Contracting Out
By contracting-out, instead of building up entitlement to the State Earnings Related Pension Scheme (SERPS), now known as the State Second Pension, an individual will instead transfer that pension liability to a private arrangement.
Since 6 April 1978, it has been possible for final salary company pension schemes to contract-out of the State Earnings Related Pension Scheme (SERPS).
From 6 April 1988, the ability to contract-out was also made available to members of money purchase pension schemes.
The principal methods of contracting-out are through membership of a company pension scheme, either a contracted-out final salary scheme or a contracted-out money purchase scheme, by taking out an individual pension policy or joining a stakeholder scheme.
- Can I contract-out?
If you are employed and contributing to your employer's occupational scheme you may want to ask your employer whether the pension scheme is contracted-out. If the pension scheme is contracted-out, the decision has effectively been made for you and you cannot contract-in to the State Second Pension. If your employer's scheme is contracted-in, you can contract-out via a personal pension or stakeholder plan.
If you are employed and are contributing to a personal pension or stakeholder plan you are able to decide whether to elect to contract-in or out of the State Second Pension.
If you are employed and not contributing to any pension plan, you can contract-out by starting a personal pension or stakeholder plan. If you are self-employed you are not eligible for the State Second Pension and consequently the issue of contracting-out is irrelevant.
If you are not employed you cannot contract out whilst you are not in employment.
- What happens if I contract out?
This will depend on the type of occupational pension scheme you are a member of.
If you are a member of a contracted-out final salary pension scheme, both you and your employer will pay National Insurance (NI) contributions at a reduced rate. In return, before 6 April 1997, your pension scheme would be required to provide a minimum benefit known as the Guaranteed Minimum Pension (GMP). From 6 April 1997, the requirement to provide future GMP ended but instead your scheme would be required to meet a test of quality known as the reference test. This test of quality means that for a scheme to contract-out it must provide benefits that are better of broadly similar to the test standard.
If you a member of a contracted-out money purchase scheme like above, you will pay a reduced rate of NI contribution. However, as a consequence, the contributions paid by you and your employer must at least equal the saving in NI contribution. In addition, the Inland Revenue will make an additional payment based upon your age. These contributions together with any investment return are kept separate from other contributions and are called 'protected rights'. The protected rights fund will ultimately be used to secure a pension and may be higher or lower than the Additional State Pension foregone restrictions on using P.R to obtain cash were removed from 6.4.05.
- My scheme is contracted-in, can I still contract-out?
Yes, you can still contract-out by using a personal pension or stakeholder plan.
See also Contracting-out in our Personal Pensions/Stakeholders section
- What happens if I'm contracted-in?
Each year you will build up entitlement to the Additional State Pension based upon your earnings. Between 6 April 1978 and 5 April 2002 the additional state pension was called the State Earnings Related Pension Scheme (SERPS). On 6 April 2002 the basis used to calculate the Additional State Pension was amended to make it more generous for low and moderate earners. It also is now known as the State Second Pension. Like the basic state pension, the Additional State Pension is payable from state pension age.
- My scheme is contracted-out and they say I do not have a choice. Is this right?
If your employer runs an occupational scheme, he will have made the decision whether the scheme should be contracted-in or out. If the pension scheme is contracted-out, the decision has effectively been made for you and you cannot contract-in to the State Second Pension. However, the scheme will need to provide benefits that meet a test of quality and as a result of joining the scheme, you will pay NI contributions at a reduced contracted out rate.
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