Why the night got darker for decent pensions - removing the National Insurance rebate

Yet another nail was hammered into the coffin of final salary linked occupational pensions with the Budget announcement of the withdrawal of the contracting out rebate for defined benefit final salary linked pension schemes.

There is, as yet, no date for the removal of this subsidy but it will go once the new flat rate pension is introduced, probably not until 2015.
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The contracted out rebate is a rebate to both employers and employees who opt out of the earnings related part of the state pension scheme – currently S2P (the state second tier pension) and formerly Serps (the state earnings related pension dcheme). It currently stands at 1.6% for employees and 3.7% for employers who operate a final salary linked defined benefit scheme or 1.4% if the scheme is defined contribution, money purchase.

Employers and employees will therefore see their NI contributions rise when the rebate is abolished. The rebate was already due to be removed in April 2012 for defined contribution schemes and will now be removed for all schemes once the £140 a week flat rate pension is introduced. This will save the government some £9.1 billion a year when the rebates are finally abolished according to the Office of Tax Simplification.

As the press report below states, the result is that most remaining final salary linked private sector pension schemes will probably decide to close because many are already in deficit and employers are unlikely to swallow the higher cost of pension provision once the rebates end.

Public sector workers

Tom McPhail, head of pensions research at Hargreaves Lansdown, welcomed the introduction of the £140 a week flat rate pension but said, ‘unfortunately this reform of the state pension will be delivered at the cost of the final salary sector. This will be particularly keenly felt by public sector workers.’ Most public sector schemes are final salary linked.

‘The proposal to end contracting out will mean higher national insurance (NI) contribution rates for all final salary scheme members - currently they pay 1.6% less, though this is due to fall to 1.4% in 2012,’ explain McPhail. ‘Under auto-enrolment employers are already facing a substantial increase to their pensions bill. This is likely to finish off any lingering support they may have for final salary pensions.’ He believes most companies will switch to defined contribution, money purchase schemes, where the risk that the accumulated contributions won’t provide enough pension at retirement age is carried by the employee.

The government is likely to face stormy negotiations over the Hutton reforms to public sector pension schemes. The unions are already threatening strike action and the removal of the rebate will make agreement even more difficult. ‘It is in the public sector though, that the real pain will be felt,’ McPhail explains. ‘Public sector workers are already facing a 3% increase to their contributions. Now it looks like they’ll also have a 1.6% increase to their tax (National Insurance) rates. They are also facing a shift from final salary to career average and if the schemes are to be contracted in then logically the overall generosity of their benefits should be further reduced to reflect this.’

‘As if this wasn’t enough, they are also facing a retirement age which is linked to the state pension which is in turn linked to longevity. This means not 60, or 65 or even 66 but probably 67 or 68. Many in the private sector will argue that they have had it too easy for too long and such reforms are long overdue but it’s fair to say that there may be trouble ahead,’ McPhail warns.

Extra costs

Eleanor Dowling, principal at benefit consultants, Mercer, is also concerned about the effect on occupational pension schemes pointing out that private sector schemes are designed to integrate with the state scheme. ‘If this change does take place, companies may have to revisit their scheme design. Potentially, there are huge costs and funding issues here too.’

She believes employers are likely to cut benefits for members of final salary linked schemes because they will lose the funding that comes from the NI rebates. ‘Schemes already have to cope with removal of the default retirement age, and will now have to respond to a moving target state pension age and proposals in this Budget to cut tax relief for employers.’

The ability to increase the age at which state pensions are paid will itself create huge new problems for both pension schemes and their members. ‘The difficult part will be in determining what the rules are that will lead to an increase, warns Deborah Cooper, head of Mercer’s regulatory group. ‘For example, how much warning do people need before an increase is made? What information will be used to determine the rate of increase, given the different longevity experiences in different social classes?’

She makes the point that whilst the government wants the flexibility to reduce the value of pension accrual by increasing state pension age, it prevents private sector employers from taking similar actions. If the age at which you receive your pension is raised you pay contributions for longer and draw benefits for a shorter period – effectively a pension reduction.

She suggests that, ‘particularly in the context of the removal of the default retirement age, there is a case to loosen restrictions governing the situations in which employers can amend accrued rights. For example, the government could permit changes to a scheme’s normal pension ages when there is evidence that life expectancy has increased since a member joined the plan.’