Contracting-out of the State Second Pension
It is no longer possible to contract-out of the State Second Pension (S2P).
Important note
Since 6 April 2012, it has not been possible to contract out of S2P using a money purchase or appropriate personal pension/ stakeholder plan, meaning it was only possible to contract out of S2P using a final salary scheme. Since 6 April 2016, it has not been possible to contract out of S2P using final salary scheme.
The figures shown are those that applied in the year to 6 April 2016 and have not been updated.
The new State Pension replaced the basic State Pension on 6 April 2016.
The State Second Pension (S2P) was the earnings-related state pension that replaced the State Earnings Related Pension Scheme (SERPS) from 6 April 2002. Our analysis The State Second Pension Explained gives full details.
Although contracting-out has ended, periods of contracted-out employment can still affect an individual’s State Pension entitlement under the new State Pension system, including the amount shown on a State Pension forecast. Let’s look at how contracting-out affected different types of plans.
Final-salary scheme
Employees who contracted-out through their employer's final-salary pension scheme received a national insurance contributions (NICs) rebate of 1.4%, that is they paid 1.4% less in NICs than someone who chose to remain in S2P that is, contracted-in. The employer received a rebate of 3.4%. These rebates applied to earnings between the employee's and employer's NI thresholds and the upper accrual point (UAP).
Recognising that S2P had different accrual rates applying to different bands of earnings and that the final-salary rebates didn't take this into account as they were a flat rate, a top up pension was introduced. This top up pension was based on the difference between what each individual would have received under S2P compared to SERPS assuming that they had not contracted-out. It applied to earnings up to the Secondary Earnings Threshold (SET).
Money-purchase scheme (Pre-6 April 2012 only)
The rebate for those who were contracted-out by way of their employer's occupational money-purchase scheme was made up of two parts.
- A flat rate rebate of 3% of NICs, 1.6% for the employee and 1.4% for the employer.
- An age-related rebate paid after the end of the tax year by HM Revenue & Customs' National Insurance Contributions Office (NICO) directly to the pension scheme.
The top up mentioned above for final-salary schemes also applied to money-purchase schemes.
Appropriate personal pension/stakeholder plan (pre-6 April 2012 only)
For those who were contracted-out via a personal pension/stakeholder plan, no flat rate NICs rebate was payable. Employers were also not entitled to any rebate. Basically, an age-related rebate was paid after the end of the tax year by NICO directly to the pension plan. This was based on the actual earnings within each band and the age-related rebate percentage that applied. So, how did you work out what the rebate was?
Step 1 - Determine the age-related rebate percentage
You'll need to have a copy of the rebates that apply at the different ages.
Step 2 - Calculate the earnings that apply in each band (all figures are for 2011/12 tax year)
Band 1 - earnings between the LEL (£5,304) and the LET (£14,400) Band 2 - earnings between the LET (£14,400) and the UAP (£40,040)
Step 3 - Calculate the total rebate payable
Multiply the earnings in each band by the rebate percentage to calculate the total rebate payable.
Here's an example to show how the rebate payable was calculated.
Michael, a mechanic, was age 35 and had earnings of £34,000. He was contracted-out under a personal pension plan for the 2011/12 tax year.
Determine the age related rebate percentage
The age related percentage in each band is 12.6% and 3.15% respectively.
Calculate the earnings that apply in each band
Band 1 - £14,400 - £ 5,304 = £ 9,096 Band 2 - £34,000 - £14,400 = £19,600
Calculate the total rebate payable
Band 1 - £9,096 x 12.6% = £1,146.10 Band 2 - £19,600 x 3.15% = £617.40
Total rebate payable for 2011/12 tax year is £1,763.50.
It is worth noting that tax relief was granted in the personal pension/stakeholder plan in respect of the member's portion of the rebate. This was 1.6%. In our example, the tax relief on the rebate was calculated as shown below.
Band 1 - £1,146.10 x 1.6/12.6 x 20/80 = £36.39 Band 2 - £617.40 x 1.6/3.15 x 20/80 = £78.40
Total tax relief on rebate is £114.79.
Total rebate invested in personal pension/stakeholder plan is £1,878.29 (£1,763.50 + £114.79).
As mentioned, the amount of rebate was based on actual earnings within each band. If an individual earnt less than the Low Earnings Threshold (LET), they would receive a S2P benefit calculated on earnings equal to the LET if they were contracted-in.
So, if they contracted-out and earnt less than the LET, a S2P top up benefit was granted based on the difference between actual earnings and the LET. An example of how this was calculated, assuming earnings are revalued at approximately 2.5% per year, is shown below.
David, age 20, joined his employer's GPP and contracted-out of S2P in the 2011/12 tax year. He had earnings of £12,000 and a working life of 52 years as his State Pension Age is 68. Band 1 (S2P) - £14,400 - £5,304 = £9,096 Actual earnings - £12,000 - £5,304 = £6,669
Assume that the revalued earnings are £29,757 and £21,818 respectively.
Band 1 (S2P) - £29,757 x 40%/52 = £228.90
Actual earnings - £21,818 x 40%/52 = £167.83
Total S2P top up benefit is £61.07 (£228.90 - £167.83).
Note: The S2P top up benefit would be converted into a weekly amount.
Disclaimer
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.