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Contracting-out conundrum

Government Actuary Chris Daykin was recently quoted as saying: “There is no doubt the contracting-out system has become extremely complex. We acknowledge that these rebates are not generous – they were not intended to be generous.”

The background to this statement is complex but it is very important to the way that IFAs advise employers and employees about future pension provision. It is also somewhat perplexing because, as far as I know, it remains Government policy that the proportion of state to private pension provision should switch from 60/40 to 40/60 over the long term. That policy would be undermined by rising numbers of employees not being contracted out.

The contracting-out terms are changing from April 2002. The rate of rebate, per pound of state pension given up, is rising to reflect increased longevity and expectations

of decreased rates of investment return.

To give an idea of the scale of the changes, the rebate for contracted-out salary-related schemes is going up to 5.1 per cent from 4.6 per cent of middle-band earnings. For money-purchase forms of contracting out, the rebates are, of course, age-related and are currently capped at 9 per cent of middle-band earnings. This cap is being raised to 10.5 per cent, which makes it less likely than it would otherwise have become that someone will want to cease contracting out just because they have become old enough to have their rebate restricted to this capped level.

The rebates are also going up for people earning less than the upper earnings limit (currently £29,900 a year) but only if they use personal pensions or stakeholder for this purpose. This reflects the fact that, from April 2002, they are contracting out of more pounds of state pension.

This is because the state second pension (S2P), which replaces the state earnings-related pension scheme in April 2002, is more generous to lower earners than Serps. For occupational pension schemes, contracting out is becoming fiendishly complex under S2P because it will only be partial contracting out.

As the Government Actuary implies, many commentators regard the new rebates as insufficiently generous compared with the changes to longevity and real rates of return which are expected. In a nutshell, the rebates contain no financial incentive to contract out. The contracting-out decision is not now about numbers – the concept of pivotal ages is redundant – but is essentially about whether employers and employees trust the state more or less than funded private pension schemes for this section of their benefit provision.

One particular likely consequence of the new rebates is that we should expect to see low numbers of people contracted out using stakeholder pensions. This is because it is difficult to see anyone positively suggesting that they contract out – decision trees, for example, sidestep the contracting-out decision – and the default option is to stay in S2P.

The default option for people already contracted out is to stay contracted out but that begs the question of whether and how an IFA should be refreshing the contracting-out advice for such people.

Why would the Government want to make contracting out less attractive? The answer may be in the tension between the Treasury and the Department for Work and Pensions (formerly the DSS). The DWP wants to encourage contracting out but the Treasury wants to limit the effect on Government cash flow. It looks like the Treasury won this time round.

All this could change again around 2007 when the Government hopes to introduce

a flat accrual rate of S2P. In other words, someone earning £5,000 would accrue the same S2P as someone earning £50,000. Yet the Government intends the contracting-out rebate to remain earnings-related. In these circumstances, high earners would be made a contracting-out offer they could not refuse.

However, the Government says stakeholder must be successful as a precondition

of S2P becoming flat rate. Time will tell.

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