Employers face new pension costs - An overview of the new pensions regime for employers

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No-one can have missed the pensions crisis in the headlines. The population is ‘going grey’ – average life expectancy is increasing steadily as general health improves, and the number of pensioners is set to double by 2055 – which creates a huge funding problem for both government and private pension schemes. Will there be any ‘money in the pot’ when we all retire?

1. Introduction

Some private schemes – defined contribution (DC) or money purchase (MP) schemes – only have to pay out what is in the fund when the worker retires, so the pension paid at retirement depends on the amount paid in and the investment performance of the fund. This is the type of scheme towards which governments of all colours have been steering employers and workers for the last fifteen years or so, because the main risk lies in the investment performance, and that can be mitigated, at the cost of potentially losing out on investment performance, by careful choices by fund managers.

Other private funded schemes are of the ‘defined benefit’ (DB) or ‘final salary’ type, which are also backed by funds saved up by employers and employees over many years. Pensions are based on a proportion of the worker’s earnings (in the final year, or more often these days, on average salary over a period) when he retires, and the employer takes on the risk of underfunding. The risk of employer insolvency led to the creation of the Pension Protection Fund and an insurance levy being collected from all scheme employers based on their assessed risk.

Schemes for public sector employees are a really hot topic: these schemes classically operate on a pay-as-you-go basis, with current contributions funding current pension spend, and limited underlying investment funds. As the number of ex-public sector workers living in retirement grows, so does the cost of funding their pensions, all of which is, ultimately, borne by taxpayers (Greece, of course, has a major problem in this area).

Underlying all of these in the UK is the state pension funded by National Insurance contributions (NICs), which is also a pay-as-you-go scheme: contributions collected via employers each month are spent on current pensioners within the year. Unlike nearly all private sector schemes, there is no bundle of investments aimed at providing a pension in the future, so as more people reach state pension age and the working population paying NICs remains static or shrinks (described as the ‘support ratio’ falling), the system comes under strain.

The UK state pension is already notoriously poor, and has been rated the worst in the EU more than once (although when the UK’s tradition of encouraging private pension saving is added in, we climb to somewhere like fifth in the overall EU table of pension provision). Changes already announced by the current government and its predecessor are set to make the UK NI pension more ‘sustainable’ (ie, citizens will contribute for more years and receive a pension for fewer years), and there is a new Green Paper on wholesale reform of the basic pension, but any objective viewer comes to the inescapable conclusion that the state pension is not good enough to give state pensioners enough money to provide for their reasonable needs.
2. An extra state pension?

How have governments reacted? The current state pension model becomes, in the face of a falling support ratio, unsustainable without reducing benefits and/or increasing contributions, neither of which is ever popular with the electorate.

The answer created by the last government was to plan for a new, national, low-cost DC funded pension plan and compulsory contributions from all workers and their employers – state sponsored and regulated, but not just an extra layer on the old scheme.

It will take several generations for the effects to be felt fully, but that is often the nature of pensions policy. The structure will undoubtedly be changed by future governments, but the logic of making people save for their retirement is hard to criticise, and we have to start somewhere.

It was realised that you can require more contributions from voters if they can see that it’s not just more tax, but is a way of putting money aside with their name on it for a better retirement. Once that principle is accepted, the rest is just detail.
3. Auto - enrolment obligations

So the law now says that employers will have to make available a quality workplace pension scheme to their workforce and, for the first time (unlike ‘stakeholder’ pensions), employers will have to (a) have a scheme in place and (b) automatically enrol all ‘eligible jobholders’.

Employers will have to register with the Pensions Regulator and provide all workers with certain information about their entitlement to join a pension scheme.

All employers are affected, even those householders who only employ a single carer or a nanny, although some such workers will have earnings below the relevant threshold (see below) and will therefore not require a scheme, while those supplied through agencies will usually fall under the agency’s scheme. One-man companies with no employees other than the sole director will also be exempt from the employer duties.

Many employers already offer membership of a scheme to employees, but employees have to opt in. Under the new rules, this will change: workers will join automatically, with the chance to opt out. And any scheme will have to meet certain minimum standards so that membership is worthwhile.

Note that the term ‘eligible jobholders’ is wider than just employees: if a contractor is classed as a ‘worker’ for National Minimum Wage purposes, he will be included in the new pensions regime. On the other hand, shareholder-directors who are simply office-holders, with no contract of employment, are excluded.

