UK: Auto-Enrolment - Using An Existing UK Defined Benefit Or Hybrid System

Introduction

The employer's duty to enrol all employees automatically in a pension scheme is being rolled out in stages based on size of employer. Employer size is calculated by reference to PAYE payroll numbers as at 1 April 2012.

If an employer already provides a pension arrangement for its employees, it can use that existing scheme for auto-enrolment purposes provided certain criteria are met. This briefing note discusses these requirements in relation to defined benefit schemes (including final salary schemes and career average schemes as well as lump sum schemes), and also considers hybrid schemes.

It assumes that the scheme is a UK scheme (that is, it has its main administration in the UK). It is also possible to use a non-UK scheme in some circumstances, but these are outside the scope of this note.

This note focuses mainly on the requirements to use an existing scheme for auto-enrolment of new employees. If an employer merely wishes to use an existing scheme to cover existing members (but intends to enrol other workers into another auto-enrolment scheme), the criteria are largely the same but certain requirements do not apply.

Defined benefit schemes

Let's assume that the UK defined benefit scheme is an occupational pension scheme and registered for tax purposes under the Finance Act 2004. Provided that it is, the scheme can be used as an auto-enrolment scheme if it meets a quality requirement. This varies depending on whether or not it is contracted-out of the additional state pension.

Quality requirement – contracted-out scheme

A pension scheme can only be contracted-out if it satisfies the reference scheme test.

A final salary scheme which satisfies the reference scheme test automatically meets the quality requirement for auto-enrolment purposes.

A contracted-out career average scheme will satisfy the quality requirement for auto-enrolment purposes if the scheme rules provide for revaluation of accrued benefits on one of the following bases:

  • At or above the consumer prices index or the retail prices index (whichever is less), capped at 2.5%.
  • Under a discretionary power, provided that revaluation at least at the minimum rate is funded under the scheme's statement of funding principles.
  • By a combination of guaranteed revaluation below the minimum rate and a discretionary power to revalue at a higher rate, again provided the revaluation is funded under the scheme's statement of funding principles.

It should be noted, however, that the government might abolish contracting-out from 2016. If so, defined benefit schemes which meet the quality requirement under the reference scheme test will need to be revisited.

Quality requirement – contracted-in scheme

A contracted-in final salary scheme can be used as an auto-enrolment scheme if it satisfies the "test scheme standard". Under the test scheme standard, the pensions to be provided from the scheme must, as a whole, be broadly equivalent to, or better than, the pensions that would be provided under a notional test scheme.

The main features of the test scheme are:

  • a pension for life from the "appropriate age". This is initially age 65, but will rise broadly in line with increases to state pension age (66 from 2024, 67 from 2034 and 68 from 2044);
  • the pension accrues at the rate of at least 1/120th of average "qualifying earnings" in the last three tax years before the end of pensionable service for each year of pensionable service (up to a maximum of 40 years);
  • statutory revaluation of deferred pensions is provided in accordance with the final salary method; and
  • pensions in payment are increased in accordance with statutory requirements.

An employer's existing scheme will satisfy the test scheme standard in relation to a member if the benefits of 90% or more of active members of the scheme (who are not in contracted-out employment and who work for the same employer) are at least as valuable as would be provided under the test scheme.

  • The requirements to be met by a contracted-in career average scheme are the same as for a contracted-out career average scheme.

Other schemes

Lump sum / Cash balance schemes

A lump sum scheme (otherwise known as a cash balance scheme) is a defined benefit scheme under which the member's entitlement is to a capital sum of an amount determined under the rules of the scheme used at retirement to secure a pension for the member. The capital sum may be linked to the member's final salary or determined in some other way, such as a specified percentage of pensionable pay in any year, which is then re-valued each year up to retirement.

To be used for auto-enrolment purposes, the scheme must meet one of the following minimum test scheme standards.

Where the capital sum is linked to final pensionable salary (as defined in scheme rules), the capital sum must:

  • accrue at an annual rate of at least 16% of average qualifying earnings in the last three tax years preceding the end of pensionable service;
  • be multiplied by the number of years of pensionable service (a maximum of 40 years is permitted); and
  • be increased annually in deferment by at least the increase in the consumer price index (capped at 2.5%).

For a scheme under which the capital sum is determined by other means, the sum must either meet the test above for a sum defined by reference to final pensionable salary or:

  • accrue at an annual rate of at least 8% of average qualifying earnings; and
  • be increased annually both in service and in deferment by a minimum of 3.5% a year.

Hybrid schemes

A hybrid scheme is one which contains both a defined contribution element and a defined benefit element.

A hybrid scheme can be used as an auto-enrolment scheme if it is registered for tax purposes under the Finance Act 2004 and it meets either:

  • the contribution requirement in relation to the defined contribution element, or
  • the quality requirement in relation to the defined benefit element.

Additional requirements for new members

In order to be suitable for use as an automatic enrolment scheme for new members, the scheme documents must not contain any provision which would:

  • prevent automatic enrolment, opt-in or re-enrolment of a jobholder (for example require completion of an application or consent form), or
  • require a member to supply information or make choices to remain a member.

Certification

If an existing scheme is to be used for auto-enrolment purposes, the employer will generally be responsible for certifying compliance with the requirements set out in this briefing note. The employer can delegate certification to the scheme actuary, and must do so in relation to any matter that requires any calculation, comparison or assessment of a description usually carried out by actuaries.

In practice, this means that an employer can self-certify a contracted-out final salary scheme as this meets the test scheme standard automatically, but is likely to need the actuary's involvement in other cases.

The DWP has produced two statutory Guidance Notes:

Because this is statutory guidance, the employer or actuary must follow the relevant guidance. The guidance includes a Template Certificate.

How we can help

If you wish to use an existing scheme for auto-enrolment purposes, we can:

  • help review the scheme documents to consider whether it meets the relevant requirements, and
  • assist with any adaptations that may be needed.

In addition to the qualification requirements described in this note, the auto-enrolment regime has timing and notice requirements which will need to be considered.

There is a statutory power so that trustees can (with the employer's consent) make certain changes by resolution to ensure compliance with the new regime. But the amendments which can be made under this power are limited. If changes going beyond the statutory power are also to be implemented, they must be made in accordance with the amendment power in the scheme's trust deed and rules, complying with any procedures and restrictions set out in that power and following usual statutory procedures on consultation etc.

As always with pensions, it is wise to plan ahead.

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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