FOOL'S EYE VIEW
SERPS – Disease or Pension?

By James Carlisle
March 15, 2002

Fulham -- There has been a lot of talk about something called SERPS in the press lately. Not in the medical section, as you might imagine, but in the financial pages, because SERPS is not a type of disease, but more a type of pension. It is, though, hard to be sure about that. Certainly too much thinking about it can make you ill.

What is SERPS?

The basic idea is relatively simple. You pay National Insurance contributions out of your earnings and, in return and so long as you've paid enough over your working life, the Government will give you the Basic State Pension. That amounts to £72.50 a week at the moment, but it goes up to £75.50 in April.

Beyond that, you can either pay extra National Insurance contributions to the Government, and they'll give you a top-up pension (currently known as SERPS – 'State Earnings Related Pension Scheme'), or you can have those extra National Insurance contributions paid into your company pension (effectively) or personal pension, making them that much bigger but, at the same time, reducing your entitlement to the state's top-up pension.

If you go for the second option, it's called 'contracting out'. If you stick with the State top-up pension, then you're 'contracted in'. Each year, you can change your mind about whether to be contracted in or out. You start your working life contracted in. If you're self-employed, by the way, then your National Insurance works differently. You don't get to build up your entitlement to SERPS and you're not able to contract out (so this doesn't affect you and you can go back to doing the crossword). 

A Three Pipe Problem

That's not so bad. Now I just have to tell you which is better and we can all go home. Sadly not. After all, if one option was always the best, then there wouldn't be much point in having the second option. As ever, whether or not contracting out makes sense depends on your own circumstances and reading of the tea leaves. Much of the recent press has revolved around various pension companies advising many of their customers to contract back into SERPS, because they are finding it harder and harder to do the sums and because investment returns are expected to be lower in future so it is less clear that contracting out will provide you with more money. Each year the 'should I contract out' question might get a different answer - especially if your somewhere near the 'middle' on the age front.

To confuse matters further, there have been a few rule changes recently and there are about to be more as the State's top-up pension changes from being 'SERPS' to the 'State Second Pension' (at least it has a more friendly name). The details of the State Second Pension are still being hammered out, but the idea is that it will be more generous to people earning below about £9,000 per year (and quite probably a little less generous to those earning more).

As Sherlock Holmes would say, it's a 'three pipe problem'. Even the best actuary in the world will struggle to answer it because of the 'rules change' and 'investment assumptions change' parameters. All people can give is a decent guess and you'll see new guesses quite regularly. Not only that, but where the decision is hardest, it makes less of a difference anyway. So I'd say that it's one of those areas where paying for advice is likely to be counter-productive.

So What Should The Ordinary Fool Do?

If you're part of a company pension, then the company pension people should have actuaries that are good at working this sort of thing out. Generally you can assume that your employer is trying to do its best for you (and your fellow employees), so it makes reasonable sense to go along with what they decide or suggest on contracting out. It's worth speaking to the payroll people at work (or whoever else looks after pension matters), though, to find out where you stand and what the policy is.

If you don't have a company pension, then the question is whether to contract out in respect of a personal pension or, indeed, whether to have a personal pension specifically for the purpose of contracting out.

Start by thinking about the basic guidelines. The younger you are, the more likely it is to make sense to contract out. Generally people put the age above which you should be contracted in at anywhere from 40 to 55 and generally this 'magic age' (whatever it is) is a few years lower for women. Also, everyone appears to be in agreement that you should not be contracted out if you earn less than £10,000.

Then think about politics. If you reckon that, by the time you reach retirement, the Government will have made the second state pension that much more attractive, then you'd be more likely to want to stay in. If you think that, by then, they might even have ditched it altogether, then you'd be more likely to want to contract out. At least contracting out puts you (and your pension provider) in charge. Of course, the closer you are to retirement, the less likely it is for the State pension arrangements to change radically before you get there.

If you want to look more deeply into it, then the Government's pension advisory service provides a useful guide to contracting out, as does the Financial Services Authority. You can also see how the National Insurance rebates are calculated in this Inland Revenue leaflet. The Inland Revenue has also produced a handy FAQ on contracting out. The one thing they won't do though, I'm afraid, is tell you what to do. The closest you'll get is in the FSA's leaflet where it says:

The vast majority of people who opted out of SERPS (and did not have access to an employer's pension scheme) stand to gain from their decision.

The decision about whether you should continue with your 'SERPS opt out' pension or go back into SERPS will depend on a number of factors. These include your age and the amount that you earn. It is difficult to generalise, but as a general guide you should review your existing 'SERPS opt out' arrangements if:

(a) you are earning less than £10,000 a year; or
(b) you are over 45.

These are only guidelines.

Overall, it's a very difficult assessment to make, but think of it this way. The harder it is for you to decide which way to go, the less difference it probably makes. So at least that's something. You can find out how much basic state pension and SERPS you are currently entitled to by completing the Retirement Pension Forecast.

So What Should The Ordinary Government Do?

They should make things a bit more straightforward, so we poor Fools can stop frying our minds!

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