On 25 May 2006, the Government published a White Paper entitled Security in retirement: towards a new pensions system which included an announcement that contracting out on a defined contribution (DC) basis (also known as money purchase contracting out) was to be abolished, likely from 2012.
The White Paper explained that the Government would consult on the possibility of reforming or removing the rules applying to contracted-out rights (known as protected rights) already built up or held in DC schemes at the point of abolition. The intention was to increase simplicity and choice for members and to reduce costs and administrative burdens for schemes.
On 13 September 2006, the Government published a consultation document entitled Abolition of defined contribution (DC) contracting out: treatment of protected rights accrued in the past and proposed operational arrangements. Thirteen industry representatives subsequently attended a DWP workshop and 37 written responses were received.
The Government has now published a report on the consultation exercise and with a response on the two main aspects of the consultation, namely:
- the treatment of protected rights accrued in the past; and
- the operational arrangements to be put in place to achieve a smooth abolition of DC contracting out.
Firstly, the Government confirms its decision to abolish DC contracting out. The judgement on whether a person would be better off contracted in or contracted out of the State Second Pension is complex and does not provide the clarity needed when making pensions saving decisions. Provisions contained in the Pensions Bill 2006 will abolish DC contracting out. From the date of abolition, scheme members will begin to build up full entitlement to the State Second Pension.
The rules applying to protected rights
Abolition of DC contracting out will mean that scheme members and their employers will no longer be entitled to a contracting-out rebate in respect of earnings relating to employment. However, they would still have to comply with existing rules that apply to the protected rights accrued prior to the date of abolition.
Protected rights derive from the amount of contracting out rebate that people who are contracted-out on a DC basis receive. The protected rights are a pot of money built up from the amount of rebate, its investment return and any tax relief. The rules that apply to protected rights require them to be tracked separately from other rights in the scheme for a number of reasons, including, for example, for them to be used to provide for a survivor benefit where the member is married or is a civil partner at the point of annuity purchase.
Retaining the rules on protected rights already accrued once DC contracting out is abolished would perpetuate the current difficulties caused by these rules. Removing all of them is the only way in which the whole of the 'pension pot' could be treated in the same way. If this were to be done, it would simplify scheme administration and provide greater flexibility and choice for scheme members.
Most of the respondents to the consultation agreed with the proposal to remove the rules on protected rights. Many took the view that it should be for the individuals to decide what provision they make for their spouse, civil partner or dependants and that the decision should be based only on their personal circumstances, their savings and those of their dependents.
The Government recognises that, unless all of the remaining rules are removed, schemes will have to continue to track protected rights separately and HMRC will have to continue to be informed by schemes when protected rights have been secured.
However, the Government also recognises that there are concerns about the potential impact on survivors, especially women, of removing the rule requiring provision of a survivor benefit. The Government believes that this question requires more in-depth consideration and has announced that this will take place as part of the joint DWP/HM Treasury review of the working of the Open Market Option for annuities. This review was announced by the Chancellor at the Pre-Budget Report in November 2006 and is expected to reach its conclusions by the end of 2007.
In the meantime, the Government has taken a power in the Pensions Bill, currently before Parliament, to abolish or vary by regulations some or all of the DWP rules that determine the use of protected rights. The use of this power will be decided once the review of the working of the Open Market Option for annuities publishes its findings.
Operational Matters
Other decisions made by the Government in the light of responses to the consultation include:
- automatic cessation of DC contracting out scheme certificates from the date of abolition
- setting up a working group to develop a communication strategy for ensuring wide publicity about the abolition of DC contracting out and to alert individuals to the need to take account of this when considering their pension savings options.
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Further information:
Abolition of Defined Contribution (DC) Contracting Out: Treatment of Protected Rights Accrued in the Past and Proposed Operational Arrangements
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