In June 2010, Lord Hutton was asked by the Government to lead a review of public service pension provision. The 'Hutton Report' (published on 10 March 2011) recommended major changes to the way that pensions are structured and delivered to millions of public sector workers. The implications are huge - not just for the public sector, but also for businesses that work with the public sector and who employ former public sector workers who transferred to them as part of an outsourcing exercise.

In anticipation of the Hutton Report, on 3 March 2011 the Government launched a consultation on the future of its 'Fair Deal' policy. The current Fair Deal policy protects pension provision for public sector workers who have transferred to the private sector. Post-Hutton, given the likelihood that public sector pension schemes will remain defined benefit (and therefore valuable) for the foreseeable future, how might a revision of Fair Deal affect companies who outsource? And what are the options for the Government: the Fair Deal, the No Deal and the somewhere in between?

What is the current situation?

The Fair Deal policy was introduced by the Labour Government in 1999 and since then has become a potentially complicated and often demanding requirement for contractors. The Fair Deal is a non-statutory policy which prescribes the level of pension provision offered to public sector staff when they are compulsorily transferred to a non-public sector employer.

At the moment, the legal minimum pension provision for employees who transfer under TUPE - where a transferring employee was either a member of, or eligible to join an occupational pension scheme - is for the new employer to provide a defined contribution scheme with matching employer contributions of up to 6% of basic pay.

In contrast, in respect of transferring public sector employees, the Fair Deal requires:

a) broadly comparable pension benefits for future service. Given public sector pension arrangements are predominantly defined benefit pensions, this ultimately means that the new employer has to provide a defined benefit pension for transferring employees; and

b) transferring employees to have the right to elect to transfer their accrued benefits in the public sector scheme to the new employer's broadly comparable scheme.

In Local Authority outsourcing contracts, "best value authorities" are also obliged to provide for pension protection in accordance with the Best Value Authorities Staff Transfers (Pensions) Direction 2007 (the 'Direction'). This has the same broad effect as the Fair Deal policy although there is no specific protection for accrued (pre-transfer) benefits.

The Fair Deal policy therefore provides for a more onerous requirement for pension provision for staff transferring under TUPE from the public to the private sector – and the cost to the new employer will be significantly more than 6% of basic pay.

Although the majority of private sector employers have moved away from defined benefit pensions for new employees (a defined benefit pension being an amount calculated by reference to scheme rules - often based on salary at or near retirement), as a result of Fair Deal, it is still therefore a requirement for outsourced public sector employees. This ultimately creates a high cost for outsourcing contractors and potentially deters many companies and charities from bidding for public sector work. As a consequence of this, the Government is seeking to find a framework to boost cost effective and varied provision of public services, whilst at the same time considering appropriate pension protection for ex-public sector employees.

Importantly, neither the Fair Deal nor the Direction are overriding law and do not apply directly to private sector contractors. The obligations are those of the public sector body and the relevant body must ensure there are obligations in the outsourcing contract to require the contractor to meet the requirements of Fair Deal.

The options under consideration

The Government's Fair Deal consultation document explains that the Government is looking at all options. These must therefore include three broad options – keeping the Fair Deal, scrapping the Fair Deal and considering a variation on the Fair Deal. For each of the three options it is important to understand the implications and to prepare for whether that option is retained or scrapped:

Keeping the Fair Deal in current form – this would seem the least likely option given a Government objective of reducing costs in the provision of public services. If Fair Deal were retained, contractors would need to consider negotiating pensions terms which protect their position, including:

(a) pension contribution 'caps and collars';

(b) indemnification at contract end; or

(c) 'shortfall' provisions to ensure that, where any pension liabilities for accrued benefits pass to the contractor's broadly comparable pension scheme, there are sufficient assets to meet those liabilities.

Reforming the Fair Deal – options could include retaining some element of pension protection which falls short of the current Fair Deal. These could include:

(a) removing the requirement to provide for transfers of accrued rights (which would remove the risk of an immediate shortfall in funding);

(b) allowing the contractor to compensate the transferring employees for a reduction in pension scheme benefits through higher salary or other benefits;

(c) enhanced contributions to a defined contribution scheme (i.e. contributions in excess of 6%).

Scrapping the Fair Deal – the result would be that contractors would only be obliged to meet the basic minimum requirements (matching contributions of up to 6% of basic pay). Given this would be a very material reduction in the employment package for transferring employees, there is likely to be significant resistance from public sector unions and the employees themselves. This could lead to unattractive industrial relations issues for the contractor.

Issues regarding re-tendering

As well as considering pension schemes for future transactions, it is import to consider what happens if previously outsourced public services are transferred to a new employer (a 'second generation transfer'). Where there is a second generation transfer, the Fair Deal, as it stands today, would also apply to the incoming contractor (subject to the terms of the original outsourcing contract).

The Government has said that any revision of Fair Deal would not override any existing contractual obligations although the relevant parties could seek to review existing contract terms. Any revision of Fair Deal may prompt negotiations between contractors and the public body who originally let the contract - although the public body authority may seek to recoup any savings made where the contract is modified in line with a change in Fair Deal.

What if you are currently bidding for contracts?

Contractors that are currently bidding for contracts may wish to highlight the Fair Deal consultation with the public authority and ask for clarity on the approach which the authority would take where there is a change in Fair Deal either:

(a) during bid negotiations; and

(b) after the contract has been signed.

Contractors (and public sector authorities) will not want to lock into contractual terms which exceed the requirements of any revised Fair Deal policy.

Final thoughts

The Hutton Report provided no real insight into the outcome of the Government's Fair Deal consultation. However, it indicated that the mechanism whereby contractors become "admitted" to a public service pension scheme to meet the 'broadly comparable pension' requirement of Fair Deal – for example through the Local Government Pension Scheme – may be restricted. Where Fair Deal is retained in its current form, but contractors are not able to become admitted to the public sector scheme, there could be an additional cost burden in the administration of the contractor's own broadly comparable scheme.

What is certain is that the outcome of the Fair Deal consultation will have significant implications for outsourcing.