What was contracting out?
In addition to the basic state pension, the government used to provide a second 'top-up' pension, based on how much you earned.
Introduced in 1978 and originally called the state earnings-related pension scheme (Serps), it became the state second pension (S2P) in 2002.
But collectively, it's often referred to as the additional state pension.
Under the old state pension rules, you were able to ‘contract out’, or opt out, of this second state pension.
This saw you paying lower or redirected National Insurance contributions, giving up part or all of the second state pension in exchange for a higher private pension.
Until 1988, people could only contract out if they were members of a defined benefit occupational pension scheme. In 1988, the government extended this to defined contribution or money purchase occupational schemes and personal pensions.
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 five million people had left Serps for a personal pension.
Contracting out ended in April 2016, but your contracting-out history will still impact how much state pension you get under both the old and the new system.
Here's what you need to know.
What happens if I was contracted out of a defined benefit pension?
If you were in a contracted-out defined benefit scheme, you and your employer paid a slightly lower National Insurance contributions. This reflects the fact that neither of you contributed to the additional state pension.
From April 2012 to April 2016, only those in defined benefit and final salary pensions scheme could be contracted out and paid a lower rate.
If you were contracted out, you were promised a certain amount of pension from your employer in place of the additional pension you were giving up.
Contracting out of a defined benefit pension ended in April 2016, when the government’s state pension reforms came into force.
What is the guaranteed minimum pension?
This is a key part of contracting out.
The guaranteed minimum pension is the minimum amount that your employer pension scheme has to provide to you if you contracted out of the second state pension.
It applies to people who were contracted out between 6 April 1978 and 5 April 1997.
Working this out is complicated. The amount of guaranteed minimum pension you get is based on your 'contracted out earnings', which are earnings between a lower and upper limit set by the government.
This is calculated annually for each year of service that you were contracted out for.
Increases to the guaranteed minimum pension
Your guaranteed minimum pension should rise with inflation each year, but it can actually rise at different rates, despite being in the same pension scheme for a long period.
For service before 1988, there is no duty on your pension scheme to provide inflation-linked increases,
For service between 1988 and 1997 they have to provide inflation-linked increases up to a cap of 3%. The DWP then recalculated the state pension payable each year, which makes sure that a person’s guaranteed minimum pension entitlement is increased.
After 1997, the law changed. There were still minimum pension benefits that an employer needed to provide if he wanted to contract out. However, instead of GMPs, the scheme had to meet a ‘reference scheme’ test.
That is, the scheme had to provide benefits at least as valuable as those that you would get as a member of a reference scheme set out in law.
For people retiring after 6 April 2016, the government decided, somewhat controversially, to no longer cover part of the inflation increases to guaranteed minimum pensions (accrued between 1988 and 1997) when uprating people’s new state pension.
In effect, this means that guaranteed minimum pensions will not be increased fully via the state pension.
What happens if I was contracted out of a defined contribution pension?
From April 1988 to April 2012, employers were allowed to contract people out into Defined contribution and money purchase schemes.
If you contracted out through an appropriate personal pension (APP) or appropriate stakeholder pension (ASP), you and your employer paid the same National Insurance contributions as before, but some of this was rebated.
This amount was known as your National Insurance 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).
In April 2012, those in a defined contribution scheme were contracted back in and paid National Insurance at the full rate. They accumulated the additional state pension between 2012 and 2016.
Will I get a bigger pension if I contracted out?
Unlike defined benefit schemes, there is no guarantee that your eventual pension will match or beat what you would have received if you'd stayed with the additional state pension.
The final amount depends on the performance of your investments in the pension into which your rebates were diverted.
However, the fact that the money was placed into a defined contribution scheme means that you can benefit from the greater flexibility of the pension freedoms, with the option to access your money at the age of 55.
How do 'protected rights' work?
In 2012, when contracting out was abolished for defined contribution and money purchase schemes, ‘protected rights’ were converted into ordinary pension benefits.
This means that protected rights were the benefits which a contracted-out DC scheme had to provide for members.
A member’s protected rights were made up of the amounts the employer saved as a result of reduced National Insurance contributions and HMRC age-related rebates. Schemes contracted-out on the protected rights basis had to comply with various statutory conditions.
These conditions included:
- Protected rights had to be separately identifiable.
- A retirement pension that can be paid from age 55 onwards to be paid through an annuity or income withdrawal.
- Annuities deriving from protected rights had to provide a survivor’s pension where the member was married or in a civil partnership
- A pension for your spouse or civil partner if you die before retirement.
What does contracting out mean for my state pension?
People qualifying for the state pension before 6 April 2016 will get less or no additional state pension if they've spent time contracted out.
If you qualified for the state pension on or after 6 April 2016, you will probably get less than the full level of new state pension (£164.35 a week in 2018/19).
This often comes as a surprise to people, but it should be explained in your state pension forecast, in the form of a 'contracted out pension equivalent'.
This shows the amount of additional state pension you would have got had you not contracted out. This doesn't form part of your state pension, but should be paid by your workplace pension.