMP, and post 88 GMP. With effect from April 2018, HMRC has confirmed that it will significantly scale back the service that it offers and, as a result, will neither track where GMPs are held nor issue statements when benefits fall due Are the trustees obliged to perform a contracted-out liability reconciliation? Current position When a scheme ceases to contract-out, HMRC provides details of the membership recorded under the Scheme s Contracting-out Number (SCON) and trustees have an obligation to notify HMRC of how the scheme intends to secure the contracted-out rights held by the scheme. This notification should be given within two years of being provided with the scheme membership information. This process includes both the membership and all the GMPs held by the scheme. In the event that the GMP reconciliation is not undertaken at the time the scheme ceases to contract-out, it is HMRC s view that all members benefits are agreed and are being retained in the scheme. Individual member queries would then be dealt with as and when they arise. Proposed changes For schemes subject to the abolition, HMRC has already confirmed that with effect from April 2016 all DB arrangements cease to contract-out and their contracting-out certificates will be cancelled. As mentioned previously, it is HMRC s intention that with effect from December 2018: n all members will be issued with individual statements and it will be the member s responsibility to track their contractedout benefits after this date n the services currently offered by HMRC will be significantly scaled back and as a result there will be little scope to query GMP / benefits after this date Footnotes 1. Occupational Pension Schemes Annual report 2011, Office for National Statistics 2. For members who are currently active scheme members, HMRC has announced plans to amend the tax year end returns to be submitted by employers or their payroll agents from in order to identify which members are linked to which pension schemes as at the abolition date. 2 PMI TECHNICAL NEWS APR 2014

3 In the event that no reconciliation is undertaken, HMRC will assume that its records are deemed to be correct. Trustees need to ensure that they do not incur additional liabilities and as it is likely that members will perceive that the statements issued by HMRC are binding, the trustees may wish to be certain that their scheme membership has been fully reconciled with HMRC s records. Going forward Following the Government s announcement in 2013, third party administrators were given the opportunity to participate in workshops organised by HMRC to discuss the proposed changes. The major concerns for administrators which were raised against HMRC included: n they will assume that members benefits are correctly recorded on their records n they will cease to track members contracted-out benefits after 2018 Therefore, without being given the opportunity to reconcile the scheme membership, the Scheme could be left with liabilities for which the administrator does not hold a record. Trustees need to ensure that they do not incur additional liabilities and as it is likely that members will perceive that the statements issued by HMRC are binding, the trustees may wish to be certain that their scheme membership has been fully reconciled with HMRC s records How would a contracted-out liability reconciliation be performed? Clearly, any attempt to reconcile contracted-out liabilities for all of these members in the two year period between April 2016 and April 2018 would place a tremendous strain on HMRC s resources and, as such, reconciliations which commence at that time are likely to encounter significant difficulties. HMRC has therefore announced the introduction of the Scheme Reconciliation Service which allows pension scheme administrators and trustees to reconcile the membership and GMP data held on scheme records against HMRC records in advance of the ending of contracting-out in April The service provides a list of contracted-out periods and GMP data for members who have left contracted-out employment. This includes deferred members, pensioners, widows, widowers, and surviving civil partners 2. The service will provide the data requested from April Schemes wishing to use the Scheme Reconciliation Service may register their request for data with effect from January As data will be provided by HMRC on a priority order to be decided by HMRC, the trustees are well advised to make their request for data as soon as possible if they wish to take advantage of this opportunity. What are the potential risks or disadvantages of not reconciling contracted-out liabilities? Some of the main disadvantages of not undertaking a contractedout liability reconciliation are: n HMRC hold records for members who ceased to be scheme members some time ago and n transferred their benefits to another pension arrangement, or n had their contracted-out liability extinguished by payment of a state scheme premium but for whom the payment has not been correctly allocated n individuals who never participated in the pension scheme n contracted-out