Home > News > 2000 > February 2000 > DSS Consultation: Contracting out of the State Second Pension
DSS Consultation: Contracting out of the State Second Pension
For further information, please contact Louise Witts at the Leeds office.
Introduction
On 29 November 1999 the DSS issued a consultation paper setting out the Government's proposals for the structure of National Insurance rebates for contracting-out of the Second State Pension (S2P). S2P is due to replace the State Earnings Related Pension Scheme (SERPS) with effect from April 2002.
This article sets out a summary of the proposals together with some comments from Barnett Waddingham. Our comments are intended to incorporate the impact of the proposed changes for employers.
The DSS's consultation paper can be found on www.dss.gov.uk/hq/pubs/strucpen/. For a copy of the Barnett Waddingham's response contact either Louise Witts at the Leeds office or your usual adviser.
Outline of S2P
The proposals for S2P were set out in the Green paper issued by the Government in December 1998 and are as follows.
S2P will accrue in three bands;
- for earnings below £9,500 pa; 40% of £9,500 pa less the Lower Earnings Limit (LEL) is accrued
- for earnings between £9,500 pa and £21,600 pa, 10% of these earnings is accrued
- for earnings between £21,600 pa and the Upper Earnings Limit (UEL), 20% of these earnings is accrued
The Lower Earnings Limit is currently £3,432 and the Upper Earnings Limit is £26,000. All of the limits above are intended to move in line with earnings.
These accrual rates give the maximum pensions that may be accrued at retirement with S2P intended to be the same as SERPS above earnings of £21,600 pa. To shown the interaction between the Basic State Pension (BSP), SERPS and S2P in current earning terms a comparison is shown as follows:
Government Proposals for the Structure of Rebates
Currently it is possible to contract out of SERPS through an occupational pension scheme or, individually, through an appropriate personal pension. One of the government's primary aims is to encourage private pension provision and so it is key for it to be able to offer the ability to contract out of S2P. However the structure of S2P makes the issue of rebates more complicated than currently.
The consultation paper considers in detail how to structure the rebates for contracting-out of S2P. It considers the issue individually for each of the three parts of S2P, namely:
- Low Earners: the rebate relating to earnings between the LEL and £9,500;
- Moderate Earners: that relating to earnings between the £9,500 and £21,600;
- High Earners: that relating to earnings between £21,600 and the UEL.
Our responses to each proposal are shown in bold italics.
Low Earners
The paper assumes that rebates will continue to be offset from National Insurance contributions and consequently will be based on actual earnings, even for those earning less than £9,500 pa. The paper suggests that, where earnings are below £9,500 pa, the top-up to benefits should be provided in S2P rather than in the contracted-out arrangement. In other words a person earning £5,000 per annum will be able to contract out of S2P for benefits between the LEL and £5,000, but will continue to earn benefits in S2P on the remaining £4,500.
The aim is to prevent a situation where a member would be better off by not joining an occupational pension scheme but instead remaining contracted in.
We agree that this is the most sensible solution.
We do not believe there is a practical alternative way of providing the "top up" from a defined benefit scheme that will ensure the resources are properly targeted at the lower paid.
The alternative that the extra rebates could be paid by the government to a defined contribution arrangement is not considered in the paper. We believe that it would be possible for an extra rebate to be paid annually to a money purchase add-on (similar to current AVC arrangements). Paying the extra rebates annually rather than monthly would help to increase the size of the contributions. However we understand that the amounts of money involved are likely to be small per person and so we expect this would still be too complex to administer and too expensive compared with providing a top up from S2P.
Overall we support the government's proposal for Low Earners, particularly for contracting out through final salary schemes.
Moderate Earners
People earning between £9,500 pa and £21,600 pa caused the government most problems and so two alternatives are presented in the consultation paper. As this is key to their proposals it is discussed in greater detail in the Appendix to this article. However essentially the alternatives are:
- to increase the rebate in respect of these earnings. In exchange, defined benefit pension schemes would need to provide extra benefits in return for the higher rebate;
- to instead provide an additional top-up via S2P (to reflect the fact that up to £21,600, the overall accrual is greater than 20%). Under this scenario, rebates would stay at their current level.
