Contracting-Out
Pension contracting out was a feature of UK Pensions Legislation from 1978 to 2012. After 2012, it is only permissible in relation to a defined pension plan benefit basis.
Persons who contracted out their salary-related scheme will become entitled to a guaranteed minimum pension for service between 1978 and 1997 and to the OSR rights after 1997.
Certain conditions apply to contracting out, including the issue of a contracting out certificate.
The State Earnings Related Pension Scheme was established in 1978, providing a mandatory earnings-related top-up to the basic flat-rate pension. Occupational pension schemes could contract out and offer members a choice of how the additional pension scheme would be provided. Contracted schemes were required to meet certain requirements and obtain a contracting out certificate.
National Insurance rebates were received on the basis that pensions would at least equal what would have been achieved from the SERPS. Until 1988, schemes could contract out on a salary-related basis, and rights could be included in a guaranteed minimum pension. After 1988, schemes could elect to contract out on the money-purchase basis, and the fund contribution available on protected rights could be included.
After 1997, guaranteed minimum pensions could no longer accrue, but schemes could still contract out on a defined benefits basis, provided they met overall quality criteria.
In 2002, SERPS was replaced by the State Second Pension. Following 2011, the proposal for contracting out was intended to be phased out.
Contracting out schemes must provide a certain level of benefits. Guaranteed minimum pensions ceased to accrue in 1997, but they continued in respect of services completed before that date. Formerly, it was possible to contract out by contributing schemes, personal pension schemes representing ABCs. Each member has to be provided with contributions-based benefits, with the employer’s contributions being at least equal to the rebates on National Insurance. Certain incentive payments are also provided for periods.
The rebate on National Insurance was given broadly in reference to the costs of providing benefits for a person of average age. This may be advantageous for those below average age and those older to remain with the State Second Pension.
Contracting out was only permissible while there was a valid contracting out certificate in force. This required compliance to start from certificates. The contracting out certificates or particulars, unique references, game references, and other information were used to monitor National Insurance liability and other matters.
Before making an election for the issue, variation, or surrender of a contracting out certificate, employers were obliged to give notice of intentions and notice of explanations. A Notice of Intention must be in writing and must contain the requisite information. It is to be given to all earners in the employment, whether or not a pension scheme member, and must also be given to independent trade unions or other recognized bodies.
Employees and representatives were entitled to make representations.
A Notice of Explanations may be given subject to certain conditions applying, which preserved the rights of employees. In this case, no consultation was necessary.
The procedures applied in making an election to contract out, vary, or surrender a contract certificate. The above notices were required. Supporting documents and forms must be completed.
A contracting out certificate required that the scheme complies with certain matters, including compliance with provisions of guaranteed minimum pensions in respect of service completed before 1997, and in respect of service completed after 1997, the scheme must comply with certain tests, including statutory funding tests, and pension rules must be subject to certain conditions in relation to lump sums, equality, compliance with requisite rules, as well as ongoing rules.
Special rules apply to the approval of a guaranteed minimum pension. For service prior to 1997, it must commence no later than state pension age, subject to limited provision for postponement. Service attributed in the period 1988 to 1997 must be increased by 3 percent per annum or the increase in the general level of prices, whichever is less. The scheme must provide for the benefit of a surviving widow or civil partner at the rate of at least 1/2 of the member’s benefit.
The guaranteed minimum pension is based on earnings in excess of lower earning limits while in contracted employment. This is calculated in accordance with the appropriate percentage of the member’s earning factors during the relevant years. The earnings factors are based on earnings up to an upper earning limit, subject to revaluation.
The GMP may be discharged in the scheme or may be discharged by way of a separate insurance or annuity contract. Rights and liabilities to a GMP might be transferred to another occupational pension scheme, personal pension scheme, or overseas scheme.
Since 2009, it has been possible to convert GMPs into scheme benefits and exempt them from the requirement for a minimum benefit. The post-conversion benefits must be equal to the pre-conversion benefits. There must be no deduction in respect of pensions and payments. Post-conversion benefits must not include money purchase benefits. Survivor’s benefits must be provided, and certain procedural requirements must be followed for a contracted-out salary-related scheme to continue to contract out from 1997 and the Second State Pension from 2002. It must comply with the reference scheme test.
The contracted-out rebate is 4.8 percent of earnings between the lower earnings limit and the upper approval point. This rate may be changed from time to time by order on the recommendation of the Secretary of State.
The reference scheme test aims to ensure that the pension satisfies the statutory standards. It must be equivalent to or better than the pension that would have been provided under the reference scheme.
The reference scheme assumes a normal pension age of 65 for men and women. It provides a pension of 180 per average qualifying earnings in the last years, subject to a maximum of 40 years. It provides a survivor’s widow or civil partner pension in most cases at a rate of 50 percent. It provides annual pension increases in accordance with the Pensions Act.
The scheme is to be certified by an actuary as meeting the test. Actuaries give statements in accordance with statutory or professional guidelines.
Changes to COSR schemes are limited. Changes may only be made provided the scheme continues to satisfy the conditions of the actuary’s certification. They may not be altered in respect of guaranteed minimum pensions (GMP), if these amendments affect increases or any other matters subject to the requirements of the GMP.
Already, an occupational pension scheme could contract out of the Second State Pension and the money purchase state, subject to conditions. SERPS schemes could contract out of the additional state pension on a money-purchase basis by opening up a COMP section, and the COMP section could contract out on a salary-related basis by opening a COSR section. The OSR is contracted out of a salary-related scheme, and the UMP is contracted out of a money-purchase scheme.
Occupational pension schemes could contract out of the Second State Pension on a money-purchase basis by providing protection rights. These are rights based on minimum payments of the scheme in respect of members, including age-related rebates and transfers, rights in another contracted-out arrangement. A member’s protection right is where his rights to money-purchased benefits lie under the scheme.
Money rules could instead provide that members’ protected rights are the rights to arrive at the payment of minimum payment and age-related rebates. Money purchase benefits derived from protector’s rights are transferred to another scheme, and money purchase benefits derived from a GMP or post-COSR right that have been transferred.
The protected rights could be discharged under the scheme’s rules by providing a pension of a MIS scheme transfer or payment, lump sum, or providing an annuity. Certain requirements applied in respect of the pension or annuity to be offered. Survivor’s pension is required.
After 2012, no further CO contracting certificates will be issued. Contracting out is not allowed for money-purchase schemes, defined contribution pension schemes include personal pensions and stakeholder schemes.
Former COMP scheme members or members of the COMP section of a COMP scheme are contracted into accrue rights under the Second State Pension. Contracting out rebates are no longer available. Contracting out certificates for COMP schemes remain valid in relation to the salary-related elements sections of the scheme.
There is a three-year transitional period under the legislation dealing with former COMP and COSR schemes. Details apply or in cessation of contract out of employment.