FOOL SCHOOL
The State Second Pension

September 3, 2003

The basic state pension replaces your lowest slice of income (that is, up to £77.45 per week currently). The State Second Pension (S2P) is designed to top up your income, depending on how much you've earned over the years. It's 'earnings-related' because the more you earn, the more you'll pay in National Insurance contributions, so the more you'll get. S2P replaced the previous scheme, known as the State Earnings-Related Pension Scheme (SERPS), in April 2002. The main difference between these two schemes is that the S2P is designed to provide a higher retirement income for low earners. Any SERPS benefits you built up prior to April 2002 will be protected.

As long as you earn above a certain level (£4,004 a year in 2003/4) and you're not a member of a company pension scheme, you'll build up a S2P entitlement. The more you earn, up to a maximum of £25,600 in 2003/4, the more S2P you'll get. However, anyone earning less than £11,200 will be treated as if they earned this amount. This is how the S2P is better than SERPS for low earners.

If you want, you can choose to opt out of the S2P. This is called 'contracting out'. The effect of this is that part of your National Insurance payments, which would have gone towards providing your S2P benefits, instead get paid into your occupational or personal pension. In certain cases, your pension scheme will more or less guarantee to pay out at least the S2P benefits that you have given up. Basically, all you are doing is replacing S2P with your own arrangements.

Whether or not to contract out of the S2P is a tricky question and depends on several factors. On the whole, the more you earn, the younger you are and the better your view of future stock market returns, the more likely it is to make sense to contract out. Similarly, the less you earn, the older you are and the worse your view of future stock market returns, the more likely it is to make sense to stay put with S2P. However, when S2P replaced SERPS, a number of pension providers advised their customers to contract back in, because they believed S2P benefits would be superior.

Find out more in our pension centre.