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

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22 November 2007

(The following news item was originally published after the 2007 Pre-Budget Report on 9 October 2007. Following publication of the National Insurance Contributions Bill on 13 November 2007, it has been updated in order to give the most current information about the changes from April 2009 onwards.)

Three thresholds are used to determine the amount of Class 1 NICs that are paid by employees and employers:

on earnings between the lower earnings limit (LEL) and the earnings threshold (ET) (known as the "primary threshold" in legislation), there is effectively a 0% contribution rate, meaning that employees are treated as having made a contribution between those thresholds even though, in practice, they have paid nothing.
on earnings between the ET and the upper earnings limit (UEL), employees who are not contracted out of the State Second Pension (S2P) pay a standard rate, currently 11%
on earnings above the UEL, employees pay, whether or not contracted out of S2P, a 1% contribution.

Only contributions paid by employees between the LEL and the UEL count towards entitlement to the S2P. This pension is paid, in addition to the basic state retirement pension, to employees who are not in contracted-out employment in respect of each tax year in which their earnings exceed the annual value of the LEL for the year. Entitlement is accrued annually on the amount of each employee's "surplus earnings", i.e. the earnings between the LEL and the UEL. Between the LEL and the UEL, three accrual rates are applied at different percentages between four different thresholds. The accrual percentages 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

Under current statutory provisions, the NICs and accrual thresholds are increased annually as follows:

LEL - set at or just below the weekly rate of the basic state retirement pension, increased in line with the retail price index (RPI)
QEF - the annual value of the LEL, increased in line with the RPI
ET - set at the same level at the tax threshold, with the annual value increased in line with the RPI
LET - increased annually in line with the average earnings index (AEI)
UET - increased annually using a formula based on both the LET and QEF
AUEL - the annual value of the UEL, increased in line with the RPI.

The accrual rates for the current and coming tax years, as they would be if the changes described in this article were not happening, 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 UET and the AUEL	21%	20½%	20%

On the basis that growth in average earnings is greater than growth in retail prices, the LET, the only threshold currently based on average earnings growth, increases at a faster rate than the other thresholds. The effect is that the bandwidth to which the 40% accrual applies is getting relatively wider every year. For example, the bandwidth was £7,196 in 2003/04, and is £8,476 in 2007/08.

Coupled with the fact that employees with earnings between the QEF and the LET are treated as having earnings at the LET, it is employees with earnings of up to £13,000 that get the greatest benefit from the current accrual calculation. For example, an employee with only £5,000 earnings in 2007/08 (surplus earnings of £476) is treated as having surplus earnings of £8,476 (i.e. £13,000 - £4,524). The intention at that time was for employees earning more than the LET to take advantage of contracted-out stakeholder pension schemes and occupational schemes, while those earning up to the LET would stay within the state framework and take advantage of the state second pension.

Changes to accrual bands and rates

Time has moved on and the Government has a new direction as a result of recommendations made by the Pensions Commission. One innovation, not the subject of this article, is the introduction of personal pension accounts from 2012, involving pension saving outside of the state pension scheme by both employee and employer. Another major change is to move the state second pension, currently, as described above, a variable pension related to each employee's "surplus earnings". The Government's long-term approach - the target date is 2030 - is to change S2P into a fixed additional pension for everyone, with accrual based on a single weekly contribution by everyone. To achieve this objective, a number of changes are necessary and already have a statutory basis in the Pensions Act 2007, with some additional recently-announced adjustments included in the National Insurance Contributions Bill 2007.

1. Upper Accrual Point

The first change is the introduction of a new threshold, called the "Upper Accrual Point" (UAP). As originally enacted in the Pensions Act 2007, this new threshold would have been introduced from 2012/13 as part of the mechanism for moving from the current percentage accrual rates to a single fixed accrual amount.

