Pension Matters April 2011

Welcome to Pension Matters, produced by Torquil Clark.

Every month I will update you on the latest legislation and news surrounding corporate and personal pension planning. To find out more about the topics covered in this edition, please call 01902 576707.

Ian Hill, Pension Technical Manager

Gender based annuities outlawed

The European Court of Justice has ruled that insurers cannot price products based on gender from 21 December 2012 therefore EU member states will no longer be allowed to permit the use of sex-based annuity and insurance premium rates.

The ruling will have a knock-on effect to pension schemes, although at this stage it is uncertain to the extent. Sex-based factors in pension schemes rely on exceptions in domestic law that are based on the sex discrimination cases in the ECJ in the early 1990s, however there now must be doubt on this way of thinking.

The impact of the judgment may extend beyond the gender based pricing of insurance contracts and as well purchasing annuities, impacting directly to the use of gender based factors in occupational pension schemes in so far as they impact individual benefits which have actuarial factors embedded in them. Cash commutation factors and transfer values could be affected together with insurance products such as bulk buy-out and/or buy-in policies.

Improving pension scheme administration

The Pensions Regulator and NISPI (National Insurance Services to the Pensions Industry) will be working more closely together in 2011 to improve administration standards.

In the Pension Regulators statement it is noted that poor member data or records often results in additional and unnecessary costs and that trustees are legally accountable for record-keeping and data reconciliation.

There is also focus on their pension's housekeeping in 2011 to ensure that schemes are ready for the end of contracting out on a defined contribution basis in 2012.

Social Security Orders

The Department for Work and Pensions has made two routine Orders. 

These are:

• The Social Security Revaluation of Earnings Factors Order 2011 which confirms the Section 148 Orders for the 2011/12 tax year.  The Section 148 Orders are the earnings factors relevant to the calculation of the additional pension in the rate of any long-term benefit or of any guaranteed minimum pension, as well as for the purposes of revaluing state scheme pension debits and credits.
•  The Social Security Pensions (Low Earnings Threshold) Order which confirms that the low earnings threshold for the 2011/12 tax year will be £14,400.  The low earnings threshold is the amount by reference to which the surplus earnings bands are determined for the purpose of calculating the additional pension (the state second pension) in a state retirement pension.

Recommendations on Public Sector Pensions Review

Following publication of an interim report last October, the Independent Public Service Pensions Commission has now recommended that existing final salary public sector pension schemes should be replaced by new career average revalued earnings schemes. 

The Commission suggests that it should be possible to introduce these new schemes before 2015, while allowing a longer transition, where needed, for groups such as the armed forces and police. However, the full pension promises that have been earned by scheme members to date including maintaining the final salary link for past service for current members will be honored. Other key recommendations include the linking Normal Pension Age (NPA) in most public sector pension schemes to the State Pension Age (introducing an NPA of 60 for the armed forces, police and firefighters - who currently have an NPA of less than 60) and setting a cost ceiling for public sector pension schemes as a percentage of pensionable pay that taxpayers will contribute to employees' pensions with automatic stabilisers to keep future costs under more effective control.

The final report contains 27 recommendations to the Government on reform to public service pension arrangements. The key recommendations are:

• a move from final salary to a career average revalued earnings ("CARE") structure for all schemes, with the indexation of such CARE benefits whilst in pensionable service being linked to earnings rather than prices
• members' normal pension age in the future should be linked to State Pension Age
• the introduction of a "cost ceiling" which would place an upper limit on the amount committed by Government to public service pensions over the long-term, with any breach of such ceiling triggering automatic mechanisms designed to bring costs back down
• protection of accrued rights for existing members to include maintaining the final salary link for benefits which have already built up in the current schemes and
• the introduction of a new formal regulatory framework to ensure the independent review of the governance of public service pension schemes, perhaps by the Pensions Regulator.

The  Commission has concluded that defined benefit schemes should continue to be "the core design feature" for public service pension schemes. Having given in depth consideration to the structure, benefits and risks associated with both career average and cash balance pension schemes, the Commission recommends that future pension benefit reform in the public service should be based on a CARE structure.

If this key recommendation is adopted, public service pension benefits will in future not simply be based on an individual's salary at (or close to) the time of retirement. Instead, the individual will each year earn an amount of pension based on the accrual rate and his/her pensionable salary in that year. Such amount would then be indexed each year until retirement. The Commission recommends that the level of indexation to be applied before the individual leaves pensionable service should be linked to earnings rather than price inflation. 

