Provided by Holborn Financial Ltd Independent Financial Advisor

Information

The State Pension comprises two principle elements, the Basic State Pension and Additional Pension.

Basic State Pension (BSP) or State Retirement Pension (SRP)

Qualification for Basic State Pension is a "contribution based" benefit, and depends on an individual's National Insurance (NI) contribution history. For someone with the full number of qualifying years (years in which NI contribution was paid) typically 44 for a man and 39 for a woman, although this reduced to 30 years on 6 April 2010. Less pension is paid for someone with fewer qualifying years.

State Pension can be claimed from State Pension age: currently 65 for men and 60 for women (rising to 65 by 2020). It is also possible to defer claiming the SRP at pension age. Deferring claiming in this way currently gives an enhancement of approximately 10.4% to the pension per year deferred, or a lump sum and an unenhanced pension. The enhancement is actually 1% per 5 weeks the pension is not claimed, and the lump sum is the amount not claimed plus interest at 2% over the Bank of England's base rate.

The Basic State Pension (or State Retirement Pension) is indexed each year for those pensioners living in the UK and also for 535,000 pensioners living overseas. However 525,000 pensioners living in certain other overseas countries have their pensions frozen at the rate at which they are first paid. This is seen as discriminatory by many because all of the pensioners have paid in the same contributions to the National Insurance Fund which pays out all pensions. People intending to retire overseas should research this issue carefully.

Additional Pension

Three different state schemes have existed to provide extra pension provision above the Basic State Pension. These are collectively known as Additional Pension. This has been available only to employees paying National Insurance and certain exempt groups (not including the self employed). The three schemes are/were:

Graduated Pension or Graduated Retirement Benefit ran from 6th April 1961 until 5th April 1975. Qualification was based on payment of a number of fixed National Insurance payments ('stamps'). Graduated pension typically pays a small amount (a pound or so per week) to those affected.

State Earnings-Related Pension Scheme (SERPS) ran from 6th April 1978 to 5th April 2002. As the name implies, the level of pension payable was related to the recipients earnings via their National Insurance contributions. Qualification was based on band earnings above a Lower Earnings Limit (LEL) in each year. The LEL is usually set at the same level as the BSP and increases when BSP does. Band earnings lie between the LEL and an Upper Earnings Limit (UEL) at which National Insurance contributions ceased to be payable by the employee, although the UEL now refers to a threshold where reduced NI payments are made, as opposed to payment ceasing. The UEL is also adjusted annually.

State Second Pension (S2P) was introduced on 6th April 2002. As with SERPS, the level of pension payable is related to the recipients earnings via their National Insurance contributions. Qualification is based on earnings at, or above, the LEL, but no band earning calculation is made until earnings reach a higher base called the Lower Earnings Threshold (LET). Earnings below the LET (but above the LEL) are credited up to the LET.

Unlike the Basic State Pension, participation in the Additional Pension schemes is voluntary. Those who do not wish to participate can contract out. This option was introduced with SERPS in 1978 and is only available to those who have made alternative pension arrangements through Personal or Occupational schemes.

You can choose to leave SERPS/S2P at any time during your working life. This is called ‘contracting out’. You can do this by joining a contracted-out occupational scheme (if your employer offers one), or by taking out an Appropriate Personal Pension (APP). The fund that accumulates in an Appropriate Personal Pension from the National Insurance rebates, is known as Protected Rights.

Contributions you have already made to SERPS/S2P are protected and will give you extra state pension when you retire. The process of contracting-out is not irreversible, and there may be a time when it is beneficial to rejoin SERPS/S2P. This will be when the expected investment return will not produce a greater benefit than the SERPS/S2P benefit being foregone.

Most pension providers have analysed the National Insurance Rebates, comparing them to forecasts of fund performance and inflation, to produce criteria for when it would generally be advisable for a client to contract-out. Predominantly, this is in the form of pivotal ages, below which it is advantageous to opt-out of SERPS. The age quoted differs between men and women due to the differing State Retirement Ages for men and women, and the phased adjustment to 65 for women.

In general, the younger the client and the greater their income, the more likely the individual is to benefit from contracting-out. However, other factors, that must be considered are:

If contracted out via an APP, the position of protected rights if the employee dies after retirement is that a spouse's pension is payable for life (although it may stop on remarriage if this takes place before State pension age, or if the spouse becomes ineligible for child benefit before the age of 45). If death occurs before reaching State retirement age the same rules are followed but the benefit can be paid as a lump sum if there is no qualifying widow(er) or dependent.

If you contract out of SERPS/S2P via an Appropriate Personal Pension you will receive National Insurance rebates into the fund at the end of the tax year. The amount of the rebate is dependent upon your age and salary.

If contracting out via an occupational Final Salary pension scheme, both the employee and the employer pay less National Insurance Contributions (1.6% employee, 3.5% employer).

If contracting out via an occupational Money Purchase Scheme there is a reduction in National Insurance Contributions (1% employer and 1.6% employee), in addition an age related percentage is paid to the scheme at the end of the tax year. The age related rebates will be capped at 10.5%.

If you are worried about your position, or want advice, contact us.

Frequently Asked Questions

What does “contracting out” mean?
Contracting out is when you choose to give up your right to the state second pension (S2P) which is the earnings related pension. Instead the government pays some of your National Insurance (NI) contributions (known as rebates) and income tax into a separate pension plan. These contributions are referred to as protected rights.
Can I decide to contract back into the S2P?
Yes, you can decide each year if you want to contract back in. This means that future rebates to your pension plan would stop.
Can I then decide to contract out again?
Yes, again you decide this every year in relation to that year. Though the Government is expected to remove this option after 2012.
Can I contract in for past years?
No, you cannot contract back in for past years during which you were contracted out.
If I rejoin the S2P what happens to my previous contracted out contributions (rebates) that were paid into my pension plan?
This money stays invested.
When do I have to decide?
You have to decide before the end of the tax year, 5th April.
What happens if I do nothing?
You previous election will stand, i.e. contracted either in or out.
Are there any changes I should know about?
Yes, contracting out may no longer be allowed from 2012 and the state pension age may increase to 68 by 2046.
What are the main differences between contracting out compared to S2P?
Contracting out provides you with more flexibility including:
  • When you can take the benefits.
  • The ability to take 25% of your fund as tax-free cash.
  • If you die before you take your benefits and you don’t have a qualifying dependent, your contracted out fund can be left as part of your estate
  • More choice in the form of the annuity you can buy (single or joint life for instance)
If I rejoin the S2P, what guarantees are there that the government will pay me an S2P when I retire?
There’s no guarantee. A future government could change the rules relating to S2P so that you actually receive more or less than you were expecting under the current rules. This is a risk you take on rejoining S2P.
What guarantees are there that my pension will be as good as the S2P if I stay contracted out?
There are no guarantees. You may get back less than you would have if you had stayed in the S2P. This could happen for two reasons, either the investments you buy with your rebates may not return as much as you need to replace your S2P pension or annuity rates may be expensive when you retire, which could mean that the fund you have built up will not be enough to buy you an annuity which will provide as much income as your S2P pension. Of course the upside is that you may be able to buy more than the S2P.
Does contracting out affect my entitlement to the basic state pension?
No, only S2P.

If you are worried about your position, or want advice, contact us.