COMMENT
The Next Mis-selling Scandal?

By Alison Hunt (TMFAlly)
November 16, 2005

A few months ago I wrote about the possible problems related to contracting out of the State Earnings Related Pension Scheme (SERPS). Which? carried out a study into the effects on retirement income of contracting out of SERPS, or the State Second Pension (S2P) as it's now known, and the results were quite interesting. Essentially, due to high investment charges and the poor performance of many private funds, a large number of the 7.5 million people who chose to contract out of SERPS/S2P would have been better off staying put.

The SERPS pension scheme was introduced in 1978 and was replaced by S2P in 2002. It's essentially an additional State pension scheme that employed people are entitled to, and in the same way as for the basic State pension we contribute to it through our National Insurance contributions. The amount we receive at retirement therefore depends on how much we've paid in over our working lives.

However, in an attempt to increase private pension contributions and reduce reliance on the State, the Government has allowed those with personal pensions to "contract out" of the SERPS/S2P scheme since 1988. Although National Insurance contributions remain the same, anyone who chooses to contract out will have a rebate (with tax relief added) paid into their personal or stakeholder pension each year.

Unfortunately, although contracting out seems like a good idea in principle, Which? found that over two thirds of those who have done so (around 4.5 million people) will actually end up with less than they would have had they stayed in the scheme. And for those aged fifty and over, only one in twenty two were found to be better off by contracting out.

Interestingly, contracting out is back in the news this week as, following an 18-month battle, one pensioner has won his case against Prudential (LSE: PRU) for mis-advising him to contract out of SERPS back in 1980, which he claims has resulted in his retirement income being around £200 less each year than if he'd remained in the Government scheme. Despite the fact Prudential initially dismissed the claim, arguing that the risks associated were fully explained at the time, the Financial Ombudsman ruled in the claimants favour, causing the insurance company to review the case. It has now agreed to pay back the shortfall, in full. What's more, the complaints-handling firm that took on this case believes that it is by no means unique and may "open the floodgates to millions of similar claims".

Of course, in the cases where risks were not adequately explained and false claims made then the case for mis-selling is strong. However, those that did understand the risks involved would be well aware that investment can go down as well as up. Would they feel differently about having contracted out if their stock market returns over the last ten years or so had been good?

The decision whether or not to contract out of (or contract back into) S2P is certainly not an easy 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. You really need to think about your own attitude to risk. And if you intend to rely on the Government for the majority of your income when you retire you should definitely stay contracted in. If you're concerned, here's some advice from Which?

1. 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 State pension forecast from the Department for Work and Pensions to find out how much you can expect.

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.

Remember, too that if your retirement is a long way off you will see many Governments come and go, and many policy changes and broken pension promises. Also, remember to consider your retirement plans - if you intend to emigrate to a non-EU country you may find your State pension will remain frozen from year to year anyway, so contracting out and paying a bit more into your personal pension may be a better option for you.

Find out more in our Pensions Centre.