Government proposals for abolishing contracting-out may obstruct some transfers (and therefore enhanced transfer value exercises) from April 2012

Concerns have recently been raised that measures proposed recently by the Government in connection with its plan to abolish contracting-out could restrict the flexibility pension scheme members have to transfer their pensions between different types of pension vehicles. Consequently, the effectiveness of employer-instigated enhanced transfer value (ETV) exercises and certain other exercises available to companies to reduce their defined benefit (DB) pension exposure could reduce, as these normally rely on individuals being able to transfer freely.

Defined contribution contracting-out to cease from 6 April 2012
Contracting-out is the facility for employees to forego earnings-related state pensions in return for them and their employers investing a portion of the resulting saving in national insurance contributions in their pensions. The previous Government announced several years ago that contracting-out for occupational and personal defined contribution (DC) pension arrangements would be abolished, and the new Coalition Government confirmed that this would be with effect from 6 April 2012. Draft regulations needed to make this change were issued last month for consultation.

Recently there have been press reports that the Government is also considering abolishing contracting-out for DB pension schemes. This is already being phased out slowly as a natural consequence of changes introduced by the previous Government gradually to remove the earnings-related element of state pensions. However, this could take twenty years or more, depending on the future course of UK average earnings and inflation. No detail of the Government's latest intentions is currently available, but it is not inconceivable that a decision may be taken to withdraw DB contracting-out more quickly.

Proposed transfer restrictions
Amongst the numerous legislative changes proposed from 6 April 2012 in connection with the abolition of DC contracting-out are new restrictions on transferring from contracted-out DB pension schemes to DC arrangements. Currently, transfers from contracted-out DB pension schemes can take place relatively freely. All that is required is that the contracted-out part of the transfer value (known as protected rights) must be paid to another contracted-out arrangement. Many transfers, including those in connection with employer-instigated ETV exercises, involve transferring from contracted-out occupational DB schemes to contracted-out personal or occupational DC arrangements and rely on this flexibility.

The draft regulations would prohibit paying the contracted-out part of a transfer value from a DB scheme to a DC arrangement from 6 April 2012. Transfers from contracted-out DB pension schemes would become problematic, if not impossible, from that date.

Comment Given that the restrictions on how protected rights can be used in a DC scheme have all but disappeared, it is unclear why the Government would want to restrict transfers in this way. Hopefully these transfer restrictions will be withdrawn or diluted as part of the consultation process (certainly, reaction to the proposal has generally been negative). It is also disappointing that the restriction results from a consequence of what, on the face of it, appears to be a trivial change to legislation with no clear flag in the consultation document of the policy intent. As things stand, there is a risk that ETV exercises and certain other liability management exercises could become significantly less effective if left until after 5 April 2012. Pending further information, companies with contracted-out DB pension schemes who are investigating the feasibility of such exercises, or are in the process of planning or timetabling them, should investigate the extent to which restrictions on contracted-out transfers could affect the outcome of the exercise and - if they have the flexibility to do so - consider timetabling them for completion before 6 April 2012.

The full consultation document can be seen at: http://www.dwp.gov.uk/docs/abolition-contracting-out-dc-consultation.pdf


GAD consult on contracted out rebates for 2012-17

The Government Actuary's Department (GAD) has published a consultation document detailing the proposed methods calculating rebates for contracted-out pension schemes for the five years starting on 6 April 2012. The consultation runs to 15 December 2010, with the Government Actuary intending to issue a final report before March 2011. Note that contracting out on a DC basis will end from 2012 so the rebates are only of interest to DB schemes that are contracted out on a money purchase (protected rights) basis.

Rebates are derived by placing a value on the state second pension that is given up by workers who contact-out, and reflect the reduction in National Insurance contributions that employees and employers pay. The rebates are generally reviewed every five years, and it has become established practice for the Government Actuary to consult with the pensions industry before reporting on the assumptions used in the calculation method. The Government Actuary must then report on the assumptions he proposes for calculating rebates and the Secretary of State then publishes his own report to Parliament, alongside that of the Government Actuary, setting out his decision on the appropriate level of rebates after considering the Government Actuary's report. This must be done at least one complete tax year before the Orders have effect; so new orders must be laid before Parliament by April 2011 in order to have effect from April 2012. At the previous review, the then Secretary of State rejected the GAD proposal and implemented a lower rebate for DB schemes.

Proposed changes from April 2012
There is a change from previous years in that the Government Actuary does not make a specific recommendation for the rebates but instead puts forward three alternative approaches for calculating them. The Secretary of State will then make a decision based on the information provided. The three approaches refer to distinct sets of assumptions:

• a "best estimate" basis - this is intended to be such that the rebate is equally as likely as not to deliver the state benefit forgone, and to reflect typical investment strategies in contacted-out DB schemes.
  Derived rebates on this basis are shown as 4.7% to 4.9%. Current rebates are 5.3% (1.6% for employees and 3.7% for employers).

• a "typical funding" basis - this should include some sort of margin for prudence.
  Derived rebates on this basis are shown as around 6%.

• a "gilts" basis - this is intended to be such that rebates would provide for benefits at least equal to those forgone with a high level of certainty (but is not supposed to be a buyout basis).
  Derived rebates on this basis are shown as around 10.1%.

• the liabilities that the PPF have taken on will have matured by then (annual claims are expected to be around 1% of PPF liabilities with the duration of liabilities around 12 years);
• the fund will have grown substantially in relation to the levy charged (liabilities are projected to be around £80 billion); and
• the number of schemes will have reduced and the risk that they pose will be much lower.

• Scheme underfunding - the Regulator's role is mentioned here as the key factor in reducing this risk.
• Investment - as 2030 approaches, the PPF will look to reduce the effect of market movements on their funding position through relevant financial agreements and low-risk investments in government bonds and cash.
• Insolvency - the more employers with eligible schemes that go bust, the more pressure is placed on the PPF.
• Longevity - the PPF will consider buying protection from a third party, so long as it is cost-effective. If not, they will look to cover these risks by building up a reserve of around 10%.

• For those schemes in deficit (around 63% of schemes), this reduced to £64 billion in total.
• For those schemes in surplus, this increased to £71 billion.

• They expect RAA applications to be accompanied by clearance applications, though they should have already been involved in earlier discussions around the possible options, and relevant information should be submitted to them.
• Any proposal should have been discussed in detail with the trustees.
• They will need sufficient information from the applicants and trustees to allow an initial assessment.
• They will consider the relevant circumstances, which may include: whether insolvency of the employer would be otherwise inevitable or whether there could be other solutions (including funding options for the scheme) which would avoid insolvency; whether the scheme might receive more from an insolvency; whether a better outcome might otherwise be attained for the scheme by other means (including through the use of the Regulator's powers where relevant); the position of the rest of the employer group; and the outcome of the proposals for other creditors.