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Second pension solution

On April 6 this year, the state second pension will replace Serps – the state earnings-related pension scheme. The main change being made now is to the rate at which entitlement to a second pension builds up. Before looking at S2P it is worthwhile revisiting Serps.

For those retiring after April 5, 2000, the current Serps basis works as follows.

All employees who paid full Class 1 National Insurance contributions between April 6, 1978 and April 5, 1988 build up entitlement to benefits for this period at a rate of 25 per cent of middle-band earnings. These are earnings between the lower earnings limit and the upper earnings limit.

For each qualifying year, earnings between the LEL and the UEL are increased in line with the national average earnings index to state pension age. These revalued earnings from each individual year are then added together and apportioned (averaged) over the retiree&#39s working life since April 1978, before applying the 25 per cent rate.

A similar calculation is done for benefits accrued after April 5, 1988 but maximum pension benefits after this date depend upon your date of retirement. This maximum is applied on

a sliding scale and will ultimately reduce to 20 per cent for those retiring from tax year 2009/10 onwards (table 1).

Finally, the pensions calculated from pre- and post-April 1988 Serps entitlement are added together to arrive at the total Serps pension (see the example below).

Turning again to S2P, it sets out with two main aims: to provide a minimum pension of 20 per cent of average earnings and to encourage those earning more than the lower earnings threshold (LET) to contract out.

Anyone earning more than the LEL (expected to be £3,900 in 2002/2003), will be eligible for S2P benefits, even although they may not be paying NI

contributions. Only employees earning more than the employee&#39s primary earnings threshold (EE/ET, £4,628 a year in 2002/03) pay NI contributions. There are three rates for S2P:

40 per cent on all earnings above the LEL up to the LET (£10,800 in 2002/2003)

All employees whose total earnings fall into this band will be assumed to earn the LET e.g. someone earning only £4,000 will still be treated as having earned £10,800. The LET will be revalued each year in line with earnings.

10 per cent on all earnings above the LET up to a higher threshold (£24,600 in 2002/

2003)

The higher threshold is calculated as three times the LET minus two times the qualifying earnings factor. The QEF is equal to the LEL.

The effect of this band is to progressively reduce the overall maximum benefit rate to nearer 20 per cent as the individual&#39s earnings approach the higher threshold. No one earning less than the higher threshold will be worse off under S2P than they would have been under Serps.

20 per cent on all earnings above the higher threshold up to the UEL (expected to be £30,420 a year in 2001/02)

For those retiring before April 6, 2009, special transitional rules will apply. Again the same sliding scale as for Serps will apply but the maximum benefit will double for those earning less than the LET. For those in the middle band, the maximum benefit for the portion of earnings that fall into this band will be half the Serps rate.

Taking Mr Smith as an example again, the maximum benefit rate, for S2P purposes, on earnings up to the LET will be 42 per cent – two times 21 per cent. This is based on his retirement date of August 6, 2007. For his earnings above the LET up to the higher threshold, the rate will be 10.5 per cent – half of 21 per cent. If he has any earnings above the higher threshold up to the UEL, the rate applying to this slice will be the same as for Serps – 21 per cent.

As well as low earners, other individuals will also be entitled to S2P based on earnings equal to the LET.

Carers who have no earnings or have earnings below the LEL will qualify if they receive child benefit for a child under six years of age; are given home responsibilities protection because they are caring for a sick or disabled person; or are entitled to invalid care allowance.

People entitled to long-term incapacity benefit or severe disablement allowance, providing that they have worked and paid Class 1 NI contributions for at least one-tenth of their working life since April 6, 1978.

Contracting-out will also change when S2P is introduced. For personal pensions (including stakeholder personal pensions), a new age-related rebate based on the three-band accrual structure will be introduced.

Occupational schemes will see no change to the current arrangements for calculating either rebates or contracted-out benefits. However, low and moderately paid employees (earning less than £24,600 in 2002/2003 terms) who are in contracted-out occupational schemes will receive a top-up via S2P to ensure that they are treated in a broadly similar way to those who remain contracted in.

When the Government&#39s green paper “Partnership in Pensions” introduced the concept of S2P in 1998, there was an expectation that it would become a flat-rate benefit, regardless of earnings.

This was expected to happen five years after the introduction of stakeholder. This is only likely to apply to those who still have a “significant” part of their working life ahead. The Government&#39s example was those people under age 45 at the time of the change.

When the flat-rate benefit is introduced, it is also the intention to retain the earnings-related contracting-out rebates. This should provide a clear incentive for those earning more than the LET to contract out, and thus achieve the second of the Government&#39s aims in introducing S2P.

As has been seen with stakeholder, new legislation often has some unintended consequences and S2P is no exception. The beneficiaries in this case are business people who employ their spouse. As long as the spouse is paid at least the LEL, they will qualify for S2P based on notional earnings equal to the LET.

NI contributions can also be avoided by keeping salary below the EE/ET. As the EE/ET has now been harmonised with the income tax personal allowance, no income tax should be payable either.

So S2P does seem to meet the Government&#39s stated aims and offers one or two planning opportunities at the same time.

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