The Single-tier State Pension: Part 1 of the draft Pensions Bill - Work and Pensions Committee Contents

4  Ending of contracting-out

84. A key element of the single-tier reforms is the abolition of the State Second Pension (S2P). This means that contracting-out of the S2P will also end. This is, in general terms, the ability to forgo entitlement to S2P on the basis of the individual being eligible for broadly equivalent occupational pension provision to which the individual and/or their employer contributes. Contracting-out entitles both the employer and the employee to pay lower National Insurance contributions (NICs). DWP estimates that 80% of people reaching State Pension Age in the next 20 years will have been contracted out at some point in their working lives.[83]

85. The Government says that key considerations in the arrangements for ending contracting-out are: minimising the impacts on employers, employees and pension schemes; ensuring that amounts accumulated in occupational schemes up to the introduction of the Single-tier Pension continue to be paid; and ensuring that the sustainability of Defined Benefit occupational schemes is not undermined.[84]

Impact on employers


86. The White Paper states that, for employers, the end of contracting-out will mean an increase in NICs paid for each contracted-out employee of 3.4% of relevant earnings.[85] DWP acknowledges that employers are likely to want "to reduce the level to which they must fund their [pension] scheme by the same amount as the increased National Insurance contributions" when contracting-out ends, either by reducing future pension benefits or by increasing employee contribution rates to pension schemes, or a combination of both. However, some private sector employers are limited by their scheme rules in the extent to which they are able to modify scheme benefits and in many cases scheme rules can only be changed by the scheme trustees or with the trustees' consent. As the changes are likely to be seen by trustees as detrimental to scheme members, they may not be willing to give their consent.[86]

87. Provisions in the draft Bill would give employers a statutory power ("the statutory override") to amend the terms of their workplace pension schemes to increase member contributions or to reduce future service benefits, without trustees' consent if necessary. This power will only apply to changes necessary to deal with the impact of the ending of contracting-out. Employers will have five years from the introduction of the STP in which to make the changes to pension schemes, but they will only be allowed to use the statutory override power once. [87]


88. There is a specific issue affecting employers in private sector companies which currently employ people who worked for these companies when they were nationalised industries. This group of private sector employers are limited in their ability to change pension scheme rules by legislation made at the time of privatisation, generally referred to as the "Protected Persons Regulations" (PPRs).

89. The Government launched a separate consultation in January 2013 on whether employers who sponsor pension schemes which have "protected persons" as members should be permitted to override the rules relating to this group. The consultation closed on 14 March.[88] We expect the Government will therefore set out its preferred way forward in response to the consultation, so that Parliament can consider this as the Bill progresses.

Impact on Defined Benefit (DB) pension schemes

90. The NAPF set out the context for DB pension schemes in which the ending of contracting-out will be taking place. A recent survey had shown that only 13% of private sector DB schemes are open to new members; 55% are closed to new members but open to future accrual. 83% of DB schemes which are open to new accruals are contracted-out. Of the 13% which are still open to new members, one in five expects to close their scheme to current members and switch to a Defined Contribution (DC) scheme in the next five years. 12% expect to retain their DB scheme but on less favourable terms for existing members.[89]

91. Hymans Robertson, a firm of pension consultants, says that "for the 1 million private sector workers still lucky enough to have DB pensions, the prospects don't look rosy due to the end of contracting out." It believes the extra cost that this will place on employers "may speed up the demise of what remains of DB pensions".[90] EEF (the manufacturers' organisation) agreed that the abolition of contracting-out and the loss of the NIC rebate could lead employers to close DB schemes.[91]

92. DWP acknowledges that "the removal of the contracted out rebate without any mitigating response may create the need for additional funding from DB sponsors [ie employers]". But it believes that "there are much bigger influences on the future of DB schemes, and loss of the [NI] rebate on its own should not, in general, trigger scheme closures."[92] The Minister told us that the decline in DB which had already taken place meant that it could be considered as a "coffin that has got enough nails in it already", but he did not believe that the impact of ending contracting-out would be "seismic" for these schemes. He emphasised that employers who continued to offer DB schemes did it because it was something their employees valued, and as a retention and recruitment tool.[93]

93. Neil Carberry of the Confederation of British Industry (CBI) agreed with the Minister both that "it is debateable whether [DB schemes] have been finished off for good already" and that the cost of the ending of contracting-out on its own was unlikely to "finish off schemes". [94] Otto Thoresen of the ABI told us "I do not see this in itself as something that will trigger a huge further decline in DB".[95] When Joanne Segars of the NAPF gave oral evidence in early March, she said that she also believed that DB schemes would continue. She was clear that contracting-out had to end with the introduction of the STP "because "there is nothing left to contract out of". Her view then was that the key issue for pension schemes was to ensure that the change was implemented in a way that "does not add increased burdens on already hard-pressed scheme sponsors working hard to keep Defined Benefit pension schemes afloat".[96]

94. In oral evidence, representatives of both employers and the pensions industry made clear that they were satisfied with the level of engagement they had had to date with the DWP on the detailed arrangements for contracting-out. They told us that the negotiations had taken place over a long period and that they were broadly content with the relevant provisions in the draft Bill. The IoD said "we are delighted at the way the Department for Work and Pensions and others are working with industry to understand and work through the issues."[97]

95. The NAPF said that the draft Bill provisions "seek to ensure that employers and schemes are able to administer these changes and the transition to a new system in the most cost effective manner" whilst avoiding placing additional burdens on employers who still offer DB schemes.[98] It said that it was now "working very closely with DWP" on the detailed arrangements for contracting-out, to be set out in secondary legislation.[99]