We have a strong preference for the second option over the first option.
Depending on the relative levels of the rebates, both of the options could be described as "fair". However, the second approach is more consistent with the flat rebate/S2P top-up suggested for earnings up to £9,500. It is also administratively more straightforward. The only disadvantage is that it would leave slightly more pension provision in the public sector.
We believe the approach set out in the first option could be so difficult to operate as to be extremely damaging.
Read more about Moderate Earners in the Appendix below.
High Earners
No changes are needed (or planned) for rebates or required benefits on earnings between £21,600 and the UEL.
We agree that no change is needed for High Earners.
Barnett Waddingham's Conclusion
We believe that the ability to contract out of S2P is fundamental to the government's aims. However the system for contracting out needs to be simple and workable as otherwise companies and personal pension providers will not choose to adopt it.
We believe that the proposal to top up pensions for the lower paid through S2P is practical and fair.
We believe that the proposal to, in some way, target extra rebates for the moderate earners is not practical. Benefits in respect of this will need to be provided from S2P.
We believe the second option for moderate earners does achieve two of the government's main aims, by targeting resources on the lower paid whilst not adversely affecting occupational schemes.
However we believe that the government should consider the effect on scheme design of these changes. The government should remember that employers can choose to contract back in. Any proposal that is difficult to administer may well result in schemes contracting back in, or even choosing to close rather than to undergo the large costs and difficulties associated with scheme redesign.
Appendix - Moderate Earners In More Detail
The concern is that the target benefit is a different percentage of earnings for each level of earning. For a person earning £10,000 per year the S2P benefit would be 25% of their total earnings, whereas for a person earning £20,000 per year the S2P benefit would reduce to 17%. This makes it difficult to come up with a smooth simple structure for contracting out that means both the rebates being paid and the benefits being granted reflect the S2P benefits being given up.
As mentioned above the government has taken the unusual step of issuing two alternative proposals for moderate earners in its consultation document.
Proposal 1
The first proposal is that the NI rebates would vary to reflect the S2P benefits. This however brings a large number of administrative concerns.
The paper suggests that the rebate could be related to the earnings bands of individuals. This would be complex to administer, especially given how the earnings for an individual can fluctuate during a year. It is not clear who will be calculating these rebates, nor at what stage in the year they will be calculated. In our view this would not be practical.
A major concern highlighted by the government is the difference between early leavers and "stayers". It is not clear how this could be resolved under their proposal. One suggestion included is to impose different revaluation on part of the pension between leaving service and retirement - in effect reverting to the Guaranteed Minimum Pension (GMP) idea recently abolished. This is fraught with problems, but if no extra revaluation is imposed then an early leaver may well lose out by contracting out.
If benefits for early leavers are revalued each year in line with National Average Earnings this may make them more valuable than those earned by the stayers whose earnings have gone up slower than National Average Earnings. By definition half the workforce's earnings should go up more slowly than National Average Earnings making this a significant concern.
Overall different revaluation causes a significant increase in administration time, complexity and costs.
Currently schemes which wish to contract out of SERPS have to satisfy a minimum benefits test, called the reference scheme test. As an alternative to different revaluation the government also considers amending the reference scheme test to solve the problem of early leavers, which we believe to be a preferable option. However it is not clear how this would work in practice to ensure additional benefits in respect of additional rebates. In particular it would be hard to do this in such as way as to ensure the member does not lose out on contracting out, whilst not imposing any extra costs on the company.
Proposal 2
The second proposal put forward is that a top up should be provided through S2P for the moderate earners.
We feel this would eliminate any new problems of comparative value for leavers and stayers as described for proposal 1.
This is also more consistent with the flat rebate/S2P top-up suggested for earnings up to £9,500. It is also administratively more straightforward. The only disadvantage is that it would leave slightly more pension provision in the public sector.
For further information, please contact Louise Witts at the
Leeds office.
Louise Witts, February 2000.