At present, when employees are in a contracted-out DB scheme they and their employer pay a reduced rate of NI to reflect the fact that they are not earning any State Second Pension benefits.

When contracting-out ends in April 2016 employees who are in these schemes will have to pay an additional 1.4% of their gross pay between £5,824 and £40,040 in NI. Their employers will have to pay an extra 3.4%.

For an employee on national average pay of £26,500 this means an increase in their NI deduction of £290 p.a., and an additional cost for their employer of about £700p.a.

Allowing for tax and NI deductions this employee would need to get a 1.6% pay rise just to offset the reduction in take-home pay caused by this higher NI.

Private sector employers may seek to recoup NI by changing their DB schemes

Employers may use this ‘pension’ related cost increases as a reason to make a change in the member contributions or benefits of their DB pension scheme. They will argue that their scheme was designed to top up, or as a complement to, the State pension and that as members may receive a higher state scheme benefit this justifies a reduction in the company scheme.

The Government has encouraged private sector employers to consider this as an option. They have provided employers with a ‘statutory override’ which allows them to impose a change in their scheme as will realise a corresponding saving without requiring them to get agreement from the scheme trustees or the members. It will also by-pass any restriction on rules changes affecting future benefits or contributions which there may be in scheme rules. Employers using this provision will still have to consult on the change (but will have less incentive than otherwise to compromise on their proposals). 

The only exception to this override relates to a prescribed group of employees in the electricity and rail industries, at the time of privatisation, who were given statutory protection for their future private sector pensions.

Where the override is used, the change must be made within five years of April 2016 and it can take effect no earlier than that date. An actuary is required to certify that the employer’s proposed change will not save more than their increased NI cost.

In most cases employers will not need to make use of the statutory override in order to be able to make changes to the members contributions required or benefits earned in the future. Increased NI costs may be only one of the reasons why change for the future may be proposed.

Generally speaking, we would hope many employers will decide to bear the higher NI cost themselves and not pass it on and, where we consider they can afford to do so, we will want to encourage them to do so.

Checking where employer changes correspond to their NI Cost

The definition of pensionable pay in the DB scheme will in most cases not correspond with the definition of pay on which NI contributions are levied. For example the DB scheme might only pension basic pay rather than gross and there may not be a deduction of £5,824 from pensionable earnings . Also relevant is that the DB scheme may pension earnings to a much higher level than the £40,040 p.a. ceiling for calculating NI contributions.

Typically the increase in DB contributions as would be necessary to recompense the employer’s higher NI cost may be a lower figure than 3.4%; figures around 2.7% or 2.8% are common. Taken together with the increase employees will have to pay in respect of their own NI contributions, paying the employers contribution as well may look unaffordable.

A reduced rate of pension accrual , or build-up, is likely to be the commonest single change in benefits that employers might propose.  For example, where a scheme is currently providing a 1/60 accrual pension at a joint future service contribution cost of around 25% of pay the reduction proposed in future accrual to compensate for the employer costs might be to 1/70.

Clearly, where any benefit change is proposed we would expect the employer to share actuarial advice as to what saving in cost it realised.

Employers are likely to suggest that all members will benefit by their gaining higher state pensions. They will tend to focus on examples where members have more than nine years before State Pension Age and assume that members have always been contracted-out. This will allow them to suggest that the member will get the maximum possible increase in their state pension  (i.e. the difference between the Basic State Pension of £119.30 and the new State Pension of £156.45 per week). In reality members closer to retirement and those who in previous employments were contracted-in may stand to gain much less. 

Public Service Scheme members

The government has given an assurance that it will not seek to clawback the cost of higher employer NI from members of public service pension schemes. This follows the recent round of reforms in those schemes in the run-up to the NI changes.

However it has not provided any additional funding to public service employers to help them meet the higher NI cost. This will intensify future pressure on jobs, pay rises and services as employers have to make offsetting savings.