Contracting-out and the new state pension

Published by Malcolm McLean on

The part of the new state pension scheme that seems to attract most criticism from those affected is the deduction they are told has to be made to the starting level of their pension in its first year (2016/17) to take account of past periods of contracting-out.

"There are potential heavy costs for the government here, with thousands of public sector workers with DB pensions who have a current job retirement age of 60."

After all, they complain, wasn't the new state pension supposed to be a flat-rate amount of £155.65 per week for everyone who had at least 35 years of national insurance (NI) contributions?

If that were completely true then it would seem there are a lot of people missing out; it is estimated that there are about 1.5 million individuals who will reach pension age in the next ten years who will get less than the full rate, even if they have 35 years or more NI contributions.

But things are not quite what they seem.

A level playing field?

The transitional arrangements actually expose a surprising generosity towards members of contracted-out defined benefit (DB) schemes (mainly in the public sector) compared to those in other schemes who didn't contract out and spent the bulk of their career paying into the state second pension (formerly SERPS) instead.

To understand why this is, we need to look at exactly how past periods of contracting-out are treated in the process of moving from the old to the new schemes.

How it works

First of all, everyone under state pension age with a pre-6 April 2016 record of NI is given a starting level figure for the new pension at that date.

The contracting-out deduction is then a one-off deduction made against what would have been their entitlement under the new scheme rules, as if those rules had been in existence throughout.

The deduction cannot, however, reduce their starting figure below what they would have received at that stage under the old basic state pension scheme rules. For example, someone with 30 or more years of contracted-out NI behind them would normally be guaranteed a starting level at the full current basic state pension rate of  £119.30 a week.

The rationale for the deduction is that they had been allowed to pay lower NI contributions and receive a Guaranteed Minimum Pension with their occupational scheme, or, in the case of an approved personal pension plan, a cash rebate paid directly into their pot.

Receiving the benefit twice . . .

As these concessions were in lieu of the state second pension which effectively is now part of the new state pension they couldn’t expect to receive an unreduced new state pension and thus, as it were, receive the benefit twice.

However, in reality many will have the opportunity to benefit twice. Assuming they still have a few years ahead of them before they reach their state pension age, they can claw back the reduction and increase their pension up the full £155.65 'flat-rate' by simply continuing in work and making NI contributions to secure the additional qualifying years needed – even if in total that takes them above 35 years.

Alternatively even if they have retired early from work they may be able to claim NI credits or purchase on very cost-effective terms voluntary NI contributions to achieve the same result.

A big bill for the government?

There are potential heavy costs for the government here, with thousands of public sector workers with DB pensions who have a current job retirement age of 60. They will now be able to increase their state pensions up to the full rate at their state pension age of 65 or 66 by making voluntary NI contributions at subsidised cost.

In contrast, for older workers with little or no contracted-out pension service, their joint basic and state second pension entitlements will often produce a starting level for the new pension at 6 April 2016 at, or slightly higher than, the flat-rate figure of £155.65.

They will not be allowed to increase this further despite still being liable for full rate NI contributions while continuing to work through till state pension age.

On this basis it does appear that the playing field between contracted-out and contracted-in schemes is not a level one, and  if anyone it is those who have contracted-in, not those who have been contracted-out, that should be complaining loudest about unfair treatment.

This article originally appeared in Professional Pensions


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