The Commission has concluded against the introduction of a cap on pensionable earnings given the associated increase in complexity and the reduction in cash flow to Government revenue caused by the loss of contributions on earnings above any such cap. It has also recommended that member contributions should be on a tiered basis to distinguish between higher and lower earners and the approach to ancillary benefits (i.e. death and ill-health benefits) should generally continue on the same basis as is currently the case.

As part of its reforms, the Commission proposes controls on benefits to keep pension scheme costs within an acceptable level and to reflect the aim of sharing risks and costs fairly between members, the Government and the taxpayer. Under the Commission's recommendations, this would be achieved by linking members' normal retirement age in the future to the state pension age, so taking account of increased life expectancies, and the introduction of a "cost ceiling". The manner in which such a cost ceiling is determined would be a matter for the Government, but the key principle contained in the Commission's final report is that if the ceiling is exceeded, automatic mechanisms would be implemented within the schemes to bring costs down. Such mechanisms might include an increase to employee contributions, or a reduction in accrual rates.

For existing members of the public service pension schemes, it is clear that the benefits which they have already accrued will be unaffected by the changes proposed. In this respect, the Commission recommends that the final salary link is maintained for members' existing benefits. This means that on retirement, members' benefits which were built-up before the changes are implemented will be calculated based on his/her final salary at the time of actually leaving the pension scheme.

A new approach to regulation and a new legal framework concluded that there is a lack of consistency in governance and in some cases a lack of transparency of scheme data across the schemes, the Commission recommends that the Government establishes a formal regulatory framework to ensure the existence of an independent review of public service schemes. One option would be for the Pensions Regulator to fulfil this role. The Commission also recommends that each scheme should have a properly constituted and trained Pensions Board with formal member representation, to be responsible for overall governance and administration of the scheme.

State Pension Reform?

The Secretary of State for Work and Pensions, Iain Duncan Smith, has stated that he hopes to start making changes in the next three to five years to radically simplify the state pension system.

The Government is considering plans to introduce a flat-rate state pension of £140 pw. and there  is speculation that the new flat-rate state pension might come in from 2016, be available only to those reaching state pension age from this date and be financed in part by the ending of accrual of the State Second Pension with the consequential cessation of salary-related contracting out.

Default Retirement Age

New regulations provide and confirm that those giving notification prior to 6 April 2011 relating to retirements before 1 October 2011 remain subject to the default retirement age procedure. 

There are also concerns that the exception to age discrimination legislation for group insurance benefits, in relation to employees at the greater of age 65 and state pension age, may not provide the hoped for exemption for pension schemes.  This is because there is uncertainty surrounding how to interpret the structure of arrangements that qualify for exemption and unfortunately the revised draft regulations do not address this concern.  It is clear, however, that those schemes that seek to self-insure their death benefits will not be exempted.

CPI  Increases for PPF

The Department for Work and Pensions has made new regulations which provide for revaluation in relation to Pension Protection Fund (PPF) compensation in respect of periods after 30 March 2011 to be determined in accordance with any rise in the general level of prices in Great Britain, such as the Consumer Prices Index, rather than specifically by reference to the Retail Prices Index.

Fair Deal policy consultation

The Government has issued a consultation paper on possible revisions to the current "Fair Deal" policy on the treatment of pension provision for public sector employees who are compulsorily transferred to a non-public sector employer.

The consultation paper has been issued response to a recommendation made in the interim report of the Independent Public Service Pensions Commission toward the end of 2010. In this report, the Commission found that the "Fair Deal" policy, coupled with current public service pension structures, may create a barrier to the plurality of public service provision.

The current policy requires the new employer to provide employees with broadly comparable pensions where they are compulsorily transferred from the public sector to a new non-public sector employer. This policy applies where a public service is outsourced to be delivered by either a private sector business or by a non-profit making organisation such as a charitable body or social enterprise. It also requires that the new employer to provide bulk transfer arrangements for those staff who wish to transfer their public service pension benefits to the broadly comparable scheme

The consultation document sets out details of the Fair Deal policy, objectives and a range of options for future policy and subsequent transfers. The consultation runs until 15 June 2011. 

Since they were introduced in 1999, the Fair Deal rules have become increasingly complicated and demanding on contractors.  Private sector employers have largely moved away from final salary pensions over this period, yet are still being required to provide such pensions for outsourced public sector employees.  This may well have deterred many companies and charities from bidding for public sector work.

The Government needs to find a way round this issue if it is to successfully encourage more varied and cost effective provision of public services.  Equally, it needs to ensure that transferred employees do not lose out on their reasonable expectations of a decent pension.  The consultation document simply outlines the two extremes and asks for ideas on how to make things better.  The challenge will be to reduce the cost and complexity of the pension element of outsourcing, whilst maintaining a pension that is fit for purpose.

