You are playing Who wants to be a Millionaire? and have reached £64,000 winnings. If you get the nex...
You are playing Who wants to be a Millionaire? and have reached £64,000 winnings. If you get the next question right you will have £125,000, but if you get it wrong your winnings will fall to £32,000. You have no idea of the answer, but have gone 50:50 and so have a one in two chance of guessing correctly. Do you make that guess or walk away with the money you have?
That situation is similar to the one faced by those considering contracting out of the State earnings-related pension scheme (Serps) using a personal pension. While the issues are more complicated, history suggests that there is a good chance of contracting-out producing a large gain compared with Serps but also a significant possibility it will lead to a large loss.
A mathematician would say that you should guess your 50:50 question because, on average, you will end up with £78,500 (the average of £125,000 and £32,000) and possibly more if you get subsequent questions right. In practice, though, a lot of people choose to walk away with the £64,000 rather than risk some of their existing winnings.
The numbers generally stack up to support contracting-out, but before choosing that option a client must understand and be willing to accept the risks involved. Here, we will attempt to quantify the potential gains and losses from contracting-out, but first it may be helpful to summarise how contracting-out works.
There are three methods of contracting out. The salary-related basis can be used by occupational schemes whose benefits match a 'reference scheme' for at least 90% of employees. In broad terms, the reference scheme provides about 1.16% of final band earnings for each year of contracting-out, averaged over the last complete three tax years of employment.
Band earnings are those between the lower and upper earnings limits (currently £67 and £535 a week respectively). For contracting-out on this basis, employers currently receive a National Insurance rebate of 3% of band earnings, and employees 1.6%. If clients have the opportunity to join such a scheme, it is usually best to do so.
Alternatively, occupational schemes can contract out on a money purchase basis. The immediate rebate is then 0.6% of band earnings for the employer and 1.6% for the employee, with an age-related top-up payment of up to 6.8% from the Government after the end of the tax year.
The rebates are lower than for personal pensions because there is a much smaller allowance for charges. So, in practice, it is often better for money purchase schemes to provide contracted-in benefits only, leaving individuals with the option of contracting-out on a personal pension basis.
Contracting-out is also available through an appropriate personal pension (APP). Here, a rebate of currently between 3.8% and 9% of band earnings is paid to the scheme by the Inland Revenue after the end of the tax year. Basic rate tax relief amounting to about 0.45% of band earnings is added on top of this, regardless of the individual's tax position.
Next we will look at personal pension contracting-out, which will also be the basis used for the majority of stakeholder schemes from April.
The financial issues
Contracting out of Serps means giving up a pension guaranteed by the State for one that depends heavily on investment returns and economic conditions when you retire.
The relationship between these two elements is crucial in assessing the viability of contracting-out, because even if the returns are excellent before retirement, the client could lose out if annuity rates are poor at retirement.
Contracted-out pensions must increase in payment at least with limited price indexation (LPI the lower of price inflation and 5% a year). However, Serps pensions consider an RPI-linked annuity. The yield on index-linked gilts that insurance companies use as the main investment for such annuities peaked at about 4.8% in 1992, but have recently been below 2%. This means that RPI-linked annuities have become much more expensive.
Yields could increase again (especially if the minimum funding requirement for final salary schemes is changed or scrapped), but it is wise to consider a range of possible scenarios.
Table 1 shows the pre-retirement investment return needed to gain from contracting-out in tax year 2000/2001 for different current ages and assumed index-linked gilt yields. It uses the same assumptions on charges and mortality as the Government Actuary did in his recent report on contracting-out, including a stakeholder-style 1% annual management charge.
The table shows that pre-retirement real returns of 2% to 3% are needed to match the Serps pension, and that the impact of changes to the yield at retirement is greatest for those currently closest to retirement.
We can then consider the likelihood of achieving the return required. The best guide to that is historical investment returns, although, as always, these need to be treated with caution when used as a guide to the future.
Table 2 summarises the range of 'real' (above NAE) returns over periods of 20, 30 and 40 years between 1918 and 2000. These periods correspond to the time until they reach State pension age for the 45, 35 and 25-year-olds in Table 1. We have assumed 80% investment in equities and 20% in gilts, which is similar to most managed and with-profits funds.
On this evidence, there appears to be a good chance of at least matching the 23% yearly return needed to justify contracting-out. In fact, if the index-linked gilt yield at retirement was 2.5%, the average gain over each of the terms to retirement would be more than 50% of the Serps pension.
At the same time, it must be recognised t
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