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It’s cold outside

Afew years ago, I met a veteran of the Spanish civil war who knew a lot about the state second pension – then called the state earnings-related pension scheme.

He told me: “That pension scheme was never meant to have anything to do with personal pensions or money-purchase pensions. It was meant for employers’ schemes.

“I don’t regard personal pensions as pensions at all. They’re just glorified savings schemes. With a proper pension, you don’t just know what you’re putting in. You know what you’re going to get out of it,” he added.

Another octogenarian, who was there at the inception of Serps and contracting out was equally obdurate. “This was the biggest public-private partnership ever undertaken. But it wasn’t meant for defined-contribution schemes. It was Mrs Thatcher who extended it to personal pensions and money-purchase schemes and we were fundamentally opposed. It should never have happened.”

These two had been at each other’s throats for a quarter of a century over industrial relations matters. But now Jack Jones and Barbara Castle were reunited to save what had once been hailed as the crown jewel of Labour’s progressive reforms – the state earnings-related pension scheme.

Was Barbara Castle right to say that contracting out into personal pensions should never have happened?

Right now, contracting out for most policyholders does not add up. The National Insurance rebates paid into policies are meant to be sufficient, on reasonable assumptions about inflation, investment growth and longevity, to replicate the benefits that would have been available had the policyholder stayed in Serps/state second pension. But for years they have been barely enough under the best assumptions. Now investment and mortality assumptions have shifted, most would be better off not contracted out of the state second pension but contracted in.

The only breaks in this consensus are what to do about it. Prudential’s UK chief executive Mark Wood has called on the Government to raise the rebates. Norwich Union has written to policyholders letting them know it is contracting them back into the state second pension unless they object.

Contracting out was first allowed for personal pensions in 1988, as part of Mrs Thatcher’s attempt to engineer a shift to pensions held by individuals, not the state.

Whether or not a rebate-only personal pension – where you only knew what you were putting in – could ever replicate the state second pension – where you knew what you would get out – was always going to depend on assumptions about investment and mortality.

In a defined-benefit scheme, such as Serps, the benefits accrued when you are younger are worth less than those you build up close to retirement, so the rebates should have risen with age. To keep it simple, the then Secretary of State Norman Fowler did not bother with age-related rebates and set a flat rate. That meant the prudent advice was to take the rebate when you were young but contract back in after a certain age when the rebate was no longer enough to have even a chance of replicating Serps’ benefits.

What a mess. In the Pensions Act 1995 they tried to clean it up by introducing age-related rebates that did rise with age. But with changing investment and mortality assumptions, the rebates and the cost to the Government just kept on rising.

Since 1988, contracting out into personal pensions has been dogged by hideous arithmetic. Millions are losing out. The ABI wants contracting out to be retained and reformed. That has been tried at least once.

Perhaps for money-purchase schemes and personal pensions, all those contracted out should be contracted back in – and a ghastly chapter in Britain’s financial history could be brought to a close.

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