members benefits may be inaccurate and incorrect n benefits and pension increases paid at a future data may be incorrect n true scheme liabilities may be unknown n the scheme is not fully prepared when/if GMP equalisation is enforced n trustees may be unable to secure benefits on more favourable terms in the event of a buy-out/in exercise The Pensions Regulator The regulator has stressed that data quality is essential to good governance and as a result of the guidance it has issued many schemes are reviewing the quality of their data. It also places great emphasis that the quality of the scheme records and accurate membership data are critical to many of the activities that need to take place during the life of a scheme and that the trustees are accountable for these records. Generally, prior to the regulator s guidance on data and record keeping, few trustees considered undertaking a GMP reconciliation project, unless they were proposing a significant scheme event e.g. such as a pensioner or deferred member buyout exercise or full wind-up exercise. A key governance point which trustees must remember is that they need to ensure that the right benefits are being paid to the right members at the right time. The scheme administrators have a duty to ensure that the scheme records which they hold on behalf of the trustees are complete and accurate. This is this key to providing high quality pension administration. Insurance If, in the future, trustees are looking to secure scheme benefits through a buy-out/buy-in exercise, our experience has shown that 3 PMI TECHNICAL NEWS APR 2014

4 all things being equal, insurers prefer to insure schemes which have already reconciled their contracted-out liabilities. If the contracted-out liabilities have not been reconciled then effectively the insurer will be agreeing to accept responsibility for unreconciled benefits and they may also be subject to future claims against the scheme for members who have a benefit in the scheme but have not been identified at the date of insurance. By setting the ball rolling to begin the reconciliation as soon as possible, the trustees will be able to take advantage of the additional two year window for reconciliation between April 2014 and April Is a contracted-out liability reconciliation covered by the existing administration contract? As such an exercise is usually classed as one-off, it is unlikely that the reconciliation of contracted-out liabilities is covered under the current administration agreement. What are the costs? The costs associated with a full GMP reconciliation are likely to be high due to the numbers of differences involved and the time consuming nature of how to address some of the queries. In an effort to control these costs, trustees need to consider the following: n set tolerance levels - decide on a GMP tolerance level that is appropriate to both the size of scheme membership and the amount of the GMPs n the regulator s suggested 2 per week tolerance - consider the above tolerance level to be set at 2 per week GMP tolerance level - the regulator is encouraging trustees to apply this as it is in line with the tolerance level accepted by the Pension Protection Fund n accept HMRCs details - accept the GMP s from HMRC without further investigation. This action would significantly reduce the timescale and the costs to complete the reconciliation exercise. Nevertheless, it may be considered extreme and not rest comfortably with the trustees. Action would be required to review records for members with transferred-in benefits since there is a risk that these are not recorded fully on HMRC s records n staged approach - once the GMP discrepancies have been identified, the trustees could take a pragmatic approach. For example, agree scheme membership first and then review the discrepancies according to the member s current status, such as accepting HMRC s values for all deferred members. Bulk buy-out view In practice While the exact detail remains unclear, it would seem reasonable to assume that HMRC s announcement means that there is now a limited timeframe in which to instigate and complete any GMP reconciliation work. Broadly, a window now exists until 2016 during which work on GMP reconciliation can commence and a further period until 2018 to complete that work. After 2018, it seems likely that HMRC will close its doors to supporting future queries, at least in terms of having sufficient resource to undertake any substantial work quickly. With this background, trustees and sponsoring employers are faced with the question: Should I reconcile my GMPs while there is still time? If a scheme does not reconcile its GMPs with HMRC then, arguably, it doesn t have sufficient certainty as to what scheme benefits are payable and so is at undue risk of paying incorrect benefits and even faces the risk of missing paying some benefits altogether Risk management If a scheme does not reconcile its GMPs with HMRC then, arguably, it doesn t have sufficient certainty as to what scheme benefits are payable and so is at undue risk of paying incorrect benefits