UK: Government Announces Radical Rethink Of Pension System

Last Updated: 31 January 2013
Article by Mark Howard, Judith Donnelly and Jack Wheeler

The UK's employers will need to review their pension arrangements following the Government's publication of its plans for a once-in-a-generation overhaul of the State pension system.

The centrepiece of the Government's proposals is a new, simplified, flat-rate State pension for all workers. This change will be of most interest to employers with contracted-out defined benefit pension schemes, since it will spell the end of the contracting-out regime and open the way to reducing employees' accruing benefits. However, all employers would be well advised to consider how their pension offering fits with the new proposals and the likely expectations of current and future workers.

Background

Not many people know how much money they are going to get from the State in retirement. Pensioners in the UK are provided with a confusing and shifting array of benefits, including the Basic State Pension, the State Second Pension (S2P), the Pension Credit, the Category D Pension and the Winter Fuel Payment, along with other welfare payments.

Not only is this array of benefits confusing, it is also becoming increasingly expensive as the average age of the population rises. A major aim of the Coalition Government has been to reform the system so that it is simpler and more sustainable for the future. In April 2011, the Department for Work and Pensions launched a consultation on the issue, and it has now reported that around 75% of respondents responded positively to the proposal for a single-tier State pension.

The proposals

The essence of the proposals is that the current Basic State Pension and S2P (and its predecessor, the State Earnings Related Pension Scheme) will be merged into a single, flat-rate pension. This flat-rate pension will have the additional effect of allowing the supplementary means-tested benefit known as Pension Credit – which 40% of pensioners currently receive – to be phased out. The reforms are designed to be cost-neutral overall.

The new pension will be worth at least £142.70 per week at today's prices, or £7,420.40 per year. This is the current basic level of means-tested support. It will be available to all workers with 35 years of National Insurance contributions (or appropriate credits). Workers with a record of less than 35 years' contributions will be entitled to a proportionately reduced pension, provided that they have made at least a specified minimum amount of contributions (projected to be between 7 and 10 years' worth).

There will be a statutory requirement for the level of the pension to increase at least in line with average earnings. It is far from clear that the current "triple lock" mechanism of calculating State pension increases will be retained. (This requires increases at whichever is greater out of price inflation, average earnings growth and 2.5%.)

The proposals are expected to be included in the next Pensions Bill in May and to reach the statute book by Spring 2014. They will not come into effect until April 2017 at the earliest. When they do come into effect, transitional provisions will apply in respect of existing members of the workforce. They will have their existing NI contribution records converted into a specified pension entitlement under the new system (those who would have a higher entitlement under the existing system will be credited with the higher amount). They will then accrue further rights, up to the full level of the new pension, at the rate of 1/35 of the full rate per year to retirement.

By the mid-2030s, it is expected that over 80% of new retirees will receive the full weekly amount of the new pension.

The new pension will be subject to the existing planned increases in State retirement age, which is set to rise to 66 by 2020, to 67 by 2028 and to 68 by 2046. In addition, the Government has stated – in line with its previous pronouncements on the subject – that these planned changes will be reviewed every five years and adjusted in line with life expectancy. The first review will take place in the next Parliament.

Contracting-out

Employers with defined benefit pension schemes can contract out of the S2P. This means that they offer scheme members a specified minimum level of occupational pension rights in return for a rebate in National Insurance contributions (worth 1.4% for the employer and 3.4% for the employees).

Due to the planned demise of the S2P, the contracting-out regime will be abolished. This will entail increased NI contributions, but will allow employers to cut the benefits offered by their defined benefit schemes below the current minimum contracting-out level. The Government plans to give employers a unilateral power to do this, so that the cuts can be accomplished without the consent of the scheme trustees, which is required under the rules of most pension schemes.

An alternative means of saving money in order to make up for the increase in employers' NI contributions would be to shift the burden of funding the pension scheme further onto employees by increasing their contribution rates.

Clyde & Co Comment

Like all such reforms, these proposals will have winners and losers. They have been welcomed by employers' groups and the pensions industry, but it remains to be seen whether they will turn out to be universally popular. It was in connection with pensions policy and his unsuccessful stakeholder initiative that Tony Blair said: "if someone isn't screaming somewhere, it probably isn't going to work".

Following the introduction of automatic enrolment in October 2012 and the Government's "defined ambition" initiative that was launched in November 2012, this is the final piece of the pensions reform jigsaw for the time being, and it marks a good point to take stock. One effect of the phasing out of the Pension Credit will be to make saving through automatic enrolment more attractive for lower paid workers: a private pension will no longer simply have the effect of removing access to means-tested benefits.

Now would be a good time for employers to take a long, hard look at their pension provision and make sure that it is fit for purpose for the next generation. All employers would be well advised to review their pensions offering to ensure that it fits with the emerging new pensions environment and corresponds with both Government and employee requirements and expectations. It is particularly important for employers with contracted-out defined benefit schemes to plan what they are going to do when the contracting-out regime is withdrawn (contracting-out for defined contribution schemes was abolished last year).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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