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Contractual conundrum

Advising on contracting out has become a real burden

It seems to me that contracting out typifies many of the difficulties facing advisers today.

Back in 1988, it seemed clear-cut. The flat rebate structure meant contracting out was likely to be financially beneficial for younger people. Those nearing retirement were likely to be better off if they remained contracted in and then there was a group in the middle where the decision depended on attitude to risk. Many providers produced “traffic light” sales aids to help advisers and clients understand the position.

Younger clients should only require a significant review as they moved into the amber area of the traffic lights or passed the pivotal ages that providers were required to calculate.

Scroll forward to 2006 and the position is very different. We are now in the tenth year of age-related rebates which means that no one can be confident of financial gain from contracting out although younger people are still more likely to be able to match the state pension given up. But over the years there have been an increasing number of factors which would encourage contracting out including much more flexibility in timing and now the availability of a tax-free lump sum. Restrictions on the form of pension have also diminished and the Department for Work and Pensions is consulting on removing all distinctions between protected rights and other pension benefits.

Advisers are faced with a situation where clients are looking for clear guidance but where the issues are complex and best advice is far from clear-cut. Compliance safety may appear to come from following the numbers and contracting clients back in but for many that could bring unwelcome restrictions on the timing and form of their pensions. Many advisers will point to the proposals to increase the state pension age as evidence that the Government is capable of reducing state pensions retrospectively so that the concept of giving up a guaranteed pension for a variable one is not entirely accurate.

Advisers who take up the challenge of providing individual advice based on each client’s circumstances and attitudes are to be commended but are unlikely to see great financial reward. Rebate levels are relatively low and commission does not amount to a great deal in respect of each client. If the advice is to contract back in, the income stream dries up completely. As often seems to happen, time-consuming explanation provides little or no remuneration.

On top of this, consumerists and ambulance-chasers are sniffing around past cases. A combination of stockmarket issues in the early years of this decade, a sharp decline in yields on index-linked gilts and ever-increasing estimates of average lifespans mean that past contracting out is likely to result in much lower pensions than envisaged. This does not mean that contracting out was necessarily bad advice at the time but the challenge is to demonstrate that clients understood the risks and were willing to accept them. In the different regulatory environment of the 1980s, documentation of such conversations may well be less than thorough.

Contracting out has become a real burden for many advisers and providers. The situation may ease a little next April because the most recent review of rebates means they will become more generous for younger people. In my view, if you are satisfied that the rebate level is financially neutral for a client, the soft factors mean that contracting out should be a relatively safe recommendation as long as the client understands and accepts the risks involved. Also, from next April, rebates for older people are reduced because of a lower cap (down from 10.5 to 7.4 per cent of band earnings) meaning they are almost certain to be better off contracted in. Of course, there will still be a group in the middle for whom the situation remains knife-edge.

Contracting out through personal pensions is likely to disappear in April 2012. I suspect many advisers will be glad to see the back of it. The simplicity of 1988 is a distant memory and the ever-changing legislative and rebate positions make it difficult to keep up to date. It says a great deal for the professionalism in our industry that many advisers continue to seek the best options for their clients despite the difficulties and low levels of remuneration.

Ian Naismith is head of pensions market development at Scottish Widows

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