Recent Government changes to the State Pension mean that, from 2016, there will be an increase in cost for defined benefit (DB) pensions, which could rack up a £2bn per annum bill for UK companies.

The change in question means that the practice of ‘contracting out’ is coming to a close. Contracting out allows individuals and their employers to forgo the State Second Pension in exchange for lower National Insurance contributions. However, with the introduction of the Single Tier State Pension in April 2016, the State Second Pension will be abolished and schemes will be forced to end this practice. There are approximately 6.9 million people contracted out through their employer’s pension scheme, of which 1.6 million are in private sector schemes.

With the contracting out option no longer available, if no action is taken DB pensions are going to cost a lot more to run, and employers will be expected to bear almost three quarters of this. By acting now (rather than waiting until 2016) however, they can seize an opportunity to reduce this outlay whilst not reducing overall employee benefits.

Without making specific interventions, there are three key implications of this change that employers need to be aware of:

• Employers will pay an extra 3.4% on pay between £5,568 and £40,040 (based on limits for 2013/14) and employees an extra 1.4%. For an employee earning £35,000 this means additional annual costs of £1,000 each year for the employer and over £400 for the employee.
• In return for these higher National Insurance contributions, employees will earn higher state benefits – up to a maximum of £144 a week of Single Tier State Pension after 2016, compared to the Basic State Pension of £107 a week today.
• Employers and their advisors will have to work through the administrative pain of bringing the 38 years of massively complex contracting out to an end.

Under contracting out, the rebate paid to employers and employees has been miserly for well over a decade. At the last review, the Government Actuary calculated that the economic cost of the benefit was over twice the value of the National Insurance rebate. As the financial crisis has continued over the past few years and gilt yields have fallen further, the financial business case for change has gone from strength to strength.

Unwinding contracting out from the state pension is an administrative nightmare and its sheer complexity has put employers off, but the Government has now made dealing with this challenge unavoidable. The reality is that companies are going to have to make a change by 2016 in any event, so there are plenty of reasons for grasping the nettle now.

For many employers, this will be the final straw forcing them to finally close their DB scheme. But for employers that want to keep their DB plan open, a number of options exist that will allow them to accommodate the changes. These include:

• Taking account of the new Single Tier State Pension accrual: From April 2016, most employees who are currently contracted-out will accrue a higher State pension.  DB plans could be adjusted to account for this increase in State pension, for example, by introducing a State pension offset from April 2016.
• Increasing employee contributions by the increase in the employer’s National Insurance contributions: This is likely to be the default position because the Government is expected to allow this route without the consent of trustees.
• Taking account of the current rate of State Second Pension accrual: Traditionally, this is the approach DB plans have adopted in ceasing to contract-out. This is the most financially beneficial route for the employer but is penal to the employee given that the more generous accrual of State Second Pension ceases in 2016.

These three routes are all valid but which one is right for each employer will depend on that employer’s specific circumstances.

Employers do have a choice about when to implement these changes but the pros outweigh the cons for acting now. If employers choose to act now, they will benefit from ending the poor value offered by contracting out. They will also give themselves sufficient time for consultation and negotiation with employees and other stakeholders and for implementation of other related beneficial changes.

As we’ve seen from auto-enrolment, complex change takes time to implement.  Unless scheme rules contain restrictive amendment provisions employers can choose to benefit from ending the poor value offered by contracting out before 2016. The benefits of this approach should however be weighed against the loss of potential administrative easements which may apply if they wait until 2016.  Whatever end date is chosen we believe that employers should start planning their approach now. This will ensure that they have sufficient time for consultation and negotiation with employees and other stakeholders and for implementation of other beneficial changes.