View more on these topics

Second chance

Many years ago,I contracted out of the state earnings-related pension scheme and since then I have received annual statements which serve to do nothing more than remind me of the suggestion that at some point it will be prudent to contract back into Serps. Can you advise me of when this should be done?

Technically speaking, you are no longer contracted out of the state earnings-related pension scheme as it no longer exists, having been replaced by the state second pension or S2P as it is referred to. However, just as with Serps, you always have the choice of staying contracted out or returning to the state scheme.

When you originally contracted out, there were pivotal ages for males and females at which it was expected that they would be better off by contracting back into the state scheme.

However, these pivotal ages were based on a number of assumptions which have proved to be incorrect, so the pivotal ages accepted by the industry have changed.

These new ages are based on further assumptions and the question is how much reliance you should give to these and whether you should contract back in now or in the future. To answer this, let us examine past events.

The first scheme intended to bolster the basic state pension was the graduated state pension scheme and, like the basic state pension, it was a flat-rate scheme. This scheme was replaced in April 1978 by Serps, the benefits of which were based on earnings between certain limits. Like the graduated state pension, it was to be paid in addition to the basic state pension.

However, in April 1988, Serps was altered and its value was reduced. The Serps benefit was cut again by the 1995 Pensions Act when the value of a person’s lifetime earnings used in its calculation was reduced. A further cut was made when, after October 6, 2002, spouses inheriting a Serps benefit no longer received all of it.

The structure of the replacement scheme, S2P, is more complex than that of its predecessors and it currently has three bands based on earnings. Those in band 1 will be provided with a significantly higher benefit than under Serps, for high earners the benefit is equal to Serps and earners in band 2 fall somewhere in between, depending on actual earnings. However, the structure of the scheme is due to change at some, as yet unknown, future point and will turn S2P into a flat-rate benefit.

Those who were contracted out of Serps on April 5, 2002 continue to be contracted out of S2P unless they elect to contract back in and you will have received communications from your personal pension provider bringing this issue to your attention.

What should you do? The decision to stay contracted out of S2P is based on the view that the National Insurance rebates invested elsewhere will provide a better pension than the additional state pension. In calculating the pivotal age at which it is theoretically prudent to contract back in, a growth rate assumption needs to be used.

While there will always be considerable debate over this assumption, a further – arguably fundamentally flawed – assumption is also made, being the assumption that the Government will leave things unchanged in future. It has not done this in the past and it appears that more changes are on the cards in the future.

In addition, there are issues relating to death before retirement, particularly if you are unmarried. The maximum a spouse can inherit is half of their deceased partner’s S2P entitlement. For unmarried individuals who are members of the state scheme, death not only means loss of life but also loss of all pension contributions made to the state scheme.

Obviously, regardless of the abilities of your financial adviser, there is no way you can take it with you when you are gone.

However, if you have contracted out, your pension fund can be passed to your dependants, chosen beneficiaries or charity or potentially provide a much higher pension for your widow/widower.

While you may have every intention of doing so, there is no guarantee that you will live to retirement age or enjoy the benefits of your pension for many years.

Furthermore, any assumption of future growth rates that may be achieved via your contracted-out pension fund could prove to be wildly inaccurate, as could the assumption that the benefits payable under the relevant state scheme will not be cut.

Consequently, the decision to contract back in must be a personal one. Do you prefer to keep the money you have been given and manage it yourself,or trade this for an arguably equally uncertain benefit?

Recommended

IFA swamped by pro bono cases

Staffordshire IFA Richard Jacobs Pension & Trustee Services is having to screen clients to cut down on the number of pro bono cases it deals with each week.

Thumbnail

Case study: administration — managing group life schemes

Our client leads the global market in high-tech electronics manufacturing and digital media. The trustees of the company’s final salary pension scheme insure death-in-service lump sum and dependants’ pension death benefits for active employees, as well as dependants’ pension benefits for deferred members (those who have left service).

Newsletter

News and expert analysis straight to your inbox

Sign up

Comments

    Leave a comment