Contracting out to be scrapped and state pensions simplified

In a much trailed announcement, Chancellor of the Exchequer George Osborne outlined in his Budget speech the Government's plan to sweep away the two-tier state pension structure and replace it with a new single-tier pension based on contributions. The new state pension would be worth about £140 per week, slightly above the guarantee credit of £137.35. The pensions credit and guarantee credit would also disappear.

The reason for the change is the complexity of the current system and probably the desire to give people the maximum possible incentive to save for their retirement. The Chancellor says the proposal would "cost no more than the current system". It would not apply to current pensioners and indeed would take years to come fully into effect. The proposals are to be set out in a green paper "shortly".

Contracting out to disappear

The main Budget report makes it clear that moving to a single-tier state pension would also necessitate bringing the system of contracting out for defined-benefit (DB) schemes to an end, as there would no longer be a second-tier from which schemes could contract out. It is very likely to sound the death knell for DB provision.

Without a reduction in national insurance contributions for contracting out, DB schemes will become significantly more expensive and require a major overhaul. There is a widespread and entirely reasonable fear that, if employers need to redesign their DB schemes, then they will scrap them completely.

The general reaction has been that the impact on DB schemes is a price worth paying for removing complexity and means-testing. Joanne Segars at the National Association of Pension Funds comments: "This is a turning point for pensions in the UK. Over half a million new pensioners a year will get a simpler and more generous state pension, and reliance on means-tested benefits will be slashed."

Hutton recommendations accepted

The Budget announced that the Government has accepted the recommendations made by the Independent Public Service Pensions Commission led by Lord Hutton (see pp.10-11) "as a basis for consultation". The Government is to "set out proposals in the autumn that are affordable, sustainable and fair to both the public sector workforce and the taxpayer".

Following earlier consultation, the Budget also announced that the Government has decided that the appropriate discount rate for calculating unfunded public service pension contribution rates should be based on the long-term expectation of gross domestic product. As a consequence of this decision, a discount rate of three percentage points above the annual increase in the consumer prices index will be adopted.

Other pension changes

The Chancellor also announced that the government plans to introduce "a new, more automatic mechanism for future increases in the state pension age based on regular, independent reviews of longevity". The Budget report states: "This should ensure the costs arising from increased longevity are spread more fairly between generations. This will apply only after the state pension age reaches 66 in 2020.

Other pension-related items in the Budget were that:

  • income tax and national insurance are to be integrated, but national insurance will not be extended to those over state pension age;
  • the Treasury is to consult on limiting the tax relief available to employers when they make asset-backed contributions to DB plans;
  • the reduction in the annual allowance for pensions saving to £50,000 per year is to go ahead as expected; and
  • as announced previously, the Government will legislate to combat arrangements intended to "disguise remuneration" or avoid restrictions on pensions tax relief.