C1.03: CONTRACTING OUT OCCUPATIONAL SCHEMES

Transcription

1 C1.03: CONTRACTING OUT OCCUPATIONAL SCHEMES SYLLABUS Nature of contracting out Nature of NI rebate or reduction Reference scheme basis GMP and WGMP Money purchase basis Protected Rights Extent of guarantees State pension residual entitlement Nature of contracting out In principle, contracting out means giving up benefits under the State Second Pension Scheme (S2P) in respect of the period of contracted out employment and benefiting from a reduction in or rebate of National Insurance (NI) contributions However, the amount given up is not necessarily the whole of the member s S2P entitlement (see below) Contracting out requires benefits to be provided under a private scheme in place of those given up under S2P Under occupational schemes this can be achieved on a defined benefit (DB) or defined contribution (DC) basis It is not necessary for the whole membership of the scheme to be contracted out Some members can be contracted out on a DB basis and some on a DC basis Note that the option to contract out is expected to be withdrawn from defined contribution occupational schemes in 2012 The option is also available on a DC basis under personal pensions (PPs) However, this option will be withdrawn at the same time as it is withdrawn under DC occupational schemes It is not possible to contract out of the State basic pension Nature of NI rebate or reduction Where contracting out is achieved by means of a DB scheme, there is a reduction in the NI contributions payable through payroll by both employer and employee Currently the reduction (which is NOT age related) is 3.7% for the employer and 1.6% for the employee In both cases, the reduction is applied to earnings between the Lower Earnings Limit and Upper Accrual Point These are the earnings taken into account for the accrual of benefits NI contributions only start to become payable when earnings exceed the NI Primary Threshold (for employee contributions) or the NI Secondary Threshold (for employer contributions)

2 These are slightly higher than the Lower Earnings Limit (LEL) As a result, contracting out can mean that a credit arises in respect of those earning between the thresholds and the LEL Where contracting out is achieved by means of a DC occupational scheme, there is a reduction in NI contributions payable through payroll by both employer and employee Currently the reduction through payroll is 1.4% for the employer and 1.6% for the employee In addition, an age related rebate is paid to the scheme after the end of the tax year concerned This is paid by the National Insurance Contributions Office of HMRC (HM Revenue & Customs) The amount increases with age, but is capped at 4.4%, giving a maximum combined reduction and rebate of 7.4% The reduction and rebate are both based on earnings between the Lower Earnings Limit and Upper Accrual Point For individuals of the same age, the total reduction and rebate under a COMPS is less than that under personal pensions except at older ages, when the same 7.4% ceiling applies The difference reflects the fact that part (the reduction given through payroll) is paid earlier under a COMPS Reference scheme basis Since April 1997, the basis of contracting out by means of a DB scheme has been the Reference Scheme test In principle, this requires benefits under the scheme to at least match those under a hypothetical reference scheme, defined under the Pension Schemes Act 1993 The test is applied to the scheme as a whole rather than to each individual member The scheme actuary must certify that at least 90% of members will receive benefits at least broadly equivalent to those under the reference scheme If there are different benefit categories, the test must be separately applied to each category The reference scheme basis is: - Retirement age 65 - Accrual rate 1/80ths of final salary, with a maximum of 40 years service to count - Final salary is based on the average of qualifying earnings over the last 3 years - Qualifying earnings for this purpose are 90% of earnings between the Lower Earnings Limit and Upper Accrual Point - 50% spouse s benefits on death before or after retirement (and from 5 December 2005 for registered civil partners, but only in respect of service from 6 April 1988) The NI reduction subsidises the cost of providing such a scheme, but there is no direct relationship between the reduction and the funding of the scheme If the scheme is non-contributory, members will simply be better off as a result of the NI reduction Although there is no guarantee that benefits under the scheme will be better than those given up under S2P, the basis of the reference scheme makes this almost certain Schemes contracted out on the reference test basis are often referred to as COSRS (Contracted Out Salary Related Schemes)

3 Benefits under a COSRS are subject to the normal tests against the annual allowance and lifetime allowance Limited Price Indexation (LPI) applies in the normal way There are no special restrictions as regards the timing of benefits, or the extent to which they may be commuted for a tax free lump sum at retirement and normal HMRC rules apply GMP and WGMP Until April 1997, contracting out on a DB basis required the scheme to provide members with a Guaranteed Minimum Pension (GMP) GMP was an approximation to the benefits provided under SERPS (which was in operation at the time, prior to its replacement by S2P in 2002) The SERPS entitlement of a contracted out member was not completely eliminated, but was reduced by the amount of the GMP, leaving a residual SERPS entitlement Because the occupational scheme had to provide GMP, and this was the amount of the reduction in SERPS benefits, the member had a no worse off guarantee In practice, benefits under most contracted out schemes were considerably in excess of GMP levels The scheme also had to provide a Widow(er) s Guaranteed Minimum Pension (WGMP) which is 50% of the member s GMP This applies both on death before and after retirement For widowers, the WGMP is based only on service from 6 April 1988 Registered civil partners now qualify for WGMP in the same way as widowers, based on service from 6 April 1988 GMP benefits cannot be commuted for a lump sum at retirement They are subject to specific requirements as regards escalation, with no escalation required for GMP accrued between 1978 (when contracting out started) and 1988, and increases in line with price inflation, capped at 3% pa in respect of GMP accrued between 1988 and 1997 The State scheme provides additional escalation where necessary to bring the level of increase up into line with the full level of price inflation In the past, the RPI has been used as the measure of price inflation From 2011, the CPI (Consumer Price Index) will be the required measure, but this may cause some problems in its application If scheme rules refer to the RPI rather than to statute, there is no override available to substitute the CPI increase if less Such schemes may therefore need to continue to use the RPI (unless members consent to the use of the CPI) In recent years, the CPI has tended to increase less quickly than the RPI, so the effect should be a reduction in pension costs where the change can be made If the member wishes to retire before State Pension Age, the scheme must ensure that the benefit payable at State Pension Age at least equals GMP, otherwise early retirement benefits cannot be permitted The Pensions Act 2008 contains provisions which will allow GMPs to be replaced under schemes with benefits of equivalent value

