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60 second guide to Contracting out

New 2012 rules for contracted out pension schemes

From April 2012, most employees will be contracted in 

From April 2012, only defined benefit (DB) pension scheme members can contract out from state second pension. Those in defined contribution (money purchase) schemes will be contracted back in.

We explain the background to the change and what it means for those affected:  

What is contracting out?

‘Contracting out’ is a process where members of a pension scheme replace state second pension with extra money from their private pension scheme. It was particularly popular in the 1980s and 90s, when people thought they would boost their overall pension this way. They remain entitled to basic state pension, but not to additional state pension they would have received if they had remained contracted in. From 1978 to 2002 this was called SERPS, in 2002 it became state second pension (S2P).

How does contracting out work? 

Defined benefit (DB) pension scheme members (and their employers) who are contracted out pay a lower rate of National Insurance than those who remain contracted in. This is because they are no longer accumulating state second pension. They rely on their employer’s scheme to make good the shortfall as part of the guaranteed payment they will receive when they retire.

Defined contribution (DC) pension scheme members who were contracted out paid standard rate National Insurance but received a rebate from HMRC, which was invested in their pension pot. The idea was that this ‘protected rights’ money would grow enough to deliver a pension as good as, or even better, than the state additional pension would have been. By 2005, it was clear that investment returns had failed to deliver this and that most people would have been better off if they had stayed contracted in. 

What are the new rules on contracting out?

The government has decided to stop contracting out for everyone except those in defined benefit (DB) pension schemes. This is because the return from defined contribution (money purchase) schemes is too risky and those who contract out could find themselves at a disadvantage when they come to retire. From April 2012 most people will be contracted in. They will pay National Insurance at the standard rate and accumulate state second pension. 

How much is second state pension worth? 

State second pension varies, depending on how much you earn. Those with higher earnings pay more National Insurance and get more back as state second pension. The amount is capped at a maximum level, however, which for 2011-12 was £159.52. The ceiling is imposed through an ‘upper accruals limit’ (£770 a week in 2012-13) on the earnings that count towards the second pension.     

Isn’t state second pension going to be abolished?

Originally, it was intended to make state second pension ‘flat rate’ by keeping the upper accruals limit frozen. The government has recently proposed a new state pension system, which pays a single flat rate (estimated at £140) to everyone. This will help those who currently rely on pension credit to top up their basic state pension but means that people who would have built up more substantial state second pension, by virtue of their National Insurance contributions, could lose out. Doing away with the option of DB contracting out as well could be seen as a necessary step in this process of pension simplification.

What about money I’ve built up while I was contracted out? 

Protected rights money, accumulated by those in defined contribution pension schemes who were contracted out of state second pension will remain invested in their pension scheme. From 2012 the rules surrounding this have been relaxed, making it easier to combine it with the rest of their ‘pension pot’ when they come to buy an annuity. 

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