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Second State Pension and Contracting-Out from April 2002
Andrew Twells looks at the Government's new Second State Pension and the proposed changes to the terms for contracting-out in the UK.
From April 2002, changes will be made to both the additional state pension (currently known as the State Earnings-Related Pension Scheme or
SERPS) and the terms for contracting-out.
Under
SERPS, employees currently accrue a pension of 20% of their revalued Band Earnings over their working lifetime. Band Earnings are earnings between the Lower Earnings Limit (LEL) and Upper Earnings Limit (UEL). For the 1999/2000 tax year, these figures were £3,432 per annum and £26,000 per annum. The LEL will also be known as the Qualifying Earnings Factor (QEF).
A person's working lifetime is defined as the number of years between his or her 16th birthday (or 6 April 1978, if later) and state pension age, which is 65 for men and currently 60 for women, with this rising to 65 between 2010 and 2020. Under this definition, older people currently have a shorter working lifetime for the purpose of
SERPS, and therefore the rate at which they accrue their
SERPS benefit (the "additional pension accrual rate") is greater than that of a younger person.
From April 2002,
SERPS will be replaced with a second state pension known as S2P. This will provide bigger pension benefits than
SERPS currently does. The main differences are as follows:
- 3 accrual rate bands will be introduced. There will be a 40% accrual band for earnings between the QEF and a Lower Earnings Threshold (LET) of £9,500 per annum in terms of 1999/2000 earnings. A 10% accrual band will be introduced for earnings between the LET and a figure equal to 3 times LET minus 2 times QEF - this figure would be £21,600 per annum in terms of 1999/2000 earnings. The third band would be a 20% accrual band and between 3 times LET minus 2 times QEF and the UEL.
- Members who earn between the QEF and the LET will be treated as if their earnings were equal to the QEF. In addition, qualifying carers and people with long term disabilities who have no earnings or earnings below the QEF will be treated as if they had earnings at the LET.
The chart below illustrates the pattern of benefits which will accrue under S2P compared with SERPS. Benefits for members earning above 3 times LET minus 2 times QEF will remain unchanged, however S2P will provide greater benefits for lower earning people.
Contracting-out
People who are contracted-out of
SERPS via an occupational pension scheme or personal pension accrue no
SERPS benefit, and the Government pays a National Insurance rebate ", either to the member's pension fund or to the member and employer via reduced National Insurance contributions.
Contracting-out will remain possible under S2P, however the benefits given up and the National Insurance rebates will be calculated slightly differently:
- Under an occupational pension scheme (either final salary or money purchase), the National Insurance rebates will continue to reflect the current SERPS accrual rate. Members' S2P entitlement will be reduced by an amount equal to their current SERPS entitlement. Members earning below £21,600 (in terms of 1999/2000 earnings) will receive a second state pension top-up from the National Insurance Fund when they reach State Pension Age, based on the difference between SERPS and S2P. This means that there should be no need for employers to change the design of these schemes.
- Under a personal pension (or stakeholder pension), the National Insurance rebates will reflect the increased S2P accrual rates. However, they will be based on actual earnings, and the S2P given up will also be based on actual earnings. Those members who earn below the LET (£9,500 per annum in 1999/2000 terms) will receive a second state pension top-up from the National Insurance Fund.
The chart above also illustrates the reductions in benefit for contracted-out employees.
Changes to the assumptions used to calculate contracting-out rebates
At the same time, in April 2002, the Government Actuary will be changing the actuarial assumptions used to calculate the National Insurance rebates for contracted-out members. The aim in constructing a scale of National Insurance rebates is to ensure that, as far as possible, contracted-out members' expected benefits from their money purchase fund or personal pension equal the state benefits given up.
It is recognised that there will be winners and losers: some contracted-out members will be better off than under the state scheme and others will be worse off depending on a number of factors, for example the investment return that their pension fund achieves.
The Government Actuary has made a number of changes to the actuarial assumptions, most importantly:
- The mortality assumption has been changed to reflect recent improvements in mortality and the fact that pensioners are living longer than ever before.
- The investment return assumption, both before and after retirement, has been reduced to reflect the fact that real interest rates are lower than they were five years ago.
- Minor changes to other assumptions, such as the expense loading, have been made. These are less significant changes.
These changes are needed because pensions are now more expensive to provide than has previously been the case, and the changes therefore increase the National Insurance Rebates payable. An example of the changes is given below:
NI Rebates - Occupational Money Purchase Pension scheme
| Age |
Current rebate 2001/2 |
Proposed rebate 2002/3 |
| 20 |
2.4% |
2.7% |
| 30 |
3.0% |
3.6% |
| 40 |
3.8% |
4.4% |
| 50 |
8.4% |
9.0% |
The comparison is slightly distorted at older ages because of reductions in additional pension accrual rates. There would be a similar increase in the rebates to personal pension schemes.
In the case of final salary schemes, the rebate is not age-related but a flat rate based on the average age-sex profile of final salary schemes. The current rebate is 4.6% of band earnings and the proposal is to increase this to 5.1%. Part of this change is due to the changes in actuarial assumptions mentioned above, and part is due to changes in the average age-sex profile (a slightly greater average age and a greater proportion of women) and the changes in additional pension accrual rates. It is not known how the rebate would be split between the employer and employee (at present, the employer receives a 3.0% rebate and the employee 1.6%).
At present, these National Insurance Rebates are just proposals, and there is a period of consultation before a final set of rebates is agreed and implemented.
Andrew Twells, November 2000.