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Down the rebate hole

What decisions face employers with contracted-out schemes?

Much has been written about the contracting-out decision from the viewpoint of an individual but what about the viewpoint of an employer who has contracted-out employees?

The Government has announced a number of actual and potential changes. The immediate change, with effect from April 6, 2007, is the new quinquennial table of contracted-out rebates. This is significantly less generous than many had hoped for.

For defined-contribution plans, rebates are in line with the Government actuary’s recommendations (which some thought inadequate) except that the Government has imposed a cap of 7.4 per cent of band earnings. This bites at age 43 for personal pensions while for contracted-out money-purchase schemes it bites at age 48 in 2007. The reason it bites at a higher age for Comps is because Comps’ rebates are less generous than for personal pensions. This may partly explain why so few people now contract out using Comps.

The 7.4 per cent cap is very significant, not least because it is much lower than the 10.5 per cent cap which operated in 2002-07. The Government justifies the reduction “to take account of fiscal constraints”. In other words, it wants to pay out less money in rebates, so it is making contracting out less attractive at higher ages.

The practical implication is that, for people using personal pensions, every year by which they exceed 43 makes it harder to justify remaining contracted out on purely financial grounds. Pivotal ages are very important but there are other issues. At the time of setting the rebates, the Government noted that it was about to publish a White Paper on the future of state pensions. The Bill is going through Parliament but it may be years until we know when money-purchase contracting out will stop. The earliest feasible date is April 2012.

Another relevant issue is the availability since April 6, 2006 of tax-free cash on protected rights. This increases the value of the rebate by 5.5 per cent for standard-rate tax payers (25 per cent of 22 per cent) and 10 per cent for those who expect to be higher-rate tax payers in retirement (25 per cent of 40 per cent). For higher-rate taxpayers who expect to be standard-rate taxpayers when they retire, it is the 5.5 per cent figure which is relevant.

There is also a harder aspect to put a value on, namely, the value of being able to get a lump sum at all – something not available under the state second pension. Experience tells us that people often take cash in hand even when the alternative would probably be more valuable in the long run.

Other relevant issues are essentially personal. Do you wish to access benefits earlier than state pension age? Are you likely to be married when you access benefits? Do you trust the state more or less than funded private pensions? The question arises as to whether the employer is going to facilitate any kind of advice for the individuals concerned.

As the Government plans to abolish DC contracting out on or after April 2012, another question arises. Is it worth bothering with contracting out for what may be no longer than five more years?

If the vehicle for contracting out is a pure defined-benefit scheme, different considerations arise. It is very clearly a blanket decision made for all members and is integral to the scheme’s benefit structure. The Government actuary’s recommendation for DB contracted-out rebates in 2007-12 was 5.8 per cent of band earnings but the Government is implementing 5.3 per cent. Unless the employer has an unusually young workforce, the risk is that contracting out will be stopped on value grounds and this will be the trigger to switch all future accrual to DC. The Government has promised a review of DB contracting out in 2017 but by then it is likely that actively contracted-out DB schemes will be restricted to the public sector.

Stewart Ritchie is director (pensions developments) at Aegon Scottish Equitable.

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