TPAS - The Pensions Advisory Service

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.

Scheme Types

Since 6 April 1978, it has been possible for final salary schemes to contract out of SERPS.

From 6 April 1988, the ability to contract out was also made available to members of money purchase schemes.

The principal methods of contracting out are through membership of occupational pension schemes, either a contracted out final salary scheme or a contracted out money purchase schemes, by taking out a personal pension plan or joining a stakeholder pension scheme.

Final Salary Schemes

Where an individual joins an occupational pension scheme, the decision whether to contract out or not is made by the scheme. If the scheme is contracted out, by joining the scheme an individual will also to be automatically contracted out and both the employee and the employer will pay National Insurance Contributions at a reduced, contracted out rate.

Before 6 April 1997 a contracted out final salary scheme was obliged to provide a minimum benefit known as Guaranteed Minimum Pension (GMP) which replaces an individual's SERPS entitlement. From 6 April 1997, a scheme no longer had to provide GMP benefits in respect of service from that date. Instead the scheme will need to demonstrate that benefits satisfy a test of quality which means that they should be broadly equivalent to, or better than a series of test benefits known as a notional reference scheme.

Money Purchase Schemes

Under a contracted out money purchase scheme, a contracted out fund is established made up of contributions equal to the amount of both the employer's and employee's reduction in National Insurance Contributions. This fund is kept separate from other contributions and is known as Protected Rights.

Personal & Stakeholder Pension Schemes

Under a personal pension plan or stakeholder pension scheme, the decision whether to contract out or not rests with the individual. If an individual elects to contract out, they continue to pay National Insurance Contributions at the full rate but the government will make a contribution to their pension plan. The contribution consists of a rebate of part of both the employer's and employee's National Insurance Contributions that has been paid, plus income tax relief on the individual's share of the rebate. This contribution is invested separately from any additional contribution the individual may make and the refund subsequently built up is described as Protected Rights. There is no guarantee that the pension eventually purchased by the Protected Rights fund will be greater than the state additional pension given up as a result of being contracted out. You will be allowed to take 25% of your Protected Rights fund as a cash sum, which will be tax free.

Basic State Pension

Being contracted out will not affect an individual's right to the basic state pension.

Important Change from 2012

Contracting out through defined contribution schemes (i.e. money purchase, personal pension and stakeholder arrangements) is to be abolished. Although a date has not been agreed, it is likely to be with effect from 6 April 2012. Anyone contracted out of a defined contribution scheme at that time will automatically be contracted back into the State Second Pension.

Q & As

Can I contract out?

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 still contract out by starting a personal pension or stakeholder plan. You don't have to make any additional contributions if you don't want to. The scheme is used to collect the contracted out rebate only. Always get advice before you make this decision.

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.

You may contract out when you are employed and subsequently become unemployed. In that case the scheme continues to run but receives no contributions until you again enter employment, at which time rebate contributions will continue to be paid unless you take action to contract in.

What happens if I contract out?

This will depend on the type of pension scheme you are a member of.

What happens if I contract 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 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 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.

How much will I get if I contract out via a personal pension or stakeholder?

The answer is difficult to predict and depends on a number of factors. Primarily these are:

• How much rebate and tax relief is paid to your plan;
• The investment performance of your plan. You should bear in mind that there is no guarantee that investments will always have a positive return;
• The annuity rates when you purchase an annuity. The available annuity rates are what determines the conversion of your fund into an income for the rest of your life.
• The charges made by your plan provider.

In deciding to contract out, you are deciding to forego the benefit of a defined benefit scheme (the State Second Pension) in return for the uncertain but potentially higher pension from a money purchase personal plan. The resulting pension could also be lower than what you would have got had you stayed in the State Second Pension.

I still don't get it. What are the main differences if I contract out via a Personal Pension?

Ok, here's a handy comparison…

Contracted In Pension	Contracted Out Pension
Each year you build up entitlement towards the Additional State Pension based upon your earnings.	The government pays a rebate of National Insurance contributions to your pension provider, who invests it on your behalf.
Your entitlement builds up over the years and is paid in addition to your basic state pension.	The value of your investment can go up or down depending upon the investment performance achieved by your pension provider. Your fund will be called protected rights.
The pension is paid at age 60 for women and 65 for men but between 2010 and 2020 the state pension age for women is gradually changing to 65.	You can take your pension at any age between 50 and 75 years, if you retire before 6 April 2010. If you retire on or after 6 April 2010, the minimum age increases from 50 to 55.
Your pension is based on a defined formula and therefore has some certainty. However, there is no certainty that the government will not change the rules for the future.	The pension you get is based on how your pension fund grows, annuity rates when you retire and the charges made by your provider. There are no guarantees.
	You can have 25% of your contracted out fund as a tax-free lump sum.
You cannot take a lump sum if you die and leave a spouse, then in certain circumstances 50% of your pension may pass on to your spouse.	In the event of your death, the accumulated fund will be used to buy a pension for your spouse.

