UK state pension reform raises contracting-out concerns

UK – Proposals to introduce a flat-rate state pension have been welcomed over expectations it will end the current "unfair and complicated" system, despite requiring the abolition of contracting-out for defined benefit (DB) funds.

A repeatedly delayed White Paper on state pension reform, to be published this afternoon following a statement by pensions minister Steve Webb in the House of Commons, is expected to outline how the UK will transition from the current multi-tier first pillar to the single-tier state pension.

As part of the change, contracting out – whereby members of occupational funds see part of their national insurance diverted away from the state second pension (S2P) to their second-pillar savings – will end, prompting concerns over the continued cost of operating DB funds.

Fraser Smart, managing director of Buck Consultants, calculated that, for a contracted-out worker on £25,000 (€30,200), the increased national insurance costs would amount to £650 per annum in additional payments from the employer.

"It is likely to be the death knell for the few private sector final salary pension schemes," he said.

Concerns over the impact on DB funds and benefits were also expressed by the assistant general secretary of one of the UK's largest unions, Gail Cartmail of Unite.

"There is a danger employers will seek to claw back the cost by reducing the quality of their current pension scheme," she warned.

"The end result could mean any gain in state benefits will be wiped out by increased costs to employees in the private sector."

Andrew Vaughan, chairman of the Association of Consulting Actuaries (ACA), agreed with Smart's assessment, saying that an element of change to the pension landscape would become "all the more essential" as contracting-out came to an end.

"Unless there are new pension design options for employers to consider by 2017," he said – likely referring to the Department for Work & Pensions proposals for defined ambition – "it seems inevitable we will see a further 'final switch' away from defined benefit schemes into defined contribution, with the likelihood of reductions in contribution levels as a result. "

The use of "less expensive" pension provision in the wake of the reform was also a shift predicted by law firm Freshfields Bruckhaus Deringer.

Partner Charles Magoffin said that if employers stayed within DB they would likely consider career average over final salary arrangements due to the reduced cost.

The view that funds should seize the reforms as an opportunity to redesign DB funds was also highlighted by Charles Cowling, director at JLT Benefit Solutions.

"By 'contracting-in' and reducing benefits to reflect that state pension will be paid 'on top', employers can reduce risk and make it less likely that members will exceed annual and lifetime allowances, thereby incurring additional tax charges," he said.

However, Magoffin had further reservations.

"Many technical issues will need to be resolved, including whether the government will need to provide schemes with an overriding power of amendment in order to allow the contracted out benefits to be removed," the lawyer said.

A senior DWP civil servant previously said a statutory override to allow for the end of contracting out was being looked at.

However, despite concerns over the implementation of the changes, the National Association of Pension Funds chief executive Joanne Segars hailed the "much-needed shake-up" for ending the reliance on means-testing pensioner benefits.

Welcoming the proposals as "radical change", Segars said: "This blueprint is a key step towards a system that will help people retire with confidence and dignity."

Noting that it would allow for a "clearer, fairer state pension" and put an end to the "unfair, complicated" current system, she added that it complemented the ongoing introduction of auto-enrolment.

Despite the reforms, expected to increase the state pension to more than £140 a week, the industry insisted that employees should not get complacent about their level of retirement saving.

Bob Scott, partner at LCP, said that while the non-means tested allowance would no longer result in high savers being "punished" in retirement, caution was advised.

"While today's announcement will mean we can all be clear on what we will be entitled to receive in retirement," he said, "the state pension, plus any benefits received through auto-enrolment into a pension scheme, are unlikely to be sufficient for retirement on their own."

The ACA's Vaughan shared his concern, noting that the current minimum contribution level under auto-enrolment of 8% would only result in around 15% of average earnings, in addition to less than 30% of average earnings supplied by the state pension.

"This level falls well short of the replacement income most people will need," he said. "We must drive up pension contributions."

The ACA earlier this month called for the minimum legal contribution level to increase to 12% by 2020 to guarantee sufficient replacement ratios in retirement.