The abolition of contracting-out under defined contribution schemes is likely to take effect from 2012, so it remains an option for the next five or six years. This means the annual ritual of insurers sending contracting-out letters to their direct customers and the latest guidance to advisers will continue as normal. However, this year's guidance is likely to be different from previous years as new rebates came into force from April 2007.
At first sight, the rebates for the five years to 2012, issued by the Government Actuary's Department (GAD), are higher than they were before. So should advisers tell people to pack away as much as possible into their protected rights fund by contracting-out during this period?
Well the GAD report is only one part of the story. The recommended rebates are then subject to agreement by Parliament, and this is where the bad news starts. The cap on rebates has been reduced to 7.4% from 10.5% although the rebates at some earlier ages have risen. In essence rebates remain stingy, making it difficult to recommend contracting-out on a purely financial basis.
Advisers need to take care when documenting any recommendation to contract-out. At most ages, equity rates of return are required simply to match S2P, giving no incentive to give up a guaranteed benefit for one that depends on future investment returns and annuity rates. For example, GAD assumes real rates of return of between 2% and 2.5% are needed to equal S2P. This means that if wage inflation is 4.5%, investment growth of 6.5% to 7%, after charges, is required just to match the state benefits given up.
Many people argue that the Government can and has changed the second tier pension in the past. However, possible future changes should not be the backbone of an adviser's recommendations. Therefore, any decision to contract-out should be client-led. The lure of tax-free cash (which was introduced from A-Day) and greater death benefits will be sufficient incentive for many clients to disregard the financial position. In addition, many people simply do not trust the government to deliver on their promises; for them a bird in the hand is worth two in the bush. The Government is also suggesting making protected rights the same as any other pension money by removing all restrictions from October this year. This will be excellent news for consumers, and greatly simplify pensions by removing complex terms and conditions which are difficult to understand. However, it should not override the financial arguments around contracting-out.
There are some instances where it is clearly not safe to contract-out and these people should be discouraged from doing so. The most likely way of achieving a return of 6.5%-7%, after charges, is to invest in a fund containing a high proportion of equities and property. For those who are risk-averse or who will rely upon state pensions to form a large proportion of their retirement income, the message is simple - contract back in to S2P.
In 2007 the Financial Services Authority (FSA) took a very close look at contracting-out cases from the late 1980s and early 1990s. They were concerned about people who were contracted-out above the pivotal ages. Expect the FSA to retain a keen interest moving forward.
Advisers should make sure that they take positive action with clients aged over 43, who are likely to be worse off financially if they remain contracted-out. Even if a client decides to stay contracted-out, advisers should obtain the client's written instruction documenting their insistence.
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First mentioned in Cridland Report
Second acquisition of 2019