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Fight for your rights

Self-investment of protected rights funds could persuade many to contract out

The latest pension consultation issued by the Department for Work and Pensions deals with contracting out and asks whether the same retirement rules should apply to protected rights funds as already apply to pension funds accumulated from voluntary contributions.

Make no mistake about it, this is a big deal. Personal pensions receive rebates of between £2bn and £3bn a year and in the past there were a fair number of contracted-out occupational defined-contribution schemes. The Thatcher Government established the right to receive a rebate in place of the state earnings-related pension in 1987. This means that upwards of £60bn has been paid into protected rights funds. With reasonable growth, these funds must be worth more than £100bn.

The remaining restrictions applying to protected rights savings fall into two main areas. The first is annuities, where rules require married people to buy a joint-life pension and where the rates used must be unisex. The second is the requirement to invest protected rights savings in insurance policies, collectives and bank accounts. This prevents full self-investment.

Removing these differences would amount to a significant simplification of the pension rules. Freeing up £100bn of assets could see a significant release of pent-up demand from people keen to invest protected rights savings in a self-invested personal pension.

Some people will have built up big protected rights funds. Until 1997, rebates were much more generous than today. They were also flat rate rather than age-related. For example, a 30-year-old could have received a rebate of over 9 per cent of band earnings in 1987/88 compared with just 4.8 per cent this year. Twenty years worth of rebates and reasonable investment growth could mean some are sitting on protected rights funds of £70,000-plus.

The Government plans to scrap contracting out by money-purchase schemes altogether in 2012. This is part of the package of measures contained in this summer’s White Paper.

In the meantime, should people pack away as much as possible into their protected rights fund by contracting out for the next six years?

Unfortunately, rebates remain stingy, making it difficult for advisers to recommend contracting out on a purely financial case. However, the addition of self-investment to the right to take a quarter of the fund tax-free, granted from April this year, is likely to be enough to tip the scales in the minds of some clients.

Advisers need to be careful when documenting any recommendation to contract out. It is unlikely that contracting out can be justified on the basis that the rebate received will outperform the state second pension benefit given up. Equity returns are required simply to match S2P. Therefore, why give up a guaranteed benefit for one that depends on future returns and annuity rates? OK, the Government can and has changed the second pension in the past but conjecture about what might happen in future should not form part of an adviser’s recommendations.

Any decision to contract out should be client-led. The lure of tax-free cash or the ability to control the management of one’s own fund will be sufficient incentive for many clients to disregard the financial case. In addition, many people do not trust the Government to deliver on its promises. For them, a bird in the hand is worth two in the bush.

However, those for whom it is not safe to contract out should be discouraged from doing so, for example, the risk-averse or people who will rely on state pensions to form a big proportion of their retirement income.

If protected rights are simplified, we are unlikely to see any amending legislation until early next year, maybe as part of the Pensions Bill dealing with White Paper changes. If that does happen, the changes could take effect from April 2007 although the consultation paper provides no concrete promises.

John Lawson is head of pensions policy at Standard Life

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