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 (based solely on the RPI), it would probably only have been about £37,700 from April 2009. Moving to a higher UEL runs contrary to the process needed to introduce a fixed rate S2P in the long-term. Consequently, the Government announced in the Pre-Budget Report 2007 that the UAP will be introduced three years earlier, from April 2009.

The Upper Accrual Point is a fixed threshold, set at £770 per week (the same as the UEL for 2008/09), the equivalent of £40,040 for a year. The UAP will not be increased each year but stay the same until 2030.

Consequently, from April 2009, the UAP will replace the AUEL as the ceiling for determining an employee's surplus earnings for S2P purposes.

Accrual Rates	2009/10
on earnings between the QEF and the LET	40%
on earnings between the LET and the UET	10%
on earnings between the UET and the UAP	20%

The UAP will also replace the UEL for the purposes of calculating Class 1 NICs. (See Changes to Class 1 NICs bands, below)

2. Two accrual bands

The second change is to remove the Upper Earnings Threshold (UET) and reduce the three accrual rates to two. 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 UAP

3. Weekly flat-rate accrual

The third change, from the 2012/13 tax year*, is to replace the 40% accrual rate with 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 NICable earnings between the LEL and the LET in any particular week. The additional 10% accrual rate on earnings between the LET and the UAP will continue in place.

The second and third changes are illustrated in the following Table.

Accrual Rates	2010/11	2011/12	2012/13*
on earnings between the QEF and the LET	40%	40%	£1.50 pw
on earnings between the LET and the UAP	10%	10%	10%

(*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.)

Over the following years, the bandwidth between the QEF and the LET will increase, especially as the QEF may not be increased each year. (See Other Related Changes, below) In contrast, as the LET will continue to be increased in line with growth in average earnings but the UAP will remain the same year-on-year, the bandwidth between the LET and the UAP will decrease until, by around 2030, it will reduce to nil. At that time, S2P will have become a flat-rate pension benefit. The following Table illustrates this gradual process, assuming that the LET increases by 5% each year, the QEF increases by 3% each year, and the existing rounding rules stay the same.

Thresholds	2007/08
QEF	£4,524
LET	£13,000
AUEL	£34,840

Thresholds	2009/10	2014/15	2019/20	2024/25	2029/30
QEF	£4,836	£5,720	£6,760	£8,008	£9,412
LET	£14,200	£18,400	£23,800	£30,600	£39,300
UAP	£40,040	£40,040	£40,040	£40,040	£40,040

In the year in which these normal increases would result in a new LET that is higher than the UAP, the two thresholds will be abolished. In the example above, this would occur in 2030/31. As the growth in the LET in the example is based on an annual 5% increase in the Average Earnings Index, much higher than current annual increases, it is more likely to occur much later than 2030.

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.

Changes to Class 1 NICs bands

The National Insurance Contributions Bill enables the UAP to be brought into effect for S2P purposes from April 2009. The change is also significant in respect of the calculation and recording of Class 1 NICs through the payroll from April 2009. In particular, contracted-out earnings will be the range of earnings between the LEL and the UAP, with a resulting impact on the contracted-out rebate. There will be a new requirement to record earnings between the ET and the UAP, as well as between the UAP and the UEL.

In summary, the effect will be as follows:

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 schemes
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.

HMRC expects to publish draft Regulations setting out employers' reporting requirements 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. Changes will be needed to forms P11, P12 (simplified scheme), P14 and P60.

Increasing the state retirement age

The state retirement pension is paid to men at age 65 and to women at age 60. From April 2020, the state pension age will be equalised at 65. The change will be introduced gradually, over a ten-year period commencing in April 2010.

The effect of this change, which has been in legislation for many years, is that women born

before 6 April 1950 will be able to claim their state pension at age 60
after 6 April 1955 will be able to claim their state pension at age 65
between 6 April 1950 and 5 April 1955 will have a state pension age between 60 and 65, depending on their date of birth.

The retirement age has to increase by 60 months (from 60 to 65) over a period of 120 months (April 2010 to April 2020). Therefore, the retirement age will increase by one month for each two months of the transition period.

