What was contracting out?
By Paul Davies
What was contracting out?
Understand how 'contracting out' worked and how it will affect how much state pension you'll get in the future.
Contracting out ended in April 2016, but your contracting-out history will still impact how much state pension you get.
In addition to the basic state pension, the state previously provided a second-tier top-up pension, based on how much you earned. Introduced in 1978 and originally called the State Earnings Related Pension Scheme (Serps), it became State Second Pension (S2P) in 2002.
Before 2012's rule changes, employees were allowed to 'contract out' of this additional pension. In exchange for lower National Insurance contributions, they gave up part or all of it and received extra pension from their occupational scheme or personal/stakeholder pension instead.
Until 1988, people could only contract out if they were members of a defined benefit (DB) occupational pension scheme. In 1988, the government extended this to defined contribution (DC) or money-purchase occupational schemes and personal pensions.
It gave incentives to encourage people to leave the state earnings-related pension scheme (Serps). For the first five years of the scheme, the government paid an extra 2% of your earnings into your personal pension. By 1992, more than 5 million people had left Serps for a personal pension.
Rule changes for contracting out
Defined benefit pension scheme
If you've been in a contracted-out defined benefit (DB) scheme, you and your employer have paid a slightly lower National Insurance (NI) contribution. This reflects the fact that neither of you have contributed to the state additional pension. From April 2012, only those in a defined benefit (DB) scheme have been contracted out and paid a lower rate. Those in a defined contribution (DC) scheme were contracted back in and paid National Insurance at the full rate. They accumulated state second pension (S2P) between 2012 and 2016.
If you contracted out through a DB scheme, you were promised a certain amount of pension, in place of the additional pension you were giving up. With the way the system works, it's impossible to lose out if you were contracted out into a final salary scheme before April 1997. However, the amount of protection was reduced from 6 April 1997, when the 1995 Pensions Act came into force. The link with the additional pension was broken, so it's possible that you could lose out.
Contracting out on a DB basis ended in April 2016, when the government’s state pension reforms came into force. People qualifying for the state pension before 6 April 2016 will get less additional state pension if they've spent time contracted out, and those qualifying on or after 6 April 2016 will get a lower 'starting amount'.
Defined contribution pension scheme
From April 1988 to April 2012, employers were allowed to contract people out into defined contribution (money purchase) occupational schemes. If you contracted out through an appropriate personal pension (APP) or appropriate stakeholder pension (ASP), you and your employer paid the same NI contributions as before, but some of this was rebated. This amount is known as your NI rebate. Tax relief was added to the rebate, and this total amount was invested, and at a retirement date was used to provide benefits called ‘protected rights’ (see below).
Unlike defined benefit (DB) schemes, there was no guarantee that your eventual pension would match or beat what you would have received if you'd stayed with the additional state pension. The final amount depended on the performance of your investments.
Since April 2012, individuals in these schemes have been contracted back in, and their National Insurance contributions were no longer rebated but went directly towards the state second pension (S2P) they started to accumulate.
Up until April 2012, protected rights included:
- A retirement pension that can be paid from age 55 onwards, to be paid through an annuity or income withdrawal. You are allowed to shop around for an annuity if you want to, but the annuity rate on a protected rights annuity had to be unisex.
- If you were married and wanted to annuitise, you were required to buy a joint life annuity, rather than a higher-paying single life annuity.
- A pension for your spouse or civil partner if you die before retirement.
- The right to take income drawdown – but only capped drawdown, which meant that you couldn’t make unlimited withdrawals or use flexible drawdown.
Many people had accrued substantial amounts of protected rights, but because of these restrictions, they had been unable to make full use of them. However, in April 2012, protected rights were abolished.
- Last updated: April 2016
- Updated by: Paul Davies