The Government has recently made a number of important announcements on contracting out. We now have...
The Government has recently made a number of important announcements on contracting out. We now have details of the rebates which will apply for the 2001/2002 tax year to personal, occupational and stakeholder pensions. We also know the structure rebates will take when the State Earnings Related Pension Scheme (Serps) is replaced by the State Second Pension (S2P) (currently planned to be introduced from 6 April 2002). We may have to wait some time before we know the level of rebates which will apply when contracting out of S2P - the Government has until April 2001 to announce these. However, the Government Actuary's Department will be carrying out a review over the summer, so we may receive an indication of what rebate levels to expect sometime later this year.
The terms for contracting out through personal pensions, contracted-out money purchase schemes (Comps) and contracted-out salary-related schemes (Cosrs) for 2001/2002 will continue as before. Rebates will continue to be age-related for personal pensions and Comps. For Cosrs, the rebate will be continue to be a flat 4.6% for all ages, which is split 3% employer, and 1.6% employee.
Rebates for contracting out under stakeholder will depend on whether the stakeholder scheme has been set up under personal or occupational pension legislation. A stakeholder scheme is first and foremost a pension scheme and must seek approval either as a personal or occupational scheme. The occupational route is likely to be taken where the stakeholder scheme relates to a single employer or defined group of employers, and membership may be restricted accordingly. A personal pension stakeholder scheme will be unable to restrict membership in this way.
Once approved as a pension arrangement, the scheme can then apply to Opra to be included on the register of stakeholder schemes. This will be possible from October 2000.
If approved as a personal pension scheme, the stakeholder scheme will receive personal pension rebates. If it is an occupational scheme, it will receive Comps rebates. There is a major financial disadvantage for contracted-out members if the stakeholder scheme follows the occupational route. Individuals will lose up to 1.6% of their middle band earnings, that is earnings between the lower and upper earnings limits (£3,484 and £27,820 respectively for the 2000/01 tax year). For someone earning above the upper earnings limit, this equates to a loss of £389 per annum. Clearly, this makes it unlikely that occupational stakeholder schemes will find wide favour.
The other point to note is that, as with current personal pension rebates, the terms for contracting out through stakeholder in 2001/2002 are, at most ages, finely balanced. There is no clear financial benefit to members in either contracting out or in remaining in Serps unless they are older (typically above age 50) where contracting-out terms are less favourable. The decision instead becomes one relating to each individual's risk profile, optimism regarding future investment returns and annuity rates, and belief in future governments paying out on promises made today.
The Government and Financial Services Authority (FSA) are continuing to explore the viability of using decision trees to help advise on pensions matters. It is difficult to envisage how any decision tree, however cleverly constructed, could lead the average stakeholder member to a conclusion on contracting out which they would feel was correct for them.
Had the Government chosen instead to set rebates at a level which made contracting out clearly advantageous to individuals, it might have encouraged many of the currently unpensioned to set up a stakeholder (or personal) pension initially simply to receive rebates. Having taken this action, it might have been easier to persuade such individuals to start making additional contributions at some later stage. An opportunity missed?
To explain the issues concerning contracting out of S2P, it is first necessary to recap on how S2P benefits will differ from those payable under Serps.
S2P is to be introduced in two stages. The plan is to introduce it initially in April 2002 as an earnings-related scheme along the lines of Serps but with higher benefits for lower earners (stage 1). Once stakeholder schemes are established, S2P will be revised and the benefit will become a flat amount (stage 2). However, even under stage 2, the intention is for rebates to continue to be calculated on an earnings-related basis as under stage 1.
This will mean that for those individuals earning above a certain level (to be referred to as the low earnings threshold (LET), expected to initially be around £9,500) the rebate will be worth significantly more than the S2P benefit being given up. This will make contracting out financially attractive for such individuals.
Interestingly, during a standing committee debate on the Child Support, Pensions and Social Security Bill, Jeff Rooker, Pensions Minister, indicated that he would not regard the stakeholder pension as established if a large portion of the workforce were to miss out on the scheme. He added: "If large chunks of the market are missed out, for various reasons, a flat rate will not apply". Depending on your view of how likely stakeholder is to attract large chunks of the workforce (or indeed what the definition of 'large chunks' is), the second stage of S2P may be more an if rather than a when.
Table 1 shows how S2P accrual will work. Under Serps, an individual, after a complete working lifetime, would have been entitled to a target benefit of 20% of earnings between the lower and upper earnings limits (LEL and UEL). Under S2P, the target benefit varies according to salary bands.
The effect of this tiered approach is that an individual earning between £9,500 and £21,600 will have a target benefit which gradually reduces from 40%, a