Employers with contracted-out final salary pension schemes will also be affected by fundamental structural and financial changes as a result of this reform, as will the trustees of such schemes and their members.
What’s the current position?
The pension paid by the State is currently made up of a Basic Pension based on a person’s history of National Insurance contributions, a Second Pension (currently known as S2P, previously SERPS) based originally on a person’s earnings and a complicated system of means-tested benefits known as the Pensions Credit.
This is an outdated, patched-up, fiddled-with and confusing system, so much so that up to 1.5 million pensioners currently fail to claim what they are due. Despite this, State pensions represent a fast growing “black hole” in the nation’s finances that needs to be brought under control.
What’s going to happen?
The Government proposes to sweep the old regime away and replace it with a “Single Tier” pension – a flat rate pension that will in theory be the same for all, sustainable and affordable for the nation. The new regime could be in place as early as 2017 and will affect all new pensioners after that date.
The amount of the flat rate pension and its increase mechanism will be confirmed by the Government before implementation, but it is intended to start as the equivalent of the maximum State pension available today, i.e. £144 per week.
For those reaching State pension age after 2017, the State pension system should be considerably simplified, although some complexities will remain if pensioners do not have a sufficient number of years of National Insurance contributions. It will be necessary to have 35 years’ worth of contributions history to receive the full amount of the flat rate pension and a minimum of 10 to qualify at all.
However, people who become entitled to a pension before 2017 will have to continue with the current system and all its problems.
State pension age is also going to rise in step with longevity and the current proportion of life spent in work compared to life spent in retirement. The Government will review the State pension age every five years. Some commentators have calculated that State pension age is likely to be 70 by 2053 on current Office of National Statistics figures.
Who will benefit and who will lose out?
Early indications are that the self-employed, women and the low paid with savings will benefit the most, and that the better-paid and today’s youth will bear most of the reductions. However, everyone will have to work for longer and pay more National Insurance to receive on average less than before. The cost of administering the State pension system should also reduce. So the real winner from these changes will be the Treasury.
What else will happen?
The introduction of a flat rate State Pension also means the abolition of S2P and the abolition of “contracting-out” from S2P, as there will be nothing to contract out from.
What does the end of S2P mean for individuals?
Many people were “contracted-out” from S2P through final salary pension schemes or through certain money purchase pension schemes before April 2012, i.e. they gave up some or all of their S2P in exchange for a reduction in their National Insurance contributions. Therefore, they may have paid insufficient amounts of National Insurance to qualify for a full flat rate pension.
Conversely, those that have not contracted-out may have built up an entitlement to S2P in excess of the flat rate pension, which they may now fear losing.
The White Paper acknowledges that the majority of people working today have been contracted out at some point in their working lives. It estimates that 80 per cent of those that reach State pension age in 2035 will have been contracted out at some point.
To deal with this, the Government proposes to translate everyone’s pre-implementation National Insurance records into a “Foundation Amount”. This Foundation Amount will be the starting point for deductions from the flat rate pension to take into account contracting-out. These deductions can be repaired by additional years of National Insurance contributions paid post-implementation. The Foundation Amount will also be the benchmark for determining if a person has an excess of S2P over the flat rate pension, which will be protected and paid on top of the flat rate pension when they retire.
The White Paper estimates that by the mid-2030s over 80 per cent of people reaching State pension age will receive the full flat rate pension.
The Task of the Century?
The mechanism for establishing the Foundation Amount will be clarified by the Government in due course.
Clearly it will be a monumental task, fraught with difficulty: the Government proposes to establish a Foundation Amount for tens of millions of people over the next five years, from data that may or may not be complete or correct. Anyone familiar with the difficulties in reconciling guaranteed minimum pensions on scheme wind-up will be able to imagine the scale of this task. This could prove to be one of the biggest public procurements in decades.
Whether or not there will be a mechanism for communicating proposed Foundation Amounts to future pensioners, and whether or not they will be able to challenge the calculation, is yet to be seen.
Again, the likelihood is that there will be a vast demand for financial advice amongst the general public in relation to this issue. Will the industry be up to the task?
What does the end of S2P mean for employers and final salary schemes?
Employers were incentivised to make their pension schemes “contracted-out” by a valuable National Insurance rebate (it currently stands at 3.4% for employers, and 1.4% for employees). The aim of this was to encourage them to continue providing “good quality pensions”.
Once that incentive is removed, many commentators fear that the sudden and significant increase in National Insurance costs may cause employers to close their final salary schemes entirely, especially with auto-enrolment being brought in at the same time.
To allay this concern, the White Paper has stated the Government’s intention to give employers a temporary statutory power to make structural changes to their final salary schemes, for example by reducing future benefits or by increasing employee contributions, in order to offset the additional National Insurance cost. Recognising that scheme trustees might not consent to such changes, if they hold the power of amendment or if their consent is required under the scheme rules, the White Paper proposes that the employers’ power will override the scheme rules and the trustees’ powers.
The White Paper has also stated the Government’s intention to exempt employers from consulting the affected employees about the removal of contracting-out, but the Government will maintain the requirement to consult employees on the structural changes to offset the employers’ additional National Insurance liabilities.
Clearly, this is a very advantageous power, and its use is likely to be resisted in any way possible by trustees and by employees. The exercise of such a radical power will have to be handled very cautiously so as not to become a battleground.
Employees will also be facing an increase in their own National Insurance payments as a result of these reforms. If they are squeezed even more by an increase in employee contributions to the scheme, they may well opt out en masse. Salary sacrifice arrangements may go some way towards preventing this, if carefully explained to employees.
What about public sector schemes?
Much has been made of the “settlement for a generation” reached on the reform of public sector pensions. However, these new reforms threaten to call that settlement into question. A number of trade unions have already raised similar concerns.
All public sector pension schemes are contracted out of S2P. And, in 2011, there were 5.3 million active members of such schemes, compared with 1.6 million active members of private sector final salary schemes. Hence these new reforms impact mostly on public sector pensions.
The White Paper clearly states that “public service employers will not be able to pass the cost of increased National Insurance contributions on to their employees by reducing the value of pension scheme benefits or by increasing employee contribution rates to their pension schemes”. Hence it would appear that the settlement will not be directly affected although public sector costs will increase as a result.
Public sector employees will nevertheless feel the increase in their own National Insurance contributions in the same way as their private sector counterparts, and they may feel that this indirectly impacts the deal they have agreed. Hence there may be trouble ahead here too.
It is clear that final salary schemes are about to be shaken up more than they have been in the last 30 years. The removal of contracting-out will require employers and trustees of final salary schemes to engage in significant legal and consultancy work to overhaul the structure of schemes as a direct result of these reforms. All of these difficulties, together with the contemporaneous roll-out of auto-enrolment, may still cause employers to close down the remaining final salary schemes, despite all of the Government’s radical attempts to prevent it.
How can I get more information on this?
Individuals concerned about the impact these changes may have on them should seek independent financial advice. A good place to start looking for an independent financial adviser is www.unbiased.co.uk.
(Source – Employment Services Partnership 15/01/2013)