Recently announced proposals for state pension reform have major implications for individuals and scheme sponsors. Matt Ritchie looks at how the end of contracting-out will affect defined benefit schemes in the private and public sectors

You know something big has happened when pension matters occupy the prime spot on the websites of major news organisations, and announcers are discussing retirement incomes in the lead items of evening bulletins.

The reforms outlined in the draft bill on state pensions recently released by Pensions Minister Steve Webb represent major, if well-signposted, changes to the pensions framework. The changes have huge implications for the retirement incomes of millions of Britons. But they could have equally significant impacts on the future of defined benefit (DB) pensions in the UK.

In a nutshell, the draft bill proposes to introduce a single-tier state pension set above the basic level of means-tested support, currently £142.70 per week.

The new regime does away with the old system of basic and additional state pensions. The income-related benefit of pension credit has been stripped back.

The state second pension and contracting-out will also go under the new regime. As a result, employers will have to increase NI contributions by 3.4 per cent of relevant earnings for each contracted-out employee. Previously contracted-out employees will be required to pay an increase equivalent to 1.4 per cent of relevant earnings.

Defined benefit
Buck Consultants head of pensions policy Kevin Le Grand says that, all other things being equal, the end of contracting-out would mean additional overall benefits for employees.

It seems unlikely that all things will remain equal, however. The government has proposed to give employers the opportunity to change DB scheme rules without trustee consent in order to balance out the additional costs of the new system.

“I strongly expect employers will not want to provide this increase and pay the higher associated costs, so most will want to adjust the scheme basis to gain a broadly neutral outcome for the employer’s costs and the members’ workplace benefits,” Le Grand says.

Towers Watson senior consultant David Robbins says the new regime could lead more private sector DB schemes to close altogether.

The bill does not exempt employers from the obligation to consult employees on scheme changes made in light of the new regime. Many sponsors will already be considering changes due to the various pressures the DB scheme places on their balance sheet, Robbins says, though the burdens of a consultation exercise may have been a barrier to carrying a change through.

“Often a reason for not having closed the scheme so far is that it wasn’t the right time to go through that redesign and consultation exercise, but if you’re going to have to do that anyway some sponsors will say ‘we may as well do that for a big change as a small change’.”

Le Grand says that where employers use the change as an opportunity to close their DB schemes, the likelihood is that this was going to happen anyway. Many private sector employers who still offer a DB scheme do so because they have a strong commitment to the design, and Le Grand would like to think the state pension changes will not spark “widespread closures”.

“Given the growing rhetoric from the government and other relevant parties in favour of improving member outcomes from workplace pensions, and some of the other changes being made to the system, I would like to think that such employers will look upon these changes in a positive overall light, rather than regarding it as a ‘last straw’.”

On top of the the existing pressures on DB schemes, National Association of Pension Funds (NAPF) head of research Mel Duffield says the increased NI costs have the potential to cause “disruption”.

But while many sponsors will review their DB offerings, it is not all doom and gloom.

“I’m sure it’s possible that some will choose to close their scheme at that point,” Duffield says. “But some of our members are certainly keen to make these adjustments and run their scheme on.”

Public sector
While the state pension has captured the public imagination recently, the changes have implications for 2011’s headline-grabber – public sector pensions.

The government’s commitment to not touch public sector benefits for the next 25 years means state employers will not have the same opportunity to adjust their pension offering as their private sector counterparts.

Aries Pensions director Ian Neale sees three possible paths for public sector pensions in light of the new regime.

Sponsors could be expected to wear the extra costs, or the Treasury could provide additional funds to public sector employers to meet the burden.

The third, and Neale says most likely outcome, is that the government does a U-turn on its commitment not to change public sector benefits.

“Of course it will depend on how much appetite the government of the day has to take on the unions. They had a pretty bruising encounter last year. We’ll have to see.”

Trade unions have focused their response to the changes on the increased NI contributions rather than the improvement in retirement incomes individuals will receive, Buck Consultants’ Le Grand says.

However, he says private sector employees would not be “too pleased” if those in the public sector received increased benefits without some increase in their contributions. This difficult balancing act requires a political decision, which may come down to the strength of will of the government
to apply consistent policies to all workers.

“One solution might be to offer a new tier of pension accrual in the schemes, combined with reduced contributions, so that, taking the revised state pension arrangements into account, the status quo is maintained for members when taking a broad brush approach.”

The future
Of course, undertaking state pension reform of the magnitude proposed by the government was always going to bring complications. Pleasing everyone in an area as complex as pensions is impossible.

The NAPF is supportive of the changes, and has long advocated a move to a simpler state pension system. In particular, the new system improves incentives for people to save for themselves, which can only be a good thing following the introduction of automatic enrolment.

“It takes out some of the uncertainty around the role of means-tested benefits. There has been a bit of a debate around lower and middle earners in particular seeing some of their savings eroded away because they lose means tested benefits because they’ve got a slightly higher private pension.”

Neale agrees that the system was crying out for simplification.

“The complications that have surrounded the calculation of state pension entitlements up to now have been a real turn-off. People have been able to find out what the headline figure for the basic state pension is but when they started to look into all the qualifications it often became very dispiriting.”

But, will it last?
The history of pensions in the UK is one of constant change, reform after reform has in many ways resulted in the convoluted system that these most recent proposals aim to fix.

Le Grand says that, particularly in light of auto-enrolment, stability is crucial to the success of the pensions system. The public must be able to participate in the system without it being subject to “constant unstructured changes”.

“We need to find a way to tie all parties into a system that makes it very difficult to make changes, and which ensures that any changes that are made are thoroughly considered first, and their likely impacts identified and assessed, and that such changes and their effects are wholly transparent, so that people can see what is being proposed and have an opportunity to express an informed opinion.

“I accept that such a system will not be easy to create, but the rewards from doing so will be worth the effort.”

Written by Matt Ritchie, a freelance journalist

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