The State Second Pension

The Basic State Pension replaces your lowest slice of income. Depending on how much you've earned over the years, you may also qualify for the State Second Pension (S2P).

Prepare to be baffled though as S2P is possibly the most ridiculously overcomplicated benefit on the face of this planet. It was introduced in 2002, replacing a similar system called the State Earnings-Related Pension Scheme (SERPS). Both allow you to build up an additional state pension, depending on how much you earn and how much Class 1 National Insurance Contributions you pay. Note that self-employed workers do not pay this type of national insurance and, therefore, are not entitled to SERPS or S2P.

S2P enables workers on low and moderate incomes to build up a bigger pension than they would have earned under SERPS. Most people earning under around £28,000 a year are better off under S2P, as are people with interrupted work records, including carers, disabled workers and parents of young children but higher earners are slightly worse off.

The contracting out conundrum

S2P is compulsory for all employees, except for those workers who decide to 'contract out'. If you contract out the government pays you a rebate each year. This rebate has to be invested with a pension or insurance company (or into a company pension scheme), and the intention is that it will eventually produce a similar pension income than S2P would provide. Of course your investments could do worse than average meaning that your pension income lower than it would have been under S2P.

These days it's very hard to make any sort of sensible decision of whether it makes sense to contract out. Rebate levels have been reduced in recent years, lessening the attractiveness of contracting out. Essentially, your decision is governed by three main factors:

1. Your age. The younger you are, the longer your invested rebates have to grow and, therefore, the greater their potential for growth. Very roughly speaking, once you're over 45, contracting out becomes less attractive.
   
   
2. Your salary. The more you earn, the more attractive it is to contract out. Conversely, low-paid workers will usually benefit from remaining in S2P.
   
   
3. Future investment returns. Over periods of twenty years or more, investing in shares is likely to produce superior returns than putting your money in cash or bonds. Hence, if you're not comfortable with stock-market risk, contracting-out probably isn't for you.

So, if you're a fairly young, above-average earner and a great believer in the stock market for long-term investing, contracting out may be right up your street. However, if you're over fifty, on a modest wage and wary of investing in shares, contracting in is certainly your best option. For everyone else in between, the calculation is fiendishly difficult!

Your decision to contract out should be reviewed every few years at least. It's important to note that if you've contracted out of SERPS and never contracted back in, you won't be in S2P. Note that signing a single form back in the 1980s or 1990s could mean that you're still contracted out today - even if it's not in your interests to be so!

The decision to contract out has become so difficult that a few pension companies have refused to give advice on what people should do. There are a growing number of cases of mis-selling, where people have been encouraged to opt out of SERPS/S2P, despite it not being in their best interest. One case involved a pensioner who reckoned that his retirement income was £200 a year lower for each year he had been contracted out. A recent Which? study suggested as many as 70% of people who had contracted out would receive a lower pension than they would have done under S2P.

In part, such situations are due to actual investment returns being lower than previous projections, which were far too optimistic. Also, old-style personal pensions carry a bewildering array of charges, which decrease investors' returns and, in some cases, mean no growth over several years. Plus it's reckoned that the current rebate levels set by the government are too low.

If you do decide to contract out, make sure that you shop around for a Stakeholder pension provider with low charges. Old-style personal pension plans levied extortionate charges, which made contracting out far less attractive. Thus, if you have directed - or continue to pay - rebates into any old-style pension plans, it may be in your interest to switch these to a low-charging modern plan.

Note that if you're a member of an occupational pension scheme (one run by your employer), the entire scheme has to be contracted in or contracted out. However, you can make an individual decision to contract out even if you're a member of a company scheme, but it's down to you to make the arrangements yourself.

How much do you get?

From April 2005, the maximum SERPS/S2P pension payment you can receive is £143.08 a week, just under £7,500 a year. Most people get far less than this though. The average weekly payment at the moment is just £12.

The maximum weekly payment relates to your own SERPS/S2P payment plus any that you may have inherited from your spouse if they've died. It used to be case that you inherited up to 100% of your spouse's SERPS payments, but this rate has been reduced for those whose partners died after 5 October 2002 and who had not yet reached State Pension age. Now you receive a maximum of between 50% and 90%, depending on when your spouse was born and subject the weekly maximum of £143.08.

It's worth noting that the maximum S2P payment people working now are accruing is calculated upon £110 a week or £5,700 a year, i.e. quite a bit less the currently weekly maximum payment. So it's a good idea to get a State Pension forecast to see what you might be entitled to, especially if you're close to retirement and/or have little in the way of non-State pension provision.

If you're interested in finding out more information on all the various types of State Pension, the Pension Service site has a 100+ page pdf file with all the gory details.

The future of S2P

The future of S2P is very uncertain at the moment. The recent Pensions Commission report made a number of recommendations that would reduce its significance, such as the abolition of contracting out for people in personal pension schemes and defined contribution company schemes. They also suggest the earnings-related element of S2P is reduced, in favour of a flat-rate scheme. It remains to be seen whether the government will implement these recommendations, but it does seem likely that S2P will become less valuable to pensioners in future.