Not many people remember when contracting out began back in the 1970s, but if you are in a defined benefit (DB) or defined contribution (DC) pension scheme, or are an employer running a pension scheme, the end of Contracting-out on 5 April 2016, will affect you.

Contracting-out began for DB pension schemes in 1978 when the government wanted to encourage employers to set up workplace pensions that would provide more than could be gained from the top-up to the basic state pension ‘earned’ through NI contributions.

The deal was that employers and employees would pay lower NI contributions in exchange for foregoing the state top-up. The extra private pension provided has to be at least as much as the amount foregone from the state and this is called a Guaranteed Minimum Pension (GMP).

Contracting-out was extended to DC pensions in 1988 with the extra NI added to the pension fund by HMRC instead of an NI rebate. There's no GMP in a DC scheme as the final pension simply depends on the growth of the fund and/or annuity rates.

From 6 April 2016 the introduction of the single tier pension will roll up the basic state pension and additional state pension into one so there will be nothing to contract out of any longer.

In fact, the beginning of the end of contracting-out began in April 2012 when  contracting-out for DC pension schemes (both occupational and contract) was scrapped. This had to happen to align them with the treatment of auto-enrollment workplace pensions from October 2012, which were to be offered on a not contacted out basis.

However, this has still left over 20 million people in the public and private sector in final salary (DB) schemes. In order to calculate what these people have ‘earned’ as their single tier pension is complex and that work has been going on behind the scenes at DWP and HMRC for a number of years, working in conjunction with pension schemes and employers. Not only are the rules complex, but applying them relies on accurate record keeping about a pension member’s employment and NI contributions and historically (and since the advent of RTI) the quality of these records is not great.

Reacting to criticism that most people thought they were in line for a new single tier pension of around £151 per week next year when many aren’t because of contracting-out, DWP have now produced a fact sheet to try to explain why this won't be the case. DWP have to calculate a Starting Amount for all of us who will reach state pension age on or after 6 April 2016 – singe tier does not affect those who are in receipt of a state pension before 6 April 2016. 

It’s important to remember that contracting out never affects the basic state pension only the additional amount based on earnings that has variously been called Graduated Retirement Benefit (GRB), the State Earnings Related Pension Scheme (SERPS) and now State Second Pension (S2P).

The single tier calculation begins with working out what an individual’s NI record would have earned them under the pre-6.4.16 rules and the post-5.4.16 rules; whatever amount is the higher becomes the individual’s starting or foundation amount. In the post-5.4.16 world individuals need 35 qualifying years to get the full single tier that is then discounted for any periods that they were contracted-out on either a DC or DB basis.

So why does this matter to employers? Well for a start they may well get questions from people who are reaching state pension age during 2016 as to what state pension they are likely to get so the new fact sheet will prove useful.

From the payroll perspective, the end of contracting-out means that the rebated rate of NI disappears as a concept. Both employers and employees will see an NI increase in their April 2016 payslips. For employers it’s a whopping 3.4% increase and for employees it’s 1.4%, although most employers will see an increase of £1,000 in the Employment Allowance to £3,000 which will help, but they need to start budgeting now. On a practical level you’ll also need to ensure that your payroll software converts everyone from table letter D to table letter A or the equivalent deferred or reduced categories.

Noel Guilford