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Second thoughts

Steve Bee says changes to S2P will change pensions fundamentally

Steve Bee Pensions

Contracting out, effectively diverting National Insurance contributions into company pension schemes, became the engine that drove the unprecedented growth in private sector pensions in the UK through the 1960s and 1970s.

There is no doubt that the advent of Government-provided, earnings-related workplace pensions for most employees in tandem with the ability for employers to offer contracted-out employment was responsible for the UK’s private-sector workplace pension boom.

In 1988, contracting out was extended to defined-contribution pension arrangements, thereby powering the spread of private-sector individual pensions and modern group pension schemes with the same engine.

Contracting out has effectively meant that much of the money raised through NI contributions for the provision of earnings-related state second pensions has found its way into private sector pension schemes of one kind or another.

In the UK, unlike all the other major European countries, funded private pension provision has flourished as an alternative to state-controlled, pay-as-you-go pensions. Our system, I think has given us the best of both worlds – a compulsory workplace pension scheme provided on a pay-as-you-go basis through the NI system, but with the option of contracting out of that in favour of a funded private sector alternative. But our 49-year experiment with the compulsory provision of earnings-related state second pensions is about to come to an end. From April next year, the state second pension will begin the process of being changed to a scheme that will eventually provide a flat-rate pension “funded” by earnings-related NI contributions.

Eventually, all employees will become eligible for a flat-rate basic pension and a flat-rate second pension both provided by the state. This is being done as a redistributive measure in part to curb the spread of means-tested handouts to the elderly in the future and, as a consequence, the right to contract out into defined-contribution schemes will soon be removed. The engine that has driven our private sector pension schemes for most of the last five decades is gradually being shut down.

Private sector pensions will still be favoured by the new legislation but the compulsion that came with the earnings-related state second pension system is to be replaced by automatic enrolment of employees by employers into qualifying workplace pension schemes. It will be compulsory for employers to auto-enrol their eligible employees but it will not be compulsory for employees to remain in the schemes. They have the right to opt out. It is hoped that inertia will play its part in optimising the number of employees who will save in workplace pension schemes in the future but clearly there will be fewer people saving for a pension than there were in the compulsory earnings-related state second pension.

These are fundamental changes that are happening to our pension system. I think it is really important that we all understand them and what they may mean for us all.

Steve Bee is head of pensions strategy at Scottish Life

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