Genuinely self-employed workers who do not commit to personal service are not covered by the new rules in respect of their own earnings. However, if they have employees, they will be subject to the new employer obligations.

Workers will be able to opt out, but will be automatically re-enrolled, roughly every three years (with the ability to opt out again each time). So why would workers who have ignored pensions for so long (with excuses such as ‘too complicated’, ‘no spare cash’, ‘too young to worry about old age’, etc) choose not to opt out immediately?
4. Compulsory contributions

The answer is that there will also be (unlike ‘stakeholder’ pensions) compulsory employer contributions in respect of most workers, which top-up the workers’ own contributions – money for nothing from the employer. Which worker is going to turn that down?

Certain workers who are not ‘eligible jobholders’ will still have the right to information and to join the employer’s scheme. Some will be entitled to compulsory employer contributions, while others will only be entitled to contribute personally, with employer contributions remaining discretionary.

In practice, employers will probably factor the extra costs into their next pay negotiations, so the full cost will eventually be borne mainly or wholly by the workers, but there is certainly an initial attraction to the ‘un-pensioned’ to accept compulsory membership and not opt out.

Employers will collect worker contributions through payroll, just like NICs, and remit the combined employer and worker pension contributions to the chosen pension scheme (not to or via HMRC) by the 19th of the month. Penalties will apply to late payment.
5. When will employers have to comply?

The new regime is being phased in, starting with volunteer ‘guinea pig’ employers this year, then the largest employers compulsorily registered by October 2012, then progressively smaller employers in stages over the next four years. SME employers of fewer than fifty people will be required to enrol in stages (based on their PAYE reference number) between March 2014 and February 2016.

The Pensions Regulator (TPR) should write to give every employer plenty of advanced warning (six to twelve months) of the relevant date for compulsory registration and auto-enrolment. However, it is no surprise that employers need not wait for the statutory deadline, as any employer can already set up a pension scheme: they can register early with TPR – even before the notification is received – and set up a qualifying scheme in advance of the deadline. The key is to set up a scheme that will qualify under the new rules.
6. Are all workers affected?

Not necessarily. It depends on age, earnings and employee choice .

Workers who earn below the auto-enrolment threshold (currently £7,475 pa) need not join a pension scheme but can opt to do so. If the worker does opt to join, the employer must agree to enrol the worker and is allowed, but not required, to pay contributions.

The auto-enrolment rules will apply to all other UK workers above age 21 but below state pension age.

Employers can choose to open voluntary membership to anyone aged 16 to 21 and those above state pension age, up to age 75. If their earnings are below the threshold, the employer must enrol them but need not pay contributions. If their earnings are above the threshold, employers must enrol them and pay employer contributions.

There are various special rules for unusual categories of workers, such as agency workers, those who work overseas, etc.

Workers will be able to opt out of membership at any time, by giving the employer an opt-out notice obtained from the pension scheme provider. Employers will not be permitted to issue the notices, so that there is less chance of pressure being applied to use the notice.

Any new worker will have to be enrolled automatically when starting work if his earnings reach the threshold. The rules allow for a ‘waiting period’ of up to three months for new employees, so that employers and pension funds do not waste resources on auto-enrolling somebody who leaves within a short period of joining. Workers can opt to join early rather than waiting for the end of that period.

Current workers will have to be enrolled by the statutory phasing date.

If workers opt out within 30 days of auto-enrolment, any contributions already paid are refunded, but after that deadline any past contributions stay in the fund until retirement. Workers will be able to rejoin at any time, and will automatically be re-enrolled within three years.

There are various rules designed to protect against employers discriminating against workers who refuse to opt out or inducing them to do so. For example, it will be illegal to prefer an interview candidate who indicates that he will opt out if he is appointed.
7. What will the costs be?
The Government Actuary estimates that people should salt away 8% of their income to provide (on top of the state pension) for a sensible level of retirement income, so we are now faced with a new regime that aims (eventually) to provide for that, on a money purchase basis rather than through a taxpayer-funded pay-as-you-go system.

When fully implemented, the new regime will require a money purchase contribution from employers of 3% of ‘band earnings’ (broadly similar to the band on which full rate NICs are paid, but yet to be defined). Employees will have to pay 4% of band earnings, and those contributions will attract a tax credit of 1%, just like current personal pension contributions.

