8 November 2010

Contracting Out - Bringing some Clarity

"Contracting out" has been - to many people - a confusing aspect of pensions for a good number of years now. What does it mean, and does it matter?!

What you are contracting out of is the State Second Pension, or S2P, and its predecessor the State Earnings Related Pension Scheme, or SERPS. Those are pension schemes set up by the Government aiming to supplement your basic State Pension in retirement, based on your earnings.

However, many people are not part of that scheme because they have another pension plan which will provide at least equivalent benefits. In return for not receiving that additional pension from the State, your National Insurance contributions (and those your employer pays) are reduced.

And just to add to the complication you are either contracted in or contracted out at any one time, but many people will find themselves switching back and forth as they change jobs or pension plans. So for some of your working years you will find that you have an entitlement to the State Second Pension but for others you won’t.

Most "final salary" or other defined benefit schemes are contracted out. So you won't receive anything from the Government beyond the basic State Pension for the years you were in that scheme.

Where your employer provides a "money purchase" or defined contribution scheme, it’s possible that the whole pension scheme has contracted out or that you may have decided to contract out on an individual basis, while a "group personal pension" or "stakeholder" plan would require you to have made the decision to contract out individually.

If you are not sure whether you are currently contracted in our out you can ask your employer or check your annual statement. Any reference to "rebates" or "protected rights" would indicate that you are contracted out. You can also check by ringing HMRC’s Contracted Out Pension Helpline on 0845 915 0150 - see HMRC Helpline information

Even if you have been contracted out, whether you are now better to be in our out is not a straightforward decision. From 2012 only final salary pension schemes will be able to contract out, so are you better off contracting back in before that? You can make the decision to do so before each tax year, although the decision will not affect previous years.

There are several factors to bear in mind in making the decision:

• If you remain contracted out, your employer or pension plan takes the responsibility of providing the additional pension, either from the employer's scheme or from the investment returns in a money purchase plan - and you may have a view on the risk involved with that

• Contracting back in will increase your National Insurance contributions a little

• The Pensions Advisory Service Contracting Out Planner suggest that you are likely to be better to be contracted in if you are aged 40-45 or older

• You will have more flexibility if you are contracted out - in a money purchase plan you can take up to 25% of your pension plan as a tax-free lump sum after age 55, and contracting out means a higher value in your pension plan, and therefore a higher lump sum

• As well as a lump sum you can take other pension benefits from age 55 out of your own pension plan (boosted by contracting out) whereas contracted in benefits (the State Second Pension) can only be taken from state pension age (increasing to 66 by April 2020)

• Legislation may change that reduces the value of contracted in benefits, whereas contracted out benefits are yours

• Conversely you may end up being better off with the state benefits, particularly if you are responsible for choosing the investment funds and those funds under-perform or have high charges

Here are some further information links:

The Department for Work and Pensions has a leaflet called Contracted Out Pensions available on the Directgov website.

The government-funded information website Moneymadeclear also has a leaflet on contracting out which you can download.

And the government’s Directgov website also has a Guide to Contracting out

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