Despite the adverse comments on the reduced level of National Insurance rebate, clients should still consider contracting out of S2P
Clients could be forgiven for overlooking their state pension but they shouldn't miss out on a benefit paid for automatically through their National Insurance Contributions (NICs).
Recent commentary from actuaries on the relative merits of contracting out of the Second State Pension (SP2) has generally given it the thumbs down, while insurance companies anxious to avoid yet another potential mis-selling scandal have rushed to contract clients back in.
But this is not a simple number crunching exercise, as the actuarial consultants themselves admit. Nor should clients be intimidated by warnings from life offices whose chief motive is to be seen to be doing if not right thing, then the least controversial.
This is despite a strong message from the Government that it is keen to the point of obsession to shift the bulk of the state pensions burden to the private sector. While it has not yet reneged on any accrued rights to state benefits, like any investment we cannot judge the future on past performance.
Without doubt this is a difficult issue on which to advise as the value of an individual's state pension is based on a very complicated, constantly changing, set of calculations as well as the individual's National Insurance Contribution (NIC) record. Getting accurate information is an obstacle in own right. Until recently the National Insurance Recording System was struggling with a seven-year backlog of data although it now claims this that the problems are 'all but sorted out'.
The state pension has two elements - the basic pension, which is a flat rate, and a second pension, which currently is linked to a slice of earnings but at some as yet unknown future date will also convert to a flat rate. When this happens it is not clear whether S2P will be combined with the basic flat rate pension or whether there will be two flat rate benefits. On top of this uncertainty, the state pension interrelates with the loathed means-tested pension credit, which, ridiculously, will apply to over half of the retired population.
'In the whole of the UK, no more than a handful of civil servants understand S2P, or that mother of all complexity ' the means-tested pension credit,' bemoans John Shuttleworth, partner with PricewaterhouseCoopers.
The earnings-related pension was known as Serps (State earnings related pension scheme) until April 2002 year when it was replaced with the new but equally complicated S2P. Serps' benefits were originally based on 25% of the best 20 years' earnings but this formula was changed to 20% of lifetime earnings, rendering the calculation impossible for all but the most skilled mathematicians. As with its predecessor, individuals can contract out of S2P either through an employer's pension scheme, a stakeholder scheme or a personal pension. In this case the Department for Work and Pensions pays a NICs rebate to the private pension plan or scheme. (For occupational schemes the system is different in that a reduced rate of NIC is paid for contracted out members and the difference paid directly into the scheme.)
There are two issues to consider with contracting out. Number crunchers argue that the main point in taking this step is to build up a better pension, based on stock market returns and annuity rates, than the state scheme provides. On current assumptions the general consensus is that most people are better off staying in the state scheme.
'If they are not contracted out then we would recommend clients stay put,' said John Lawson, senior technical manager at Standard Life. However, even based on number alone, the decision may be less clear-cut where clients have already paid to set up a contracted out personal pension.
'People who have already built up a fund through the rebates may benefit from staying contracted out until they are in their late 40s or early 50s,' Lawson explained. At this point, no matter how you do the sums, the level of the rebate does not reflect the value of the state pension given up.
So once clients reach a pivotal age should they automatically rejoin? There are various 'soft' issues to consider here. First, if the client is keen to take control of the entire pension there is an argument in favour of remaining contracted out in order to be able to make the investment decisions. The downside here, of course, is that current market conditions are anything but favourable, while S2P does at least offer a link to earnings inflation, albeit only on a small tranche of actual earnings.
The second point relates to the uncertain future of S2P. Leading industry bodies and think tanks, including the National Association of Pension Funds, the ABI, and the Institute for Public Policy Research, have called on the Government to scrap this benefit altogether, along with the deeply unpopular minimum income guarantee and the pension credit.
If the Government is looking for an excuse to simplify the state pension system by shutting down the S2P then it has one ready-made. Whether it would take the full argument on board and increase the flat rate basic state pension is another matter. As recent consultation papers have demonstrated, the Government's selective hearing is a problem with any reforms to the pension system, private and state.
Along with calls to scrap S2P are arguments in favour of raising the state pension age ' possibly to 70. So far this has been rejected but it is a decision that most Western governments will have to face over the next few years as they fail to reconcile their massive state pension deficits with the ageing population.
In conclusion there are no easy answers here. However it is important to consider the client's views on the future of S2P, the trustworthiness of the present and future governments not to introduce retrospective benefit changes by sleight of hand, as well as the value of the rebate compared to the S2P benefits given up. Older clients who will be retiring within the next few years may well do better to stay in the state scheme but younger clients may prefer the level of control conferred by contracting out rather than to rely on a chameleon-like state system run by a chameleon-like government. After all the fancy calculations your client may well base the decision on the old adage about a bird in the hand.
The decision to contract out is not just based on the rebate terms but is also a question of trust in the Government not to make retrospective changes.
The complexity of the calculations to assess an individual's prospects are beyond the scope of all but the actuarially trained.
The Government may still yield to pressure to scrap S2P altogether or combine it with the basic pension when it becomes a flat rate benefit.
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