Between 1978 and 1997, contracted-out defined benefit pension schemes were required to provide a Guaranteed Minimum Pension (GMP). This note looks at t arrangements for inflation-linking GMP rights.Jump to full report >>
Since the additional State Pension was introduced in 1978, it has been possible to contract-out of it into a pension scheme that meets certain criteria. Where an employee is a member of a contracted-out scheme, they and their employer pay a reduced rate of National Insurance (NI), designed to reflect the cost of providing the benefits foregone. Between 1978 and 1997, contracted-out schemes were required to provide a Guaranteed Minimum Pension (GMP). Since 1997, a different test has applied but contracted-out schemes still have to provide a GMP for rights accrued between 1978 and 1997.
Pension schemes are required to index GMP rights accrued between 1988 and 1997, in line with prices, subject to a 3% cap. The increase required by schemes each year is provided for in a draft Statutory Instrument, the Guaranteed Minimum Pension Increase Order.
There is a link between the GMP and the additional State Pension in that, when a person reaches pensionable age, the total amount of GMP is subtracted from the total amount of additional state pension built up between 1978 and 1997, and any net amount is paid. This is referred to as a ‘contracted-out deduction’. It reflects the fact that reduced National Insurance (NI) was paid during the period of contracting out in return for meeting legislative requirements. This calculation is performed each year that the pension is payable.
The effect of these arrangements is that, although schemes are not required to provide increases on the GMP on rights accrued between 1978 and 1988 (or in excess of 3% on rights accrued between 1988 and 1997), the additional State Pension built up during that period is subject to increases. When the contracted-out deduction is subtracted from the additional state pension, the remaining additional state pension includes an increase linked to prices. In this way, an amount broadly equivalent to the GMP, but which is in fact additional state pension, is subject to an increase (HC Deb, 6 January 2014, c51W).
Under the Pensions Act 2014 a new single-tier State Pension will be introduced for future pensioners from 6 April 2016. Because there will no longer be an additional State Pension, the option to contract-out will also end. If an individual has been contracted-out during working life, a deduction will be made from their single-tier entitlement to reflect this. This is to ensure that “all provision funded by the taxpayer, including that funded by the National Insurance rebate, is taken into account when calculating people’s entitlement to the state pension.” A person who has spent many years contracted-out may, therefore, find that their foundation amount is less than the full amount of the single-tier. However, they will be able to increase their single-tier pension up to the full level, at the rate of 1/35th of the full rate for each additional qualifying year they gain before reaching State Pension age.
In January 2014, the then Pensions Minister, Steve Webb, explained that pension schemes are liable for any statutory indexation of GMPs and this liability would not change as a result of the single-tier reforms. He said that the design of the transition to the single-tier pension would benefit many people who had been contracted-out and that those who held GMPs are no more likely to have a lower outcome as a result of the reforms overall than the rest of the population (HC Deb 6 January 2014 c51W).
Commons Briefing papers SN04956
Author: Djuna Thurley