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Pensions Q+A: All about contracting out

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If you were one of the millions of pension scheme members who contracted out of the Government's Additional State Pension in the past few decades, the potential incoming changes may affect you, Here's what you should know.

What is contracting out?

Contracting out means that you or your employer chose to leave ('contract out') the Additional State Pension, known as either SERPS (the 'State Earnings Related Pension Scheme') or S2P (the 'State Second Pension'). In exchange for paying lower National Insurance Contributions (NICs), your employer promised to pay a top-up pension in addition to the pension you had with them, while the Government could also pay NICs into a personal pension scheme.

This lower NIC bill made contracting out popular, while in its early years, the Government also promised to pay an extra 2% of earnings into people’s pensions.

Contracting out was abolished for Defined Contribution (DC or Money Purchase) pensions in 2012 and will be abolished for Defined Benefit (DB or Final Salary) schemes in April 2016, when the New State Pension comes into effect.

According to consumer group Which?, more than five million scheme members had contracted out – or been contracted out by their employers – of DC schemes by the early 1990s. It was the norm for DB schemes to contract out their members by default.

To know whether you are or have been contracted out, Richard Butcher, chief executive of PTL, a pensions advisory firm, says: “Look at your payslip – next to your National Insurance, it will say something like NI Reduced Rate or NI Contracted Out.”

What about the New State Pension?

However, because of the complexities of the pension system – it's a standing joke among pension professionals that anything designed to make the system simpler usually does the opposite – having been contracted out may have an impact on whether you are eligible to receive the full New State Pension, set to come in from 2016.

People with at least 35 years’ National Insurance Contributions will be eligible for the full New State Pension, which will be worth at least £148 a year (the final rate is to be set in Autumn 2015). The New State Pension replaces the current system of Basic State Pension supplemented by various top-ups, such as the Additional State Pension.

PTL's Richard says. “If you've not contracted out, then you will get the flat rate, based on how many years NICs you have. But if you have contracted out, then the amount of New State Pension will be reduced to offset that.”

The Government is beginning to roll out State Pension statements to adults at or near State Pension Age, detailing how much they may be entitled to under the new system.

In its official advice on calculating the effect of contracting out on the transition to the New State Pension, the Government says it will make deductions to take into account people’s higher workplace pensions that they built up as a result of having being contracted out ‘otherwise [they] would get the benefit of the increase [in the State Pension] and any [extra] workplace pension they built up as a result of being contracted out’.

“It's so complicated, and the Government needs to make sure that nobody loses out because of the change,” says Richard Smith, a pensions expert at Spence & Partners, an advisory firm. But he adds that the calculation has to take into account deductions for people who have been contracted out because ‘otherwise it's a free lunch’ They may receive more than their NIC history entitles them to.

To find out how much your State Pension entitlement may be, contact the Government's State Pension Statement service.

What other consequences might there be?

When contracting out is abolished altogether from 2016, any members of pension schemes still working on a contracted-out basis will see their individual and company National Insurance contributions rise.

Without steps to offset this, people will see a fall in their take-home pay, Spence & Partners' Richard says. But more importantly, he warns that this may be another reason why companies might choose to close the already dwindling number of open final salary schemes, or further water-down benefits.

“I expect to see from 2016, a further raft of scheme closures or benefit reductions as companies get to grips with this,” he says.

This article has been commissioned by retiresavvy and any opinions voiced are the author's own.

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Comments

I'm assuming "New State Pension, which will be worth at least £148 a year" should be per week, at least I hope so or I'm much less prepared than I thought I was! :)
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