Know your legal obligations on pensions

It is sensible for everybody to make sure that they have some sort of pension provision. As an employer, you need to understand your legal obligations in this area.

You should consider your own retirement needs as well and even if you own the business, do not rely on selling your company as a guaranteed source of income on your retirement.

Employers are not currently obliged to set up a pension scheme but – depending on your size and your existing provision – you might be obliged to provide access to one run by a third party. However, the Pensions Act 2008 will introduce new obligations on employers to provide access to, and contribute towards, a workplace pension scheme for eligible employees.

The two main types of private pension are final-salary and money-purchase schemes. Money-purchase schemes include occupational money purchase, personal pensions, stakeholder pensions and executive pension plans.

Whichever pension you choose, either for yourself or on your employees’ behalf, you need to understand the relevant regulations and tax implications. Talk to a professional adviser about your particular needs before deciding.

This guide will help you understand your options and explain your legal obligations.

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Final-salary pension schemes

Final-salary pension schemes are usually based on an individual’s final earnings at or near retirement – or when they leave the company if this is before retirement – and how long they were in the scheme. These are also known as salary-related or defined benefit schemes. See our guide on how to choose the right pension scheme.

Salary-related schemes generally operate through a trust that receives contributions from the employer and employees and pays out members’ benefits. The trust’s objectives are set out in the trust deed, and the day-to-day decisions are made by the trustees.

There are a number of legal obligations governing the relationship between the employee, the trust and the employer:

• the employer is bound, like the employee, by the legal obligations of the contract of employment – for example, the payment of pension contributions
• all trustees, including those nominated by the employer, must act in the interests of all the scheme’s beneficiaries – which includes scheme members, but may in some rare situations also include the sponsoring employer rather than those of the company
• the employer has a duty to notify the Pensions Regulator if there is any reason to think that there are any problems or wrongdoings occurring in the scheme and that the wrongdoing is important to the Pensions Regulator
• the employer is responsible for ensuring that any employee contributions deducted from pay reach the pension scheme within 19 days of the end of the month in which they were deducted, and that the employer contribution (if any) arrives when it is due
• the employer must ensure that the assets of the pension fund are kept totally separate from those of the business
• the employer must ensure that employees are informed and consulted on developments that affect the pension fund
• trustees must be assisted in the performance of their duties – employee trustees must be given paid time off to undertake those duties and any necessary training

Find out how to meet the requirements for trustee knowledge and understanding using the toolkit on the Pensions Regulator website (registration required)- Opens in a new window.

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Money-purchase pension schemes

In a money-purchase scheme (also known as a defined contribution scheme), the final pension amount will depend on:

• the amount of money paid in 
• the investment performance of the pension fund
• the age at which the fund is used to purchase an annuity – the later this is, the higher the annuity payments are likely to be
• the level of annuity rates at the time
• the ancillary benefits offered – such as spouses’ pensions, or annual increases in pensions paid

Some employers now provide occupational money-purchase pension schemes for their employees. Both employers and employees can make payments into such a scheme. Once the employee leaves, these payments cease.

The investment risk is moved from the employer to the employee with an occupational money-purchase scheme and the risk that the employer will have to find substantial extra sums of money to fund the scheme because of poor investment performance is eliminated.

Occupational money-purchase schemes generally operate through a trust. Objectives are set out in the trust deed and day-to-day decisions are made by the trustees. Employers still have some key responsibilities, either as employers or as trustees – for example, on the level of employer contribution, or the extent of provision for dependants.

Money-purchase schemes must offer members the open market option whereby members can transfer funds at retirement to draw an immediate annuity with another provider. Members of a money-purchase scheme approaching retirement will need timely information on this option and other retirement income options. Read information on the open market option on the Pensions Regulator website- Opens in a new window.

Employees can also make regular payments for their retirement through individual personal pension schemes. These are money-purchase schemes and the risk of poor investment performance is carried by the employee. In some cases, employers will make payments into these schemes for the benefit of their employees.

