Contracting out: The end is nigh

Kate Upcraft
Kate Upcraft Consultancy Ltd
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2016/17 sees a significant restructuring of national insurance with the end of contracting-out.

As State Second Pension (S2P) will no longer exist when the single tier state pension is introduced on 6 April 2016, there will no longer be anything to contract out of.

In essence ‘contracting-out’ has meant giving up earning an entitlement to S2P in exchange for an occupational or personal pension scheme benefit that would be worth more than the foregone S2P.

To square the circle in an occupational scheme both employee and employer pay a lower – rebated – rate of National Insurance. In a contracted-out personal pension, the pension provider historically received rebates to add to the pension fund direct from HMRC after the end of each tax year.  

Whilst S2P is the current top up to the Basic State Pension that you can buy with NI’able earnings, this too has had several incarnations and older employees may have an NI history that contains all three of these elements within that state pension entitlement if they have been contracted-in for any period of their working life:

  • Graduated Retirement Benefit or GRB
  • State Earnings Related Second Pension or SERPS
  • State Second Pension or S2P

NI rebates for those who chose, or whose employers chose to contract them out, have also varied over the years and are different for employees and employers. Historically there were two types of pension schemes that could contract-out:

Occupational pension schemes: 

  • final salary or defined benefit known by HMRC using the acronym COSR – contracted-out salary related; and 
  • money purchase or defined contribution known by HMRC using the acronym COMP contracted-out money purchase
  • Appropriate personal pensions (APP)

Contracting-out began for final salary schemes in 1978 when the government wanted to encourage employers in both the private and public sector to set up workplace pensions.

Between 1978-1997 these schemes had to provide a Guaranteed Minimum Pension (GMP) i.e. a promise of what would be provided to the employee which was ring fenced as the amount that they would get if they left the contracted-out scheme and had to be bought back into the state top-up pension.

One of the huge tasks for the remaining final salary schemes that are contracted-out (predominantly in the public sector) is to reconcile GMPs to 1997. Historically the accurate earnings’ data to correctly calculate these benefits has not always found its way to the scheme.

This hasn’t always been the top of the Trustee’s agenda as GMP reconciliations are time consuming, costly to fund and of course if it turns out the the GMP has been incorrectly paid for some time retrospectively rectifying the position for the affected members can also be expensive. Now there is a deadline as HMRC have given schemes until 2018 to reconcile their data to that held by HMRC so that these periods of service can be locked down.

The rebated amount of NI for these schemes has varied over the years but currently provides for employees to pay 1.4% less than employees who are contracted-in and for their respective employers to pay 3.4% less than an employer providing a contracted-in pension 

However, this lower rate of NI has not been paid on all earnings since 2009 when the government had to act to stem the loss to the NI fund. They did this by capping the amount of earnings that were subject to the rebate (and incidentally the amount that could be used to earn S2P entitlement) at a limit called the Upper Accrual Point or UAP. This has been frozen since then at £40,040 p.a.

Contracting-out was extended to money purchase pensions in 1988. There's no GMP in a money purchase scheme as the final pension simply depends on the growth of the fund and/or annuity rates. The beginning of the end of contracting-out actually began in April 2012 when money purchase pension schemes (both occupational and personal) were no longer able to contract-out. This had to happen to align the treatment of auto-enrolment workplace pensions from October 2012, which were to be offered on a not contracted out basis.

However, this has still left over 20m people in the public and private sector in contracted-out final salary schemes, who now face a hike in NI from 6 April 2016 on this rebated band of earnings. In the private sector, regulations have been laid to allow schemes to re-design pension benefits to offset the additional cost to the employer. In the public sector this redefining of benefits has led to lots of protracted industrial action prompted understandably by unions keen to protect members from a loss of pension benefits coupled with additional NI contributions. 

It is to be hoped that all affected employers have budgeted for this increase in NI from April (of course they weren’t expecting to have to pay the national living wage too at the same time) but it may be that some small employers such as doctors, dentists and pharmacy clients are still unware of the change which may also be true of their employees.

From an operational perspective all affected employees will need to be assigned a new NI table letter. In many cases this will see a move from table letter D to table letter A but that will not be appropriate in all cases. You may therefore need to make some decisions about certain employees as to the appropriate table letter which rather than A, could be:

  • M if the employee is aged under 21 and not an apprentice
  • H if the employee is aged under 25 and is an apprentice (this is a new NI table letter from April 2016)
  • C if the employee has reached state pension age
  • B if the employee has a valid reduced rate certificate
  • J if the employee has a CA2700 deferral certificate
  • Z if the employee has a CA2700 deferral certificate and is under 21
  • X if the employee has no liability

The scrapping of rebates will see: 

  • employers paying an additional 3.4% NI on earnings from the threshold of £156 p.w to the former Upper Accrual Point (UAP) of £770 p.w. – an additional £20.88 p.w or £1,085.55 p.a.
  • employees paying an additional 1.4% NI from the threshold of £155 p.w. to the former Upper Accrual Point (UAP) of £770 p.w. – an additional £8.61 p.w or £447.72 p.a.


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27th Jan 2016 14:54

Numbers are exaggerated

The ONS provides data on pension scheme membership, which is a lot lower than suggested above:

In 2013, there may have been around 20m 'members' of occupational pension schemes, but the key point for the forthcoming change is how many are 'active' (ie, earning, as opposed to deferred or retired) and how many of those are contracted out.

Many public sector workers and most private sector workers are now in DC schemes, which have not been able to contract out since 2012.

According to the ONS, there are around 1.6m private sector DB earners and 3.2m public sector DB earners, so 4.8m in total.  I would guess that all the public sector earners are contracted out, but not all the private sector schemes will have waited for April 2016 to deal with the change, which has been flagged up for three years.

It's a big deal for the employers of these 4.8m workers, as the rate examples show, but it's not a population of 20m.

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16th Feb 2016 06:18

The end of the contracting-out era is fast approaching and both trustees and employers should be thinking about reviewing their contracted-out defined benefit schemes to ensure they are compliant come 5 April 2016. On and from 6 April 2016 employers will no longer be able to opt out of the earnings-related component of the state pension on behalf of their employees. dissertation assistance

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17th Mar 2016 12:21

In any case, this has still left more than 20m individuals in the general population and private division in contracted-out definite pay plans, who now confront a trek in NI from 6 April 2016 on this refunded band of profit. In the private area, regulations have been laid to permit plans to re-outline annuity advantages to counterbalance the extra cost to the business. best dissertation writing service uk In the general population division this reclassifying of advantages has prompted heaps of extended modern activity provoked naturally by unions quick to shield individuals from lost annuity advantages combined with extra NI commitments.

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16th Mar 2017 19:12

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