Should I contract out?

Whether you should contract in or not depends on a number of factors, including your age and your attitude to risk. Whatever your decision, you should review it regularly. Nevertheless, the main factors you will need to take into account are:

Your age – the younger you are, the more investment time there is to hopefully provide you with the returns needed to give you a better pension than the state.

Your marital status – single people at retirement with funds built up from April 1997 can purchase a single life pension. The state scheme will assume you are married.

Your earnings – because of the higher accrual rates for lower paid employees, they are more likely to be better off by being contracted in.

Your attitude to risk – if you are contracted out, there is no guarantee you will get a higher pension. Fund performance can go down as well as up.

Investments – the government calculates the NI rebate on the basis that there should be no winners or losers. If investments perform better than assumed, you will be better off. If they perform worse than assumed, you will be worse off.

Government Policy – governments have continually tinkered with the calculation of the additional state pension. There is no guarantee that there may be more tinkering in the future. However whatever changes have been made in the past, benefits accrued up to the date of change have been protected.

Pensions Legislation – what you can and cannot do with a pension continues to change.

Should I continue to be contracted out?

Your decision as to whether to contract in or out should be reviewed regularly. As you get older, the additional state pension may appear more attractive as there is less investment time for your contracted out rebate to grow. Many commentators currently hold the view that contracting out is not good value for most people and some insurance companies and banks have advised all their contracted out policyholders to contract back in. Others take the view that there is a break-even age, below which they recommend contracting out and above which they do not. There are a range of ages used as this break-even age. For women the age range is usually 40-45 and for men it is 45-50. In reality it is impossible to say that someone will definitely benefit by being contracted out. However, age is not the only factor. People's circumstances and attitudes to risk change and therefore there may be other factors in the future that will be more important to you. One particular issue may be future changes to the additional state pension itself and therefore it is important to review your decisions at regular intervals.

I am single, does that make a difference?

If you contract in, the additional state pension assumes everyone is married and incorporates a spouse's pension. If you contract out and you are married the fund you build up must cater for a spouse when a pension is bought. If however you are single at retirement then you can choose a single life pension, which may provide you with a higher pension.

Is contracting out a once and for all decision?

No, it is not a once and for all decision and you can contract back in (or out) at a later date. The date you contract out can be effective from the immediately preceding 6 April or the immediately following 6 April. You can, however, change your contracting in or out decision for the future only; the past is unaffected by your decision.

Can I contract back in?

Yes. To do so you will need to ask your pension provider for form CA1543 for completion and the election to contract back in can take effect from 6 April immediately preceding or succeeding, although cancellation cannot be effective in the first tax year of being contracted out.

If I contract back in, what happens to my contracted out pension?

It is not possible for funds built up as a result to being contracted out, to be subsequently transferred to the state in order to reinstate the state second pension that has been given up. Consequently, those funds will need to remain invested. They can be transferred to another pension provider.

Was the advice I received to contract out mis-selling?

If you have concerns that the advantages, disadvantages and risks of contracting out were not properly explained or that you were given mis-leading information, you should write to the company that recommended contracting out and ask them to review their advice. If they agree that their advice was inappropriate they should take steps to compensate you. If you remain unhappy with their decision, you will then have the right to ask the Financial Ombudsman Service to adjudicate.

I am thinking of emigrating. Will that make any difference to any decision I make about contracting out?

If you have not already contract out, you should bear in mind that if you are emigrating in the near future, you may have not given yourself sufficient time to build up a sizeable fund. If however it is a long term plan, one factor to take into account is that for some countries, the state does not pay increases on the state pension. So, if you are not contracted out, the pension payable from the State Second Pension will not increase each year. If you have contracted out, when the pension is put into payment, you can choose whether it increases in payment.

Can I get a cash sum from the State Second Pension?

No, the State Second Pension does not provide a cash sum. The benefits are paid as a pension until you die.