4 This has come into effect from 6 April 2009 and should simplify the administration of schemes considerably However, there are some issues relating to the detailed operation of the option, which so far has meant that it has not been taken up as widely applied as hoped The issues relate primarily to the determination of equivalent value Money purchase basis The money purchase or DC basis for contracting out was introduced in 1988, in order to widen the potential take-up of contracted out status The basis is that at least an amount equal to the contracting out reduction and rebate must be paid into the scheme and be used to provide benefits for members The rebate is paid direct to the scheme by HMRC The employer must ensure that an amount at least equal to the reduction in NI through payroll is also paid in Generally, the reduction subsidises contributions at a higher level by both employer and employee However, if the scheme is non-contributory, the employees will benefit from the NI reduction, and the employer must pay an amount at least equal to the total NI reduction into the scheme The benefits provided by the reduction and rebate are Protected Rights, which are subject to certain special requirements (see below) Occupational schemes which are contracted out on a DC basis are referred to as COMPS (Contracted Out Money Purchase Schemes) Protected Rights The Protected Rights fund under a COMPS must be separately identifiable (otherwise the restrictions on Protected Rights benefits will apply to all scheme benefits) Protected Rights under a COMPS are subject to essentially the same rules as apply to Protected Rights under personal pensions This means that: - If an annuity is purchased, the rates must not differentiate by gender (ie unisex rates must apply) - The annuity must also include a 50% pension payable on the member s death to a surviving spouse or registered civil partner if there was such a person at the time the annuity was purchased In the past, Protected Rights have been subject to a number of restrictions, including a prohibition on cash and an earliest access age of 60 These restrictions have been abolished in respect of Protected Rights coming into payment on or after 6 April 2006, irrespective of when they accrued The benefits can therefore be taken from age 55 (50 prior to 6 April 2010) In cases of incapacity, there is no minimum age requirement However, where an annuity is used to provide Protected Rights, the rates must not differentiate by gender The annuity must also include a 50% pension payable on the member s death to a surviving spouse or registered civil partner if there was such a person at the time the annuity was purchased

5 These restrictions have been retained for the present but are to be removed in 2012, when the ability to contract out under a DC arrangement will also be withdrawn If income is provided by means of income withdrawals, normal limitations apply with a maximum income of 100% of the amount that could be provided based on GAD (Government Actuary s Department) rates These rates and therefore the maximum income levels do vary by gender Up to 25% of the Protected Rights can be taken in the form of a lump sum when retirement benefits crystallise Escalation is not required for Protected Rights benefits coming into payment on or after 6 April 2005 (though it was previously a requirement) On death before taking benefits, the Protected Rights fund must be used to provide income benefits if there is a surviving spouse or registered civil partner Otherwise, the fund can be paid as a lump sum in the usual way Income benefits paid on the death of a member would be taxed as non-savings income, but any lump sum would be free of tax (subject to the usual lifetime allowance rules) Extent of guarantees Contracting out seldom guarantees that members will be no worse off than had they retained full membership of SERPS or S2P The exception is for contracting out on a GMP basis under a DB scheme in respect of service prior to April 1997 Contracting out under a DB scheme by means of the Reference Scheme Test makes it likely that the member will be better off, but there is no guarantee Contracting out under a DC scheme carries no guarantee, and if total contributions are little more than the NI reduction and rebate, there is a significant risk that the member will be worse off State pension residual entitlement There is often a residual SERPS or S2P entitlement in respect of contracted out periods of employment Under a DB scheme, in respect of service before April 1997, SERPS benefits were reduced only by GMP entitlement and this results in residual SERPS benefits In particular, the level of escalation required of GMP benefits is lower than provided by SERPS in many circumstances, and the additional escalation will still be provided by the State scheme There is generally also a small pension entitlement for the member, and often additional survivor s benefits Under a DC scheme, for service before April 1997, SERPS benefits were again reduced only by GMP (even though the occupational scheme did not itself provide GMP benefits) As a result, residual SERPS benefits arise in the same way as where the individual was contracted out under a DB scheme For service between 1997 and 2002, contracting out under an occupational scheme (whether DB or DC) resulted in the loss of all SERPS benefits, and there are no residual benefits in respect of this service In April 2002, S2P replaced SERPS

6 However, to minimise the administrative changes required for occupational schemes, the contracting out basis was not changed, and continues to reflect the old SERPS basis, rather than the new S2P basis There will therefore remain a residual S2P entitlement where S2P benefits exceed those that would have been provided by SERPS This is true of members earning at modest levels in excess of the Lower Earnings Limit but not those whose income is close to or exceeds the Upper Accrual Point