The issues here are complex. Many factors influencing the decision relate to what may happen in the future and therefore it is not possible to be certain of making the correct one. Additionally, some factors are subjective, for example, the political risk, and each individual’s view will have a large part to play in the decision.
There are a number of elements to consider. With the state second pension, there is no investment risk. The state will pay you a certain amount for each year that you are in S2P based on your earnings.
If you contract out of S2P, you give up these benefits and the Department for Work and Pensions will pay a proportion of your National Insurance contributions to a personal pension in your name. This is called the rebate and when it goes into your personal pension it is referred to as protected rights.
The amount you will get from your protected rights pension fund will depend on how well the fund grows, the plan charges and the annuity rate when converting your pension fund to pension income on retirement. Hence, one of the main risks is that your pension fund will not grow well and provide a pension that is lower than S2P. Conversely, it may grow well and exceed S2P.
When the Government calculated the NIC rebates, it worked on the basis of being neutral. This means it made certain assumptions about inflation and investment returns and set the rebate at a level where, if the assumptions proved correct, you would receive exactly the same protected rights pension as the S2P you had given up.
If it was a simple as this, then no one would contract out as what would be the point of taking an investment risk where there was unlikely to be an advantage?
If you contract out of S2P, then you will be buying an annuity with your fund when you get to retirement. The amount of income will therefore depend partly on the annuity rate at the time. The annuity rate will depend on a number of factors:
The interest rate the annuity provider can achieve with the money you give it.
Life expectancy. If you bear in mind that the annuity provider is giving you an income for the rest of your life, then clearly the annual income will depend on how long it thinks you will live. The longer you are expected to live, the lower the pension income.
Inflation. The annuity you buy with your protected rights pension will need to be inflation-linked, at least in part. Therefore, the higher the rate of inflation, the lower the annuity rate.
If you contract out of S2P, then these factors could work in your favour or against you, depending on what happens in the future.
One aspect is that of life expectancy. Life expectancy in the UK has been increasing significantly in recent decades and is expected to continue to do so. If this trend continues, annuity rates will fall. We need to consider the potential effect this will have on the decision.
Then there is political risk. This is most problematic as it is entirely down to the individual’s view of what the Government may do in the future. Some people are concerned that they may not get S2P when they reach retirement. We cannot answer this but we can provide a little background so you can make up your own mind.
The Government does not tend to make changes that have a retrospective effect. Hence, it is unlikely to change the level of S2P that you have earned so far. You could reassess the situation in the future in if the benefit changes. But the Government could potentially change benefits retrospectively. For example, the age at which you can take S2P might be changed to, say, 70. This would effectively be a reduction of benefits as you would miss out on five years payments.
A protected rights fund is much safer in this respect. It is a pot of money with your name on it and no one can take it away. You are not reliant on anyone else’s decisions as it is your money.
There are also differences between S2P and protected rights when it comes to benefits on death :
Death before retirement– Protected rights
If you are single at the time, then the whole fund is paid out as a tax-free lump sum to your nominated beneficiary. If you are married, the fund is used to buy a spouse’s pension.
If you are married, then your spouse will inherit 50 per cent of your S2P entitlement.
Death after retirement
– Protected rights
If you were married at retirement, you would have bought an annuity with a 50 per cent spouse’s pension.
If you are married, then your spouse will continue to receive 50 per cent of your S2P pension.
Another difference is that you are now able to take 25 per cent of your protected rights funds as a tax-free lump sum. This is not expected to be the case with S2P.
The choice as to whether you should be contracted out of S2P will therefore vary according to your personal circumstances and your views on the above issues.
Patrick Murphy is director of investment management services at Thinc Destini