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Ask Justin

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How does contracting out affect the flat state pension?

Retirement | Pension Rules Helpful? 10

Asked by savvy3, submitted 26 March 2013.

Open Quote As I understand it, long serving members of company pension schemes (paying lower contracted out NI contributions) who are just coming up to retirement in April 2016 are likely to gain little if any benefit. Particularly relevant for those currently aged around 60/62 at present.

Younger members will be paying higher NI contributions from April 2016 (except members of public sector schemes who I believe will be exempt) but older people will have paid lower rates of NI over perhaps a long period.

Because of the lower NI contributions having been paid, the new pension will be reduced prorata perhaps even
back down to the existing basic SRP figure. Can you please provide more information on this.
End Quote

Answered by Justin on 13 August 2013

Let's start with 'contracting-out'. Before 2012 employees could choose to contract out of the State Second Pension (S2P), the successor to the State Earnings Related Pension Scheme (SERPS). In simple terms, S2P (and previously SERPS) allows you to receive a small National Insurance Contribution (NIC) rebate that must be invested in a pension scheme to potentially provide extra pension income when you retire. The alternative being to remain in S2P and enjoy additional state pension on retirement, dependent on how long you worked and your yearly earnings over your working life.

Whether contracting out was worthwhile depended on pension fund investment performance (after charges!). Needless to say, it wasn't a black and white decision - especially since Governments have a habit of moving the goalposts on these things further down the line.

From 2012 only employees in final salary pension schemes may be contracted out of S2P - and in reality most are since the schemes are automatically set up to contract out. This means employees and employers receiving respective NIC rebates of 1.4% and 3.4% (between certain income limits), paid into the pension scheme. Such employees should broadly enjoy resulting pension income at least equivalent to having remained contracted in to S2P, although the associated guarantee was dropped in April 1997.

Contracting out for final salary pension members will cease with the introduction of the flat state pension in April 2016. So, you're right, affected employees and employers will see their NICs rise by 1.4% and 3.4% respectively from April 2016 with nothing to show for it moving forwards - although some will benefit from a higher state pension under the new proposals than they would have received under the current system.

Non final salary pension employees who chose to contract out of S2P/SERPS in the past will still benefit from any state pension accumulated above the new flat rate as determined via a 'foundation amount' calculation in April 2016.

Their state pension will be based on this 'foundation amount', being the higher of their entitlement under the current system (including any S2P/SERPS) and the below formula based on the new system:

(pre 2016 qualifying years x £144 / 35) less a 'rebate derived amount' if you contracted out of SERPS/S2P at any point. Note the pre-2016 qualifying years are effectively capped at 35 since you can't receive more than £144.

The rebate derived amount is likely to broadly equal the additional pension you would have received had you not contracted out.

But you're right, employees nearing retirement who have contracted out long term are unlikely to benefit from the introduction of the flat rate state pension. The chances are the rebate derived amount will push the above calculation below their entitlement under the current system (probably just the basic state pension), so they'll end up with around the same as they'd get under the current system. Although for each year they work post April 2016 (until state pension age) they could accumulate an extra 1/35th of the flat rate pension, worth £4.11 a week on current figures.

An interesting side issue to all this is what employers with final salary pension schemes will do when faced with extra 3.4% NICs from 2016. You'd expect them to pass on the cost to employees in some way, but rules mean this might not be straightforward. It's especially pertinent to the public sector, where cash strapped government departments and councils will likely wince at the added cost.

Please note this answer does not constitute a recommendation or financial advice and should not be relied upon when making specific investment or other financial decisions. You should always undertake your own research into whether a product or service is appropriate for your needs and, if necessary, use a qualified professional adviser.

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Readers' Comments (1) - To post a comment please register or login .

Comment by savvy3 at 11:36am on 14 Aug 2013:

Thanks Justin.Having been a member of a company pension scheme for about 31 yrs,no longer working and reaching state retirement age in January 2017- guess there may be an option to pay 4 yrs voluntary NI contributions.Will though have to see whether this will be cost effective in due course.