Autumn; conkers, fallen leaves, bonfires and fireworks. And contracting out. Each year, just as the clocks are turned back, insurers follow the annual ritual of sending contracting-out letters to their direct customers and the latest guidance to advisers.
This annual spectacle is usually accompanied by a healthy public debate conducted in the trade and national press. And this year was no different.
On the one hand, there are those who say that people should contract back in regardless. On the other are those who say that it is not quite so clear cut and that individual choice is best.
I can see and appreciate both arguments. There is no easy right or wrong answer to this complex question.
But what I don’t understand are those whose views have changed from one side to the other for no obvious reason. Let me explain.
Contracting-out rebates are set in advance for five years, every five years. The rebates we are working with today, 2006/07, were set in 2002. Between 2002 to 2007, the rebates change very little. If anything, they increase slightly over the five years up to 2007.
In deciding whether it is worthwhile contracting out or not, these rebates are projected forward to retirement and turned into a pension income. This income is then compared with the state second pension given up in favour of the rebate. If the projected pension is greater than the S2P given up, then it might be better to contract out, depending on personal circumstances.
The rate of investment return used to project the rebate forward to retirement is crucial, as is the annuity rate at which the projected rebate is turned into income. The latter rate is heavily dependent on the longdated gilt yield.
Long-term expectations of investment returns ought not to have changed markedly over the last five years. The long-term inflation outlook is a key determinant of long-term investment returns. The Bank of England lowered and stabilised inflation at its current level in early 1998. And most economists would agree that the long-term outlook for inflation is that it will continue around its current level.
Likewise, conventional long-dated gilt yields have hovered around the 4.5 per cent yield line since the middle of 1998. Given the inflation outlook, one might also expect long gilt yields to stay put for the foreseeable future too.
So, if rebates haven’t changed, and long-term expectations of investment returns and gilt yields haven’t changed, why is it that some people’s views have changed since 2002? Why is it that some insurers were happy to suggest that contracting out was OK for some customers in 2002, but not in 2003, 2004 or 2005?
I might see their point if they changed their minds in 2007. Next year brings with it a new set of rebates. Something has changed and it is therefore right to review one’s thinking.
Has anything affecting this decision changed since 2002? The only thing I can think of is that the FSA started to take a special interest in contracting out two or three years ago. It was instrumental in driving the guidance that is sent out on an annual basis.
Maybe some companies changed tack because they felt threatened by the FSA?
Contracting out is an individual decision. Even if the long-term economic picture isn’t changing, clients’ personal circumstances could be. For example, they might now be over the age at which rebates are capped, or now expect state pensions to form a larger proportion of their retirement income.
Good communication will help these people make the right decision. But contracting people back into S2P en masse is only appropriate if something has changed that affects everyone.
John Lawson is head of pensions policy at Standard Life