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The new choice on contracting out

Reports by the Government Actuary may not be at the top of everyone&#39s holiday reading list but the most recent report on contracting out should be of interest to IFAs and perhaps also to the FSA who recently assigned contracting out to the “too difficult for decision trees” file.

The report proposes the rebate levels which would apply for the five years starting April 2002. DSS ministers must confirm these not later than April 2001.

In addition, the Government Actuary explains his reasoning for revising the rebates, including longer life expectancy and lower anticipated investment returns, reinforcing the message that providing for your retirement is getting more expensive.

For non-actuaries out there, the following is a layman&#39s summary of the proposed changes and the reasons behind them.

Rebates should represent the actuarial value of state benefits being given up. The State Earnings Related Pension Scheme is due to be replaced by the State Second Pension (S2P) in April 2002, just as these new rebates would become effective.

Contracting out of S2P is a complex subject with different approaches for different types of scheme. The GA has produced figures assuming Serps remains but explains how to adapt the figures should S2P actually arrive on schedule.

The revised rebates reflect two other changes to Serps. First, the phasing in of a female state pension age of 65 and also a general lowering of accrual rates as the scheme matures. Both lead to a lower benefit being given up and hence imply lower rebates.Fortunately, other factors counteract this.

One of the most significant factors hav-ing an impact on reb- ates is the assumption about future investment returns. For pre-retirement, the key factor is by how much investment returns will exceed earnings&#39 inflation. For post-retirement, it is the excess over price inflation which is important.

The GA has reduced his expectations in both these areas. Pre-retirement, he is now assuming a 2 per cent real return as opposed to 2.25 per cent. Post-retirement, the previous assumption was 3.75 per cent. Current levels are well below this but are unlikely to remain quite so low. The new assumption is 2 per cent for those retiring in 2002-03, increasing gradually to 3.5 per cent for retirements in 2017-18. The lower expected returns put upward pressure on the proposed rebates.

Average life expectancy has been increasing more quickly than had previously been predicted, particularly for men. In round terms, the GA is assuming that our life expectancy once we reach age 65 will be two years longer for males and 1.5 years longer for females than was allowed for the last time that the rebates were set. So, by contracting out, the average person gives up Serps for longer, implying a higher rebate.

There are two points of interest here. The GA is proposing that rebates to contracted-out money-purchase schemes should continue to reflect a low expense basis, which means they will remain unattractive. Any employer which has continued to offer a Comps or is thinking of an occupational stakeholder should be encouraged to rethink.

The second point concerns stakeholder under which charges are capped at 1 per cent of fund a year. If stakeholder will truly have lower costs than personal pensions, then it could be argued their rebates should also be set lower. I suspect that the Government would have been less than happy to see stakeholder apparently disadvantaged in this way. The GA proposal is to adopt identical expense assumptions, meaning personal pension-based stakeholders will receive the same rebates as other PPs.

When rebates are set for salary-related schemes, a single level rebate percentage is set for all members, whatever their age or sex. The idea is that, for a typical membership, things will average out. Evidence suggests two changes in typicalmembership profiles – first, the average age has increased and second, there is a greater proportion of women. Both these factors put pressure on rebates to be higher.

There have been factors placing both upward and downward pressure on rebates. The good news is that, on balance, the GA is proposing increases to rebates.

For salary-related schemes, the flat-rate rebate is proposed to increase from 4.6 per cent to 5.1 per cent.

At present, the rebates are capped at 9 per cent, even if the assumptions would have produced a higher figure. There is no suggestion yet that the cap will be changed, other than perhaps under S2P.

When Serps is replaced by S2P, contracting out will become significantly more complex. With occupational schemes, rebates will not change. The individual will – confusingly – give up only part of their S2P, equal to current Serps, so rebates need not change.

Under PPs, including PP stakeholder schemes, individuals will normally give up their full S2P entitlement on contracting out. There are special provisions for those earning under £9,500 to retain part of S2P.

Under Serps, benefits accrue over a complete working lifetime to deliver 20 per cent of earnings between the lower and upper earnings limits. The rebates have in the past been based on this 20 per cent accrual and this has been carried forward into this latest set of proposals.

But S2P will accrue at different rates on different bands of earnings – at 40 per cent on an initial band (lower earnings&#39 limit up to £9,500), at 10 per cent on the next band (£9,501 up to £21,600) and at 20 per cent on the third band (£21,600 up to the upper earnings&#39 limit).

To calculate the actual rebate an individual will receive for contracting out of S2P, earnings must first be broken down into these bands.

This latest report is a welcome acknowledgement that in current economic conditions and against a background of improving mortality, it is appropriate to increase rebates. Let us hope the Government takes this on board. However, it is doubtful whether it goes far enough to make contracting out the clear choice for most of us.

Steven CameronManager (pensions development), Scottish Equitable

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