Some employers may also arrange for a pension provider to set up a group personal pension (GPP) arrangement. In a GPP, employees contribute to individual personal pensions which are then grouped together and managed by the pension provider, to reduce costs. The employer may often pay the administration costs of running a GPP.

Employees can contribute up to 100 per cent of their earnings and get tax relief (or up to £3,600 a year can be contributed even if an employee’s earnings are less than this amount). However, there is a limit on the amount of tax relief that may be given on pension scheme contributions and other increases in pension rights each year. This annual allowance has been set at £255,000.

Further measures have been announced to restrict the tax relief available on pension savings for the highest earners. Those with incomes of £150,000 or more (subject to a floor of £130,000 of pre-tax income including personal pension contributions and charitable donations) will have their tax relief gradually tapered down so that individuals with incomes in excess of £180,000 will receive tax relief at 20 per cent with effect from 6 April 2011.

Employer contributions also generally qualify for tax relief as they can be set off as expenses, although employers should seek professional advice to make sure their contributions qualify as true business expenses. See our guide on how to choose the right pension scheme.

Most personal pension decisions are made by individual pension holders and the pension managers (the ‘pension providers’), or investment specialists. However, employers are still legally obliged to ensure that employee contributions deducted from wages reach the fund within 19 days of the end of the month in which they were deducted.

The responsibility for registering the pension scheme rests with the pension provider. This information must also be provided to employees – see the page in this guide on keeping employees informed.

Find guidance on personal pensions on the Pensions Advisory Service (PAS) website- Opens in a new window.

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Stakeholder pensions

Stakeholder pensions are flexible money-purchase arrangements targeted at individuals on moderate incomes. They are available from financial services companies such as banks, building societies and investment companies. For information on the different types of pension schemes, see our guide on how to choose the right pension scheme. 

If you have five or more relevant employees on your payroll, and do not provide another qualifying scheme, you are obliged to provide your employees with access to a stakeholder pension. Qualifying schemes are occupational schemes that are open to all employees within one year of starting work for you, or personal pension schemes which all employees – except those under 18 – can join, and to which you contribute at least 3 per cent of each member’s basic salary. It must also be possible for them to have their contributions deducted from their pay. Contributions can be less than £20 and should not be reduced due to transfer costs.

You don’t need to provide access to a stakeholder pension scheme for some employees. These are known as ‘non-relevant’ employees and include:

• those who have been in continuous employment with you for less than three consecutive months
• those who are already members of your existing pension scheme, and those who could have joined but declined
• those who cannot join your existing scheme because they are under 18 or within five years of the scheme’s normal pensionable age
• those who earned less than the National Insurance lower earnings limit for one or more weeks within the last three months 
• those who cannot join because of HM Revenue & Customs (HMRC) restrictions – for example, the employee does not normally live in the UK

If you have five or more employees and some of them are non-relevant, you are still required to designate a stakeholder pension scheme. You are only exempted from this requirement if all of them are non-relevant.

You can give your employees access to a stakeholder pension even if you are not required to do so. However, if you are required to offer a stakeholder pension, you should:

• select a scheme from the Pension Regulator’s list of registered stakeholder providers
• discuss the proposed choice with your employees 
• formally choose a scheme for your workers
• give contact details to your workforce
• allow the designated provider access to your employees at your workplace
• make payroll deductions for employees who want to pay into the scheme, and keep a record of them
• forward contributions to the stakeholder provider

Read more about stakeholder pensions on the HMRC website- Opens in a new window.

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Promoting stakeholder and group personal pensions to employees

You may be thinking of offering, or have already offered, your employees a stakeholder or group personal pension scheme. You may want to promote your scheme to them, or find that they are looking to you for help. But as financial services are regulated, you may be unsure about what you can do.

The Financial Services Authority (FSA) regulates financial services in the UK. They offer information about what you can do to promote your stakeholder or group personal pension scheme to your employees and how you can give them further help or advice without needing to be authorised. Download an employers guide on promoting pensions to employees from the FSA website (PDF, 165K)- Opens in a new window.

The FSA guide only covers stakeholder pension schemes and group personal pension schemes.  It does not cover occupational pension schemes.

