By contracting out, instead of building
up entitlement to the Additional Pension (previously known
as the State
Earnings Related Pension Scheme (SERPS) and now known
as the State Second Pension (S2P)),
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 and career
average 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, career average or money purchase schemes,
by taking out a personal pension plan or joining a
stakeholder pension
scheme.
Final Salary and Career Average Schemes
Where an individual joins a final salary or career average
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 or career
average 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 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.
Protected Rights benefits built up from contracting-out will
become the same as any other benefits in the scheme.
Click here to read more about this.
Contracting-Out Planner
This planner will help you make a decision about whether
you should contract-in or contract-out of the State Second
Pension.
Click here to use the
Contracting-Out Planner
Q & A's
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.
This will depend on the type of pension scheme you are a member
of.
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.
If your employer runs an occupational scheme, they 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.
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.
Ok, here's a handy comparison…
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Contracted In Pension
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Contracted Out Pension
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Each year you build up entitlement towards the Additional State
Pension based upon your earnings.
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The government pays a rebate of National Insurance contributions
to your pension provider, who invests it on your behalf.
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Your entitlement builds up over the years and is paid in
addition to your basic state pension.
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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.
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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. Between 2024 and 2046 the pension age will
gradually rise to 68.
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You can take your pension benefits at any age
after 55. It is likely that many pension schemes will
still have rules requiring you to take your pension benefits by age
75.
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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.
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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.
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You cannot take a lump sum.
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You can have 25% of your contracted out fund as a tax-free lump
sum.
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If you die and leave a spouse, then in certain circumstances 50%
of your pension may pass on to your spouse.
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In the event of your death, the accumulated fund will be used to
buy a pension for your spouse.
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The Additional Pension increases in April each year in line with
inflation (from April 2011 the CPI will be used as the relevant
measure).
Note however that, if you move overseas to a country not on the
list found here, then an increase will not be paid.
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At retirement, you choose the rate in which your retirement
income from the contracted-out plan will increase (i.e. a
fixed-rate or in-line with inflation). However this will reduce the
initial annual income payable.
If you move overseas, irrespective of the country, the chosen
increase will continue to be paid.
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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.
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.
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.
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.
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.
It is not possible for funds built up as a result of 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.
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.
If you have not already contracted 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.
No, the State Second Pension does not provide a cash sum. The
benefits are paid as a pension until you die.
