The decision on whether to contract out of Serps and invest the rebates in a personal pension was fairly straightforward in the past.
Based on the earnings and risk profile of a client, a pivotal age was calculated to find the point beyond which contracting out of Serps became less attractive than opting in.
But things have changed and the criteria are not clear-cut. A suitable recommendation is difficult to assess.
The introduction of the state second pension and the revision to the level and format of contracting-out rebates makes it essential to review clients who are already contracted out using an appropriate personal pension or stakeholder plan.
This is also an opportunity to review clients who have not yet contracted out.
The introduction of stakeholder has meant that product providers have revised the terms of their new products used for contracting out and for some of their existing plans.
These changes can have a significant effect. For example, investing rebates in a stakeholder with an annual charge of 1 per cent or less may tip the balance to contracting out.
A structured approach
The position of clients who are contracted out has to be reviewed and advice will need to be given on whether:
Clients should remain contracted out or contract back into the state second pension.
If they remain contracted out, whether they should continue with their existing personal pension policy or redirect future rebate contributions to a new one.
For clients who are not contracted out, some of the lower-charge personal pension or stakeholder plans now available, together with the revised age related rebates, may make contracting out a viable option.
What information do advisers need to provide the appropriate advice and to meet the compliance requirements? I would suggest the following in a structured report format:
A comparison of the benefits which might be obtained from a personal pension if a client is contracted out with the estimated additional state second pension if contracted in.
The comparison should include a review of the position under the existing product, if the client is currently contracted out, and also under alternative products.
With an understanding of the client's attitude to risk, a suitable recommendation can then be made.
To obtain and collate manually the relevant information into a client report could be time-consuming. Technology can help to provide the information in a clear, concise report.
One such example is the contracting-out guide available to IFAs via The Exchange's Exweb portal. The reports can show a comparison of benefits which might be payable if a client is contracted out, with the estimated additional state second pension if contracted in.
Multiple product-charging structures, including any current appropriate personal pension, can be included in the comparison and the results for each product can be shown in a number of ways.
Individual years – the potential percentage gain or loss from contracting out on the basis of a 1 per cent real return and a 3 per cent real return, until the date the pension becomes payable, as required by the FSA illustration rules. The results can be shown for the current and subsequent four tax years.
Cumulative over term – the potential cumulative gain or loss over a number of years, also presented in a tabular format (see table on left). The results are colour-coded to show gains (green) or losses (red).
There has been much discussion over the poor value of National Insurance rebates. Industry representatives have gone as far as to suggest that it would be beneficial for all men and women who have contracted out to contract back in.
However, it can be strongly argued that the decision is not that straightforward and the decision on contracting out must be assessed on an individual basis. Age, gender, earnings' levels and the client's attitude to risk are the key considerations.
With the help of specialist software tools, it can be demonstrated it may be appropriate for clients to contract out or remain contracted out until they are into their mid-50s for men and late 40s for women, provided that a real rate of return of 2 per cent or more is considered reasonable.
It should be recognised that, in the case of the S2P, the “real rate of return” has to be measured against average salary increases and not merely against the retail price index. The S2P earned in any year is increased in line with national average earnings each year up to state pension age. National average earnings' increases are published as section 148 orders, which have consistently been higher than the increase in RPI.
A specialist calculation tool for contracting out can save advisers time and effort, providing clients with a clear, well-structured report and, importantly, helping to meet compliance requirements.