96. However, these views were expressed before the Government's decision to bring forward the starting-date for the STP by a year. In response to this announcement, the NAPF reiterated its support for the reforms but emphasised that "the Government has to ensure that the implementation of these changes is workable for pension funds". It highlighted that the new implementation date created a "very tight timetable" and expressed concern about "whether it can be delivered". Joanne Segars argued that "it is essential to give pension funds the flexibility and time to adapt and make the changes". She believed that "if the Government gets it wrong it risks a fresh round of final salary pension closures in the private sector. Business which get caught on the wrong side of these changes will lose a significant rebate from the end of contracting out, and they will question whether they want to continue running these pensions".[100] The NAPF believed "it would be a shame if big mistakes were made in a rush to implement the changes".[101]

97. The Government's decision to bring forward the implementation date for the Single-tier Pension after we had finished taking oral evidence and within a week of the deadline for us completing the scrutiny process meant that it was not possible for us to seek the views of employers and the pensions industry about the implications for them of this major policy change. However, it is self-evident that having one year less to prepare for the ending of contracting-out will impose a significant burden on both groups of stakeholders. Having previously appeared to listen and respond to the concerns of pension schemes and employers about the impact of the STP, the Government has now sprung this earlier implementation date on them. We believe it is therefore the Government's clear responsibility to work with these key stakeholders to ensure that the transition to the ending of contracting-out is as smooth as possible and that already beleaguered Defined Benefit private sector occupational schemes do not suffer further adverse consequences.


98. The NAPF highlighted that the ending of contracting-out might provide an opportunity for further developing the Minister's ideas for a new form of pension scheme which combined elements of both DC and DB—known as "Defined Ambition". Joanne Segars emphasised that if Defined Ambition was going to be encouraged, this should be done in parallel with contracting-out ending, so that employers did not have to go through two major changes in their pension schemes in rapid succession.[102] In oral evidence, the Minister accepted that he would need to have Defined Ambition in operation by 2017 and said that "we are working non-stop" on the plans.[103] It is clear that the Government's revised implementation date will place even more time pressure on DWP to develop its Defined Ambition proposals. We will explore the potential for Defined Ambition schemes in more detail in our forthcoming report on governance and best practice in workplace pension provision.

Impact on employees

99. Employees starting to pay full National Insurance Contributions as a result of the ending of contracting-out will see an increase equivalent to 1.4% of relevant earnings.[104] The TUC calculates that on average employees will have to pay about £350 a year in additional NI contributions.[105] The PPI estimate was that the maximum additional NICs for employees would be £480 a year.[106]

100. The Government points out that "around 90 per cent of those reaching State Pension age in the first two decades after implementation will gain enough extra state pension over retirement to offset both the increased National Insurance contributions they will pay over the rest of their working lives and any potential adjustments to their occupational pension."[107]

101. However, the TUC believes that "removing the need for trustee consent creates a significant risk of material losses for individual members". It accepts that "higher NICs will generally represent good value for money for people currently contracted out" and acknowledges that, on average, scheme members will not be worse off because in general they will be compensated for reduced benefits or higher contributions through higher State Pension outcomes. But it points out that "because offsetting measures will be calculated at scheme level, rather than based on the impacts on individual members, it is highly likely that some members will be made worse off through this process". It believes that these changes "will have an immediate detrimental impact on individual welfare following a long period of wage stagnation, and alongside higher pension contributions in the public sector".[108] A number of other trade unions made similar points in their written evidence.[109]

102. The Minister emphasised that the private sectors employers concerned were not "out to do over their employees" but were simply seeking to offset the additional pension liabilities arising from the ending of contracting-out. They were "the good guys. These are the people who are still running final salary pension schemes".[110]

103. We accept that, on average, employees who were previously contracted-out will not lose out in the longer term from having to pay increased National Insurance and pension scheme contributions, because most will gain enough in increased State Pension to compensate for this. However, within this average, some individual employees could lose out and some may face difficulties in the shorter term, especially if current wage restraints continue. We recommend that the Government undertakes more analysis of which employees might fall into this category, so that Parliament can properly consider what measures, if any, might be put in place to limit losses.

83   DWP White Paper, p 38 Back

84   DWP White Paper, p 10 Back

85   DWP White Paper, p 39. Relevant earnings are earnings between the Lower Earnings Limit (LEL) which is currently £5,564 pa and the Upper Accrual Point (UAP) which is £40,080 pa. Back

86   DWP White Paper, pp 39-41; see also DWP, Impact Assessment of Abolition of contracting out - consultation on a statutory override for Protected Persons Regulations, January 2013, paras 12-13 Back

87   DWP White Paper, pp 40-41 Back

88   DWP, Abolition of contracting out - consultation on a statutory override for Protected Persons Regulations, January 2013  Back

89   Ev 73-74 Back

90   Ev w26 Back

91   Ev w18 Back

92   DWP, Impact Assessment for Abolition of Contracting Out - Consultation on an override for Protected Persons Regulations , January 2013, paras 57-58 Back

93   Q 245; see also Q 241 Back

94   Q 136 Back

95   Q 78 Back

96   Q 76 Back

97   Q 153; see also Qs 76-7 Back

98   Ev 72 Back

99   Q 77; see also Q 80 Back

100   Ev 96 Back

101   Daily Telegraph, 18 March 2013, "Pension firms warn of threat to private plans" Back

102   Q 79 Back

103   Q 247 Back

104   DWP White Paper, p 42 Back

105   Qs 16-17  Back

106   Q 66 Back

107   DWP White Paper, p 10 Back

108   Ev 87 and 89-90 Back

109   See for example Ev w45 (PFEW); Ev w21 (GMB); Ev w56-7 (Unite) Back

110   Qs 241 and 243 Back

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Prepared 4 April 2013