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Keeping employees informed

You now have a duty to inform and consult your employees about significant changes in any occupational scheme you offer, or personal pension schemes your contribute to, by a direct payment arrangement on behalf of your staff.

For occupational schemes, you need to inform and consult on changes about:

• increasing the pension age
• closing the scheme to new members
• closing the scheme to existing members
• removing liability for employer contributions
• introducing member contributions
• reducing employer contributions to money-purchase schemes
• changing to money-purchase benefits
• changing the method of determining the rate of future accrual

For personal pension schemes, you need to inform and consult on changes about:

• ceasing employer contributions
• reducing employer contributions
• increasing employee contributions

You have to provide information to affected members and/or their representatives in writing before the changes occur. You must describe the changes and their effect on members, accompany it with relevant background information and indicate the timescale. At least 60 days consultation must be allowed before the decision to make the change is made. Consultation must be conducted with a view to co-operation.

Download guidance on consulting with members on pension scheme changes from the Pensions Regulator website (PDF, 29K)- Opens in a new window.

There are some exceptions to the consulting requirement. It does not apply to:

• employers with less than 50 employees
• public service schemes
• small occupational schemes with less than 12 members who are all trustees of the scheme
• occupational schemes with less than two members
• schemes not registered with HM Revenue & Customs

If you are consulting with employee representatives, you must give them paid time to undertake their duties and must not subject them to dismissal or any other detriment – otherwise they can take you to an employment tribunal.

See our guide on how to inform and consult your employees.

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Contracting out of the additional State Pension

Providing that a company pension scheme meets certain conditions, it can be used to contract employees out of the additional State Pension (also known as the State Second Pension). Employees who join a scheme that is contracted out will automatically be contracted out of the additional State Pension.

Employers providing such contracted-out schemes pay a lower rate of National Insurance Contributions (NICs) for those employees who join their schemes, and employees themselves also pay reduced-rate contributions. If the scheme is contracted out on a money purchase (or ‘defined contribution’) basis, HM Revenue & Customs (HMRC) will also pay an additional rebate direct to the scheme for investment on behalf of the employee. This is to compensate for the additional State Pension given up by the employee.

Where an employee contracts out of the additional State Pension with a stakeholder or personal pension plan, both the employer and employee continue to pay NICs at the full rate. At the end of each tax year, HMRC pays a rebate of NICs plus tax relief on the employee’s share of the rebate directly into the pension fund for investment on behalf of the employee.

Since 2002, employees who contribute to a contracted-out occupational, personal or stakeholder scheme may get some additional State Pension for the year in which they contribute. This is because of more generous State benefits for lower-income earners and is intended to prevent them being put at a disadvantage when they contract out.

Find contracted-out guidance booklets on the HMRC website- Opens in a new window.

There is no guarantee that the contracted-out pension will be as good as or better than the additional State Pension given up as the level of a defined contribution pension payable is dependent on a range of things that can vary, such as contribution levels, investment returns, and annuity rates it is difficult for people to be certain about what they will get until they actually take benefits.

It is intended that from 6 April 2012 contracting out of the additional State Pension on a defined contribution basis will be abolished by bringing into force the relevant provisions of the 2007 and 2008 Pensions Acts. From this date employees will automatically be brought back into the State system and they will start to accrue entitlement to additional State Pension instead. Employers and employees in money purchase/defined contribution occupational schemes will both then pay the standard rate National Insurance contributions instead of the reduced rate.

If your employees are in contracted out stakeholder or personal pension schemes, their scheme provider will inform them of these changes. After 6 April 2012, HMRC will no longer pay the National Insurance rebate into their pension scheme in respect of earnings paid in tax years beyond this date. You can find information for individuals affected by the abolition of contracting out on the Directgov website- Opens in a new window.

Download an employer factsheet on the impact of the abolition of contracting out from the Department of Work and Pensions website (PDF, 28K)- Opens in a new window.

Additional Voluntary Contributions

Following reform of the tax regime on pensions, employers are no longer required to offer Additional Voluntary Contributions to employees who want to improve their pension provision, though some may continue to do so on a voluntary basis. See our guide on running a pension scheme.