Contracting-out and the State Second Pension - New NICs recording requirement from April 2009

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25 October 2007

The State Second Pension (S2P) is paid, in addition to the basic state pension, to employees who are not in contracted-out employment in respect of each tax year in which their earnings exceed the annual NICs lower earnings limit. Entitlement is accrued annually on the amount of each employee's "surplus earnings", i.e. the earnings between the lower earnings limit (LEL) and the upper earnings limit (UEL). Within that range of earnings there are three accrual rates that are weighted heavily in favour of those with low earnings.

The accrual thresholds for 2007/08 are:

the "qualified earnings factor" (QEF), i.e. the annual value of the LEL	£4,524
the "low earnings threshold" (LET)	£13,000
the "upper earnings threshold" (UET)	£30,000
the "annual upper earnings limit" (AUEL)	£34,840

The accrual rates for the current and coming tax years are:

Accrual Rates	2007/08	2008/09	2009/10
on earnings between the QEF and the LET	42%	41%	40%
on earnings between the LET and the UET	10½%	10¼%	10%
on earnings between the HET and the AUEL	21%	20½%	20%

Not only is the highest accrual rate targeted at employees with earnings up to £13,000, but an employee with earnings above the QEF but less than the LET is treated as having earnings of £13,000. For example, an employee with only £5,000 earnings in the year (surplus earnings of £476) is treated as having surplus earnings of £8,476 (i.e. £13,000 - £4,524).

S2P is currently a variable pension, i.e. the higher the employee's "surplus earnings", the higher the second pension. However, the Government's long-term objective is to change S2P to a fixed additional pension for everyone, by about 2030. To achieve this objective, a number of changes are necessary and already have a statutory basis in the Pensions Act 2007.

One of the first changes is to reduce the three accrual rates to two by merging the second two bands. This will take place from the 2010/11 tax year, when the accrual rates will be 40% on earnings between the QEF and the LET, and 10% on earnings between the LET and the AUEL.

From the 2012/13 tax year*, the 40% accrual rate will be replaced by a weekly flat-rate accrual amount of £1.50, equivalent to an annual amount of £78.00. (Note that the £1.50 is not a payroll deduction but an automatic pension accrual based on the employee having earnings between the LEL and the LET in the particular week on which primary NICs were paid.) The additional 10% accrual rate on earnings above the LET will continue in place and will ultimately be withdrawn by around 2030, by which time S2P will be a flat-rate pension benefit.

(*Note: 2012/13 is the planned commencement date for these reforms but is subject to confirmation. References to "2012/13" in the following paragraphs should be read with that understanding.)

Another significant change will be the abolition of contracting-out for both occupational and personal defined contribution (money purchase) schemes, also from 2012/13. The effect will be that members of schemes that had been contracted-out on a money purchase basis will be contracted back into S2P and will start to build up entitlement to the additional state pension.

The Government also has long-term plans to abolish contracting-out for defined benefit (salary-related) pension schemes. From 2012/13, the flat-rate accrual and the additional 10% accrual rate will also apply to contracted-out employment, thereby drawing employees into the state second pension scheme. This change will affect the level of the rebate paid in respect of contracted-out employment, resulting in higher contracted-out NICs rates from 2012/13.

The Pensions Act 2007, among the rules governing the new flat-rate accrual, introduces a new upper limit, the "Upper Accrual Point" (UAP). Its value has not yet been set but will be less than the annual UEL from April 2009 after alignment with the income tax basic rate limit (BRL) but more than the UEL would have been under normal indexation. (See the news item Annual Uprating of PAYE, NICs and related thresholds) The UAP will replace the AUEL as the ceiling for determining an employee's

surplus earnings for S2P purposes, and
contracted-out earnings for applying lower contracted-out NICs rates.

As enacted, the UEL would continue to be used for these purposes until the 2011/12 tax year and the UAP would replace the UEL in 2012/13. The UEL would continue to be the starting point from which primary NICs are paid at the 1% rate.

However, the use of the UAP, as defined in the Pensions Act 2007, was defined before the Chancellor's announcement in the 2007 Budget that the UEL would be increased considerably to align it with the income tax basic rate limit. From April 2009, the UEL is likely to be around £44,000, much higher than was anticipated when the reforms to S2P were decided. If the UEL had been indexed normally, it would probably only have been about £37,700 from April 2009. To maintain the structure of the S2P reforms and prevent excessive accrual between 2009 and 2012, the Government has announced in the Pre-Budget Report that the UAP will be introduced three years earlier, from April 2009.

The implications of this announcement are enormous and far outweigh, from a payroll perspective, the effects of the upper limit alignments.

The implications for S2P are not directly payroll-related. From April 2009, the UAP will replace the AUEL as the upper limit for earnings-related accrual under S2P.

However, the implications for the payroll calculation and recording of NICs are considerable:

as at present, no NICs will be due on earnings between the LEL and the ET, and rebates will continue to apply in contracted-out employment
NICs will be due at current rates on earnings between the ET and the UAP, with lower rates, reflecting the appropriate rebate, continuing to apply in contracted-out employment
NICS will be due at the full rates (11% primary and 12.8% secondary) on earnings between the UAP and UEL, even in contracted-out employment
NICs will be due (1% primary and 12.8% secondary) on earnings above the UEL
the UAP will be the upper threshold for the employer's liability for "minimum payments" in defined contribution pension scheme
earnings for NICs purposes will be split on the P11 Deductions Working Sheet (or equivalent) into (1) earnings up to LEL, (2) earnings between LEL and ET, (3) earnings between ET and UAP, and (4) earnings between UAP and UEL
year-end P14s will also reflect the same four splits of each employee's earnings.

Legislation to bring forward the introduction of the Upper Accrual Point is to be included in a new National Insurance Contributions Bill and in relevant Regulations. The Bill is likely to be introduced in the next session of Parliament. Draft Regulations providing the level of the UAP and employers' reporting requirements will be published in January 2008. These significant changes will have to be fully tested and operational in payroll software from 6 April 2009, the same date from which electronic filing of in-year PAYE forms becomes mandatory for employers with 50 or more employees.

...UK Payroll News - Latest

Further information:
Changes to State Second Pension (S2P) And Contracting Out
Pensions Act 2007
Explanatory Note on the Pensions Act 2007

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