and even faces the risk of missing paying some benefits altogether. We carry out many GMP reconciliation exercises and it is not unknown for some to result in a large number of discrepancies. It is true to say that the majority of any discrepancies typically result in only small changes in overall liabilities as a consequence of GMPs being only part of a DB pension promise. Usually, changing a GMP amount does not change a member s total pension. One example where there can be large scale differences between a scheme s records and HMRCs records relates to past bulk transfers in or out of the scheme. GMP reconciliation exercises can unearth significant groups of members which the trustee believes have long since been removed from the scheme through a bulk transfer to another scheme. However, unless the trustee takes the opportunity to reconcile the position with HMRC now, it might later find that some GMPs continue to reside with the scheme and yet there are no longer any quick and/or robust avenues available to transfer this responsibility elsewhere. We are aware of cases where, as a result of discrepancies between scheme and HMRC records, bulk transfers introduce an additional, hitherto unknown, GMP liability equivalent to around 10% of the known membership. With the reduced resource at HMRC beyond 2018, it may prove difficult in future to gain sufficient traction to enable a scheme to remove GMPs from their records. Failure to remove such liabilities will ultimately impact funding levels, accounting disclosures and the general management of a scheme. PMI TECHNICAL NEWS APR

5 Do I have to reconcile? The starting point is generally considered to be HMRC s records are correct unless proven otherwise. Whether that is a legally binding position is perhaps open to debate. It is probably worth considering the following question: What argument does a scheme have for not accepting HMRCs GMP record after 2018 if the scheme did not take advantage of the well-defined and publicised four-year reconciliation period?. Traditionally, buy-out and wind-up are catalysts for undertaking a GMP reconciliation. These reasons will remain beyond An insurer might well err on the side of caution and side with HMRC s view. Without knowing what HMRC s records show it may be difficult to convince an insurer to take on the scheme at all. Therefore, if buy-out is the goal, then the legality of the position is perhaps less of an issue than the practicalities. GMP equalisation also seems likely to be a strong reason why the reconciliation of GMPs should be carried sooner rather than later. If it becomes clear how to equalise GMPs, how can this be done without first having established what those GMPs are? Even though there is no legal requirement for trustees to undertake a reconciliation of their schemes contracted-out benefits, they may wish to consider such an exercise bearing in mind the potential risks involved Trustees need to ask themselves: 1. Can you afford not to undertake this work? 2. If you are going to, register their request for data sooner rather than later. In summary, having read the views of the Cessation Specialist and the Bulk Buy-out Consultant the following are the main points for trustees to remember and consider: n DB contracting-out is ending in April 2016 n all reconciliation needs to be completed by April 2018 n all individuals within these schemes will receive a notice of membership based on HMRC records during December 2018 n trustees of contracted-out schemes can start a reconciliation process now n if trustees decide not to reconcile their contracted-out benefits, the following may happen: n having members in their schemes which don t belong n holding incorrect GMP amounts being paid n funding for incorrect benefits As we said at the start, things never stay still in pensions. Angela Moran, Cessation Specialist, Mercer Adrian Marshall FIA, Bulk Buy-Out Consultant, Associate, Mercer What are a trustee s duties? Arguably, a key duty of a trustee is to take all reasonable action to maximise the chance of paying each scheme member the correct benefits at the correct time. Given this, there does not appear to be a strong argument for not reconciling a scheme s GMPs. This is particularly pertinent in the context of the knowledge that a GMP reconciliation exercise might identify a large number of cases where the records held by the scheme are inconsistent with the record held by HMRC. What does this mean? Ultimately the proposed changes mean that after 2018 the opportunity to reconcile contracted-out liabilities will be lost. Even though there is no legal requirement for trustees to undertake a reconciliation of their schemes contracted-out benefits, they may wish to consider such an exercise bearing in mind the potential risks involved. 5 PMI TECHNICAL NEWS APR 2014

6 Opinions expressed in this publication are the personal views of the contibutor and should not be regarded as the official views of the PMI. Published by: The Pensions Managment Institute PMI House 4-10 Artillery Lane London, E1 7LS T: F: E: 6 PMI TECHNICAL NEWS APR 2014