COMMENT
Are You Part Of The New Billion-Pound Pensions Scandal?

By Alison Hunt (TMFAlly)
August 18, 2005

If you're one of the 7.5 million people who opted out of the State Second Pension you are likely to find a recent report from consumer group Which? very interesting. Essentially, the study has found that, due to high investment charges and poor performance in many private funds, millions of us would have been better off simply staying put.

Most of us know about the Basic State Pension, but in addition to this employed people are entitled to what's known as the State Second Pension (S2P). Introduced in 2002, S2P replaced the State Earnings Related Pension Scheme (SERPS) which had been in existence since 1978. The amount these schemes provide at retirement is based on how much you earn during your working life. And in the same way as for the Basic State Pension, we contribute to S2P via our National Insurance contributions.

Employers with occupational pensions schemes have always been able to remove their employees from these additional state pensions - known as 'contracting out' - provided their scheme provides an equivalent pension. However, since 1988, the Government has allowed those with many personal pensions to contract out too. The purpose of this was for the Government to increase private provision for pensions and reduce reliance on the State. Although the amount of National Insurance contributions payable by those who opted out wouldn't change, the Department for Work and Pensions would pay a contracted out rebate once a year. This rebate would have tax relief added and would be paid directly into your personal or stakeholder pension.

It's always been assumed that the investment returns generated by the rebate would be greater than the pension payments lost by leaving SERPS and/or S2P. Unfortunately, in many cases this hasn't occurred. Many private funds have failed to perform and coupling this with high investment charges means that they have failed to live up to the initial high expectations. In fact, of the £35bn in taxpayer's money that the Government has handed to the pensions industry to invest, around £3bn has been used to simply pay charges.

What's more, rule changes in 1997 resulted in the rebates paid into personal pensions being too little to match the additional state pension payments given up by contracting out. The result of this is that the pension funds of those who contracted out will have to perform extremely well to even match, let alone beat, what's on offer from the government.

It's reckoned that, two thirds (4.5 million) of the 7.5 million people currently contracted out of S2P look likely to end up with less than they would had they stayed in. In fact, those that have opted out and are likely to lose money are likely to receive just 80% of the pension they would have received had they stayed contracted in. And, unsurprisingly it is those approaching retirement (aged over 50) who look set to lose out the most as only one in 22 will get a better pension by contracting out.

So what should you do if you contracted out of S2P and are concerned? Here's some advice from Which?

1. Are you Contracted In/Out?

If you're not sure, give HM Revenue and Customs a ring on 0845 9150 150 to ask (have your National Insurance number to hand). It's worth noting that if you contracted out of SERPS, your contracting out certificate is likely to have automatically been applied to S2P without further paperwork.

2. Pension Forecast

Send off for a pension forecast (form BR19) from the Department for Work and Pensions to find out how much you can expect from your State pension when you retire.

3. Have you lost out?

Give your pension provider a call and ask for a personalised statement. This will compare your projected income from your contracted out personal pension to how much you would have received from staying contracted in. It's worth noting that those who contracted out and are members of a final salary schemes will not lose out as their employers have to ensure that their pension will be at least as good as if they had remained contracted in.

4. Should you remain contracted out/contract back in?

This is a tricky one. Many pension products advisers hold the view that we should not contract out of S2P and that if you have already, you should consider contracting back in. Indeed, if you intend to rely on the government for the bulk of your income when you retire, you should consider contracting back in.

However, if you're comfortable with the risk that you may end up with less than what you would have under S2P, or if the bulk of your retirement provision is through other investments etc, you may feel happier staying contracted out. Additionally, there's also a trust issue. Retirement, for many people, is a long way off during which time many Governments will come and go and we all know that they have the annoying habit of changing their minds and reneging on previous pension promises. There is also likely to be changes to the whole pension system following the ongoing review of the UK pension situation being conducted by the Pension Commission. It is due to make its initial recommendations at the end of November. However, the financial services industry is not without risk too, as those who held their pensions with Equitable Life can verify!

You can find out more at the Department of Work and Pensions website, or about pensions in general in our Pension Centre.