STATE SECONDARY PENSION BENEFITS
The State pension scheme consists of two components, the basic old age pension and the State Second Pension (S2P). Both employed and self employed persons who have paid the required amount of National Insurance contributions are entitled to the basic pension but S2P is only available to employees.
The State pension age is to be equalised to 65 for men and women. The retirement age for women was 60 and this will not change for those who reach the age of 60 on or before 5 April 2010. A 5 year sliding scale will apply to women born after April 1950 so that a woman born on or after 6 April 1955 will retire at age 65.
Some History
The State secondary pension was introduced in 1978 to provide a top up to the basic old age pension. It replaced the old graduated contributions scheme which provided very poor benefits. When the secondary scheme was first introduced it was known as the State Earnings Related Pension Scheme (SERPS). It was designed to replace only part of earnings within a defined band i.e. between the lower and upper earnings limits for National Insurance contributions which are currently £95 and £844 per week.
The cost of providing SERPS is significant and successive Governments became concerned that the financial burden would increase because people were living longer and the number of people who were contributing to the scheme (in order to pay for the benefits of those who had retired) was gradually falling.
Since the introduction of SERPS, the formula for calculating the State benefit has been changed several times and each time the benefit has reduced. For example, the SERPS benefit was initially based on the best 20 years of a person’s working life but in 1986 this was changed to average lifetime earnings. As a result of these changes, many people have become cynical about the Government’s intentions with regard to the secondary State benefit.
Changes in 2002
In April 2002, SERPS was replaced by the new and rather complicated State Second Pension (S2P). This was done because the Government wanted to give certain disabled people and those with long term illnesses the chance to benefit from an additional pension scheme.
The main difference between SERPS and S2P is that S2P was designed to provide a higher level of retirement income for low to middle income earners. Basically, if a person was earning less than £10,800 per annum in 2002 they would have got a higher pension from S2P than they would have received under the old SERPS arrangement.
If, prior to April 2002, a person had opted out of SERPS then they will not participate in S2P and consequently, they will continue to have the National Insurance rebates paid into their personal pension plan unless they take action to contract back in.
Contracting Out
In 1988, due to the abovementioned demographic pressures, the Government allowed and indeed actively encouraged many employed persons to opt out of SERPS by having part of their National Insurance contribution re-directed to a personal pension plan in their own name. The effect of this was to relieve the financial burden on the State scheme. Anyone who opted out at that time will still be entitled to all the SERPS benefits which accrued from 1978 to 1988.
The NI rebates are paid into a special personal pension ‘protected rights’ fund and the investment return will be determined by the level of risk which has been selected and the performance of the investments within the fund. The higher the fund’s value at retirement age, the greater the amount of the pension. The pension is also affected by interest rates which have a direct bearing on the annuity rate which in turn determines the amount of lifetime pension the insurance company will pay.
If legislation currently being progressed through parliamentary processes is fully implemented, it will no longer be possible to contract out after 2012, when it is proposed that a new type of "all in one" State pension is introduced.
Contracted in or out?
Everyone has the right to opt back into the State scheme if their circumstances change e.g. they might change their attitude to investment risk. It is in fact possible to review the contracting out decision on a yearly basis although this is not recommended.
When deciding on whether or not to be contracted out, it is important to consider all the pros and cons of both the State scheme and the personal pension alternative.
State Pension
Advantages
- Guaranteed benefits based on a specific formula.
- Benefit is not dependent on stock market performance.
- Suits the cautious individual.
- No need to buy an annuity (lifetime pension).
Disadvantages
- Benefit cannot be taken before State retirement age, currently 65 for males and 60 for females. This will ultimately be 65 for both males and females and following the publication of the Turner report in December 2005, the normal retirement age for younger people will increase to 68.
- You are dependent on a future promise from the State.
- The structure of the scheme has changed several times already and could change again. We do not know what future Governments will do to S2P or indeed whether it will continue in its present form. It has been proposed that with effect from 2012, the option to contract out will be abolished and the earnings related pension will be replaced with a flat rate benefit.
- The secondary scheme could be subject to financial means testing or some other sort of curtailment in the future. However, this is unlikely to affect those who are now near State retirement age.
- The returns on death before retirement are poor (especially for widowers) and there is no return at all on death if there is no surviving spouse or dependent children.
- It is not possible to take part of the State benefit as a tax free lump sum.
Personal Pension (Protected Rights)
Advantages
- You have your own personal fund invested in your name.
- You can decide how and where the fund is invested.
- Under current rules, protected rights benefits can be taken from age 50 for males and females (55 from April 2010).
- There is no possibility of future means testing because the fund belongs to you.
- The fund cannot be lost on death before retirement.
- National Insurance rebates increase with age.
- If you have an adverse medical history (e.g. you have suffered from a life threatening medical condition) then you may qualify for an impaired life annuity which can considerably increase the amount of lifetime income your protected rights fund could provide.
- Protected rights pensions no longer have to increase each year so you now have the option of securing a higher starting pension. It is however important to be aware that a level pension will be eroded by the effects of inflation.
- On 6 April 2006 the rules were changed to allow Protected Rights policyholders to take 25% of their fund in the form of a tax free cash lump sum.
- Under the new simplification rules introduced in April 2006, there will be more flexibility in the way in which protected rights pension can be paid.
- Those who are not married or in a civil partnership at retirement will be able to choose a single life pension which might add approximately 10% to the pension income.
Disadvantages
- Investment risk - pension fund unit prices can and will rise and fall in line with the performance of the underlying investments.
- When you retire, the pension secured by the fund is based on the fund value and the annuity rate applicable at retirement age. However, annuity rates have fallen due to significant increases in life expectancy over the last 20 years.
- You have to pay plan charges.
- The amount of NI contributions rebated by the State is based on several factors including your salary, age and advice provided by the Government Actuaries Department. The levels of rebate was last reviewed in the 2007/2008 tax year.
The decision to remain contracted out or to opt back in to the State scheme is extremely complex, particularly since the introduction of the State Second Pension.
If you are not optimistic about future investment returns and annuity rates then you should consider contracting back into the State scheme. Older, married people are almost certain to be better off by contracting back in until 2012. There is no certain way of knowing what at what age this would be the "right" decision, but we would encourage everyone to review their options every year.
In making your decision, you must take into consideration all the pros and cons of the State scheme compared to having your own personal pension plan into which is paid the National Insurance rebates.
If for example, you have been contracted out of SERPS since 1988, are aged 55, single, in poor health with non-dependent children, you may feel that you should remain contracted out, irrespective of your attitude to investment risk so as to protect the value of your protected rights personal pension fund if you were to die prematurely.
You should also consider whether or not the ability to take a tax free cash lump sum from your protected rights fund from the age of 50 will be an important incentive to remain contracted out. On the other hand you risk having a lower pension than you might otherwise have received from the State - it depends on what matters most to you.
July 2009