However, the last government admitted that the current economic situation was not ideal for the imposition of extra costs on employers, so:
- initially, total compulsory contributions will be limited to 2% (with employers paying at least 1%),
- rising to 4% in October 2016 (employers will pay at least 2%) and
- up to the full 8% in October 2017.
Employers with a defined benefit pension scheme will be subject to a different test, which is based on a reference scheme and the minimum rate at which benefits accrue rather than a minimum contribution rate.

Employers and workers will be free to contribute more than the minimum on a voluntary basis, and the official contribution rate need not be limited to band earnings – earnings below the starting threshold and above the upper limit can be taken into account – but total contributions will be capped at a maximum of £4,200 pa (in current cash terms) if the employer uses the NEST scheme (see below).

The cap is intended to focus the scheme on the low earners who typically have poor pension provision, and to prevent the NEST scheme (see below) from competing unfairly with private sector pension providers.

Note that there are two different thresholds:
- Earnings must be above £7,475 (the single personal tax allowance in 2011–12 terms) before automatic enrolment applies
- Contributions will then be due on earnings above £7,225 (the employee threshold for NICs in 2011–12 terms).
This is designed to ensure that membership, once triggered, requires the payment of more than a trivial amount in contributions.
8. Is there a single national scheme?

Yes and no.

The new rules recognise that many employers already have very adequate pension schemes, so for them the only changes required are likely to involve provision for auto-enrolment and opt-out procedures.

Some employers, though, will have schemes that do not meet the minimum standards, so those schemes will have to be amended and upgraded to comply before they can be used.

Employers who currently have no scheme will have to make arrangements to comply. Unlike the stakeholder regime, there is no exclusion for small employers.

The choice of scheme is open: any pension scheme that meets the minimum requirements is acceptable, provided the employer certifies to the Pensions Regulator that it is compliant.

All employers can choose to comply by using an existing scheme, setting up a new, dedicated scheme, or signing up to the National Employment Savings Trust, NEST. An employer who has a compliant scheme for some staff but not others can meet the standards for all by offering membership of NEST as an alternative to the existing scheme.
9. National Employment Savings Trust

NEST is, in effect, a national money purchase pension plan into which any employer can enrol to provide a qualifying pension scheme for all its employees. NEST will operate on a not-for-profit basis. While employers have the right to choose any provider to meet the requirements, and some will choose to buy from well-known life and pensions offices, some employers are too small to be of interest to those private sector businesses. NEST offers them a home.

NEST will collect the monthly contributions and operate personal accounts for every enrolled employee. Members will have a limited choice of funds, with the emphasis on protecting the value, but annual management charges will be limited to 0.3%. Employers and employees will interact almost exclusively online with NEST, to keep management costs to a minimum.

The creation of the NEST infrastructure has been funded by a loan from the government. This is to be repaid from an initial charge of 1.8% on all investments into the scheme for the first few years, until such time as the setup costs have been recovered.

NEST will invest contributions by default into a series of funds run by target retirement date, which will move money steadily into more conservative investments such as gilts over the years up to the target date. There will also be a small number of other low-cost funds available, such as an ethical fund and a Sharia-compliant fund. Employers and employees may need to take investment advice before choosing a fund.

Self-employed workers will be entitled to use NEST for their own pensions saving, subject to the same limits as employees.

For a number of years, the amounts accumulated by low-paid workers from their compulsory membership are likely to be small. There will be special rules allowing small pension pots to be encashed in full at retirement, but those with larger pots will be able to take the usual 25% of the fund tax-free and draw a pension from the remaining fund. A small panel of pension providers has been selected to offer annuities.

Further information about NEST is available from its website – http://www.nestpensions.org.uk/
10. What do employers need to do now?
Employers with existing pension schemes will need to check whether they are compliant under the new rules and, if not, take steps to bring them up to standard (eg, the current scheme might have a probationary or waiting period of more than the permitted three months).

Employers who currently make no pension provision for their workers will have to take a number of steps, for which the time needed should not be underestimated:
- Check when their obligations must be met: www.tpr.gov.uk/staging.
- Plan to set up their scheme – choose a provider, design the rules, design the systems, make decisions about whether to include workers in addition to those who are required to be included, design opt-in processes for those who may join voluntarily even though not subject to auto-enrolment, etc.
- Plan to assess their workforce to identify those who will have to be auto-enrolled.
- Provide those workers with information about the scheme and their options (simple intranet pages and posters around the office will not suffice).
- Budget for the costs – setting up and running the scheme, as well as the employer contributions.
- Watch for further information and guidance as the new regime approaches.
- Register the new scheme online with the Pensions Regulator.
- Update payroll software.

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