Tax relief review

The Office for Tax Simplification (OTS) has made public a report recommending the abolition, simplification and retention of an array of tax reliefs, allowances and exemptions administered by HM Revenue & Customs.

In its interim report, the OTS settled on a subgroup of some 155 reliefs, upon which its final report is based.  Out of the 155, the OTS is recommending that 54 remain unchanged, 37 be looked at in more detail, and 47 be abolished and 17 be simplified.

Of particular note concerns salary related contracted out rebates. The reasoning given is to align the treatment of all schemes and provide a simplification for employers and employees that participate in more than one scheme.  The recommendation is that these rebates are withdrawn at the same time as the rebates for personal pension and occupational money purchase schemes.

Updated Compensation Cap Factors

The PPF has released updated compensation cap factors. These will apply from 1 April 2011.
 
They have been updated to reflect the statutory increase in the PPF compensation cap at age 65 to £33,219.36 as of 1 April 2011. This equates to £29,897.42 after the 90% has been applied.

End of the road for Final Salary Contracting Out?

The Government intends a complete overhaul of the current state pension system. 

The headline is a proposed flat-rate pension of around £140 per week replacing the various state pension benefits people can currently be entitled to (such as the Basic State Pension, the earnings-related State Second Pension and the means-tested State Pension Credit).  The £140 per week would be subject to contribution requirements but the intention is that virtually everyone who has yet to reach State Pension Age would be entitled to it.

The big news of the Budget for many defined benefit pension schemes will be that as a result of the ending of the State Second Pension they will no longer be able to contract out.  Employers and employees who are currently contracted-out of the State Second Pension will have to brace themselves for higher national insurance contributions (or income tax levels - see below) in the medium term.

The proposals are designed so that overall spending on state pension benefits will not increase.  Importantly, the Government has committed to honouring the contributions paid towards earnings-related pensions up to now.

A Green Paper on the options for State Pension reform will be released shortly but it is acknowledged these changes, that will not affect current pensioners, will take some time to implement.

The abolition of contracting-out will have significant implications for many defined benefit pension schemes.  Most schemes with active members will wish to reconsider their benefit structure (given employees and employers will together be paying an extra 5.3% of relevant salaries to the Revenue) and are likely to bear in mind the Test Scheme standard for auto-enrolment, which is based on an accrual rate of 1/120th of relevant salary for each year of service worked.

Schemes with either a Pensionable Salary definition that has an offset for the Basic State Pension or a similarly-linked deduction from benefits will have to be careful - there is a danger members could see their accrued pension rights dramatically reduced if the offset were to increase from around £100 per week to £140 per week.  And there may be other arrangements that integrate with the Basic State Pension that could spring surprises.

Automatic Increases for State Pension Age

It is no secret that the State Pension Age is already planned to increase from 65 to 66 by April 2020, but after that the intention is for increases to reflect more closely the costs of the population living for longer.

One option under consideration is to put in place a system of regular independent reviews into the implications of longevity changes - broadly the longer people appear to be living the more quickly State Pension Age will increase.

Pension Input Periods

Pension savings are measured for the purpose of the AA test over what is known as a Pension Input Period ("PIP").

Pension savings made by or on behalf of an individual over all PIPs ending in a tax year are summed and tested against the AA. PIPs are generally a year in length, although there are some exceptions.

A PIP can start on a date nominated by the trustees of the scheme (or trustees/member in the case of a Defined Contribution ("DC") scheme). Where no such nomination is made, the default position is determined as:

• For DB arrangements, the PIP ends on the anniversary of the date the member joined the scheme, if they joined after 6 April 2006, or 6 April if they joined before.
• For DC arrangements, the PIP ends on the anniversary of the first contribution made, if the member joined after 6 April 2006, or the first contribution made after 6 April 2006 if they joined before this date.

Many trustees took the decision when the AA regime came into force that they would align their PIP with the scheme renewal year in order to make administration easier. Other trustees picked a different period, for example to align with the tax year. However, many schemes are still operating under the default position.

For arrangements where a nomination is yet to be made, trustees may want to make a nomination so that the current PIP finishes before 6 April 2011. By doing this, the pension savings made during the current PIP will be covered by the current AA rather than the new lower AA applying from 6 April.

Note that transitional arrangements apply to individuals whose current PIP is due to end after 5 April 2011 if that PIP started before 14 October 2010 (the date on which the regime changes were announced). However, pension savings for the part of the PIP falling after 14 October 2010 cannot be more than £50,000.