As part of the radical changes to pensions recommended by the Pensions Commission, the state retirement age for both men and women is to be increased over a nearly 30-year period to 68, but in three separate exercises, starting in 2024, 2034 and 2044. The method to be used mirrors the process that will be used from 2010 to increase the retirement age for women.

The increase from 65 to 66 will start in April 2024. The retirement age will increase by one month for each two months of the transition period. After the transition period is over, anyone born after 5 April 1960 will have a state retirement age of 66.

A person born in the period shown in the first column will attain state pension age on the date in the second column.

Born between	Retirement Age
6/4/59 - 5/5/59	6/5/24
6/5/59 - 5/6/59	6/7/24
6/6/59 - 5/7/59	6/9/24
6/7/59 - 5/8/59	6/11/24
6/8/59 - 5/9/59	6/1/25
6/9/59 - 5/10/59	6/3/25
6/10/59 - 5/11/59	6/5/25
6/11/59 - 5/12/59	6/7/25
6/12/59 - 5/1/60	6/9/25
6/1/60 - 5/2/60	6/11/25
6/2/60 - 5/3/60	6/1/26
6/3/60 - 5/4/60	6/3/26

The next increase, from 66 to 67, will start in April 2034, and follow the same pattern. After the transition period is over, anyone born after 5 April 1969 will have a state retirement age of 67.

Born between	Retirement Age
6/4/68 - 5/5/68	6/5/34
6/5/68 - 5/6/68	6/7/34
6/6/68 - 5/7/68	6/9/34
6/7/68 - 5/8/68	6/11/34
6/8/68 - 5/9/68	6/1/35
6/9/68 - 5/10/68	6/3/35
6/10/68 - 5/11/68	6/5/35
6/11/68 - 5/12/68	6/7/35
6/12/68 - 5/1/69	6/9/35
6/1/69 - 5/2/69	6/11/35
6/2/69 - 5/3/69	6/1/36
6/3/69 - 5/4/69	6/3/36

The final increase, from 67 to 68, will start in April 2044, and follow the same pattern. After the transition period is over, anyone born after 5 April 1978 will have a state retirement age of 68.

Born between	Retirement Age
6/4/77 - 5/5/77	6/5/44
6/5/77 - 5/6/77	6/7/44
6/6/77 - 5/7/77	6/9/44
6/7/77 - 5/8/77	6/11/44
6/8/77 - 5/9/77	6/1/45
6/9/77 - 5/10/77	6/3/45
6/10/77 - 5/11/77	6/5/45
6/11/77 - 5/12/77	6/7/45
6/12/77 - 5/1/78	6/9/45
6/1/78 - 5/2/78	6/11/45
6/2/78 - 5/3/78	6/1/46
6/3/78 - 5/4/78	6/3/46

Other related changes

To qualify for the full state basic pension, a new single qualifying condition will be introduced for all men and women reaching state pension age on or after 6 April 2010. The condition is that the contributor must have paid or been credited with Class 1, 2 or 3 NICs for at least 30 qualifying years in their working life. Earnings in those years must have been not less than the QEF (annual rate of LEL) for the year.

The basic state pension will be increased annually in line with average earnings instead of retail prices, likely from 2012. At the same time, the link between the LEL and the rate of the basic state pension will be broken and any annual increase in the LEL will be at the discretion of the Treasury and subject to the approval of Parliament. There will no longer be any automatic annual increases in the LEL.

The existing rules for increasing the UEL do not allow the UEL to exceed 7½ times the level of the earnings threshold. The larger than normal increase from April 2008 is within these rules - the £40,040 UEL is still less than 7½ times the £5,435 ET. However, as the further increase planned for April 2009 would exceed the statutory limit, the limit will be removed altogether from that date. Future increases in the UEL will be at the discretion of the Treasury, subject to Parliamentary approval, and will not be automatic each year.

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

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