Contracting out your pension abolished: what it means for you
Guest blogger Stuart Grennan of Gallagher Private Clients looks at the history of contracting out pensions, and what its abolition means for your money.
How many of you can remember the start of contracting out via a personal pension? Introduced back in 1988, this was the first time an individual paying full National Insurance contributions could opt out of the-then State Earnings Related Pension Scheme (SERPS) other than via a company scheme.
SERPS was subsequently replaced by the State Second Pension, or S2P. The Government was going to call it SSP but realised this was already taken by Statutory Sick Pay!
What is contracting out?
The Government of the day had realised that the generous State Pensions were expensive, and so had the bright idea that if they got a few million employed individuals to opt out of SERPS, they could reduce the drain on the creaking state system by reducing the future accrual.
If this sounds familiar, it is what most companies have done with their defined benefit or final salary schemes.
To encourage people to opt out, the Government allowed them to back date to 1987 and thus receive a rebate on the previous year's National Insurance contributions. Not only that, but on top of the rebate of employee and employer National Insurance contributions, the Government paid a sweetener, called an incentive payment.
This was seen as a no brainer at the time. You could give up some weird state top up pension which was somehow linked to your earnings, and was very difficult to quantify (and therefore not seen as a tangible benefit). In its place you could have real money, paid by the-then Department of Social Services (DSS), into a policy which would be invested to buy you additional pension at retirement.
These funds were known as Protected Rights and there were originally restrictions on how the benefits could be taken; i.e. no tax-free cash lump sum, and if married, a spouse’s pension had to be bought.
Reducing the benefits
Advisers at the time were given lots of tables and ready reckoners to help them give advice, because there did come a point when the potential State benefits given up could not realistically be matched by the investment of the rebates. The theory was that at some stage in the future you would go back into the State system.
The original rebates were quite generous and increased with age. Over the years successive Governments have both reduced the size of the rebates and SERPS/S2P benefits.
Why contract out?
As a result it became progressively harder to justify contracting out when looking at projections of the rebates compared to the State benefits given up. According to the Department of Work & Pensions (DWP), which replaced the DSS, 3.85 million individuals contracted out using money purchase plans in the year 2000. By 2009 (the latest figures available) this had fallen to 1.7 million.
People who remained contracted out tended to do so because they liked the idea of increased flexibility and having the money under their control, both in terms of investment risk and the timing of the benefits.
So what has happened? The Government has decided that individuals can no longer contract out on a money purchase basis. As a result, the Government again resumes control of the money that was exiting the National Insurance system and 1.7 million people go back into S2P. Consultation is under way looking at whether S2P and the basic State pension should be combined in to a single, albeit larger, State pension. This will benefit the lower paid as they will receive the same pension as a higher paid individual, but will have contributed less.
For those with individual polices, which at best will receive one last rebate payment later this year in respect of National Insurance paid in the previous tax year, or those who have paid up plans and have already gone back in to S2P, now is the ideal time to have them reviewed.
Stuart Grennan is director of Gallagher Private Clients