Those individuals whose current PIP started after 14 October 2010 will not be subject to transitional protection and the whole of the pension savings made in that PIP will be subject to the new lower AA if the PIP end date remains unchanged.

If no nomination is made, the default position will continue to apply. This could mean different members having different PIP end dates, depending on when they started to make pension savings. It will also mean that for a large number of members, their current PIP will end after 6 April 2011 and pension savings made over part (in the case of those who fall under the transitional arrangements) or all of that PIP will therefore be subject to the new AA.

Arrangements where a nomination is yet to be made have until the date the Finance Act 2011 receives Royal Assent (expected to be in July or August of this year) to nominate the PIP to be aligned with the tax year (or some other period).

For arrangements under which a nomination has already been made, it is not now possible to amend the PIP to align it with the tax year. This is because it would result either in more than one PIP ending in a tax year or a PIP lasting longer than 12 months, neither of which is permissible under legislation. In the case of a DC scheme in which members can nominate their own PIP, this may mean that even if the trustees now nominate a PIP for the scheme, it can still be the case that some members will have different PIPs.

Trustees that haven't already done so should consider whether they wish to nominate the PIP for their scheme, rather than relying on the default. HMRC do not need to be informed; in order to make a nomination, trustees just need to inform all affected members.

Increase in trigger point for auto-enrolment

From 6 April 2012 the personal allowance will become £8,105 a leap forward for the Government's ambition for individuals to have to earn at least £10,000 pa before paying income tax.

This could reduce the number of workers employers will have to auto-enrol into pension schemes when their duty to do so starts at their staging date sometime after October 2012 as it is likely that this will be a bench mark for the earnings trigger that has to be exceeded before the duty applies.

The one thing the auto-enrolment independent reviewers sought to achieve was a sufficient gap between the starting point for earnings on which to base contributions to money purchase schemes and the earnings trigger in order to avoid trivial amounts being paid. 

State Pension Age at 75?

Government proposals to link the pension age to life expectancy could force a person in their mid-twenties to wait until they're 75 to pick up their state retirement benefits, experts warn.

In a surprise Budget announcement Chancellor George Osborne said the Government would seek a "more automatic mechanism" for increasing state pension ages in the future by linking the figure to life expectancy.

NEST's investment fund strategy

The NEST Corporation has published unveiled an investment strategy centering on members, diversification and choice.

NEST Corporation expects up to 90% of NEST members to utilise the default funds.  A target date approach has been adopted using pooled funds and passive management.  Unless they opt for something else, NEST members will be enrolled into one of over 45 Retirement Date Funds that will target the year NEST expects members to take their money out (State Pension Age unless otherwise notified). Nest is taking a particularly cautious approach to the foundation stage as it was important to develop a savings habit for younger members and to avoid negative reactions to volatility.

Each target date fund will have a glide path which is split into three phases:

• Foundation - which refers to the early years of a member's working life when a savings habit is being built.  The objective is to preserve the value of contributions in real terms
• Growth - where the maximum growth in assets is being targeted through asset classes which are expected to grow in value relative to inflation quicker than other investments.  The objective is to deliver inflation + 3% pa over the long term
• Consolidation - this prepares a member's asset allocation for retirement.  The primary objective is to manage the risks associated with converting a member's accumulated savings into a retirement income and/ or cash lump sum by progressively switching investments out of return-seeking assets.  The focus in the early years will be on the cash lump sum target in recognition that members are likely to have too small a fund to buy an annuity cost-effectively

The transition between each phase will be managed dynamically depending on what is happening in financial markets, the economy and the NEST Corporation's understanding of different member cohort characteristics.

In addition to the NEST Retirement Date Funds, NEST will provide the following fund choices:

• NEST's Higher Risk Fund will target high returns through taking more investment risk
• NEST's Lower Growth Fund will take very little investment risk but may not protect against inflation over the long term
• NEST's Ethical Fund will have similar investment objectives to the NEST Retirement Date Funds but will invest in companies that meet ethical criteria, as well as gilts and a liquidity fund.  The fund may well be more volatile than a Retirement Date Fund over the longer term but NEST will look to manage risk throughout a member's savings career
• NEST's Sharia Fund will only invest in companies that are compliant with Sharia principles.  No life-styling approach is currently envisaged
• NEST's Pre-retirement Fund is for those members who, in the early years of the scheme, may want to buy a retirement income with their pot rather than target a cash lump sum.  It will invest 75% in a fund that aims to track level annuity prices and 25% in the liquidity fund