What does 'opting out' or 'contracting out' of S2P or SERPS mean?

If you are an employee and you pay National Insurance contributions you can choose whether or not to be part of S2P. (as you could with SERPS.)

Sometimes though this choice is made for you if your employer provides an occupational pension scheme.

contracted-out schemes

If your employer provides what is known as a contracted-out scheme, you have to opt out of S2P to join the scheme.

In return for opting out of S2P, the scheme must provide minimum benefits at least as good as S2P.

You will pay lower National Insurance contributions, which will help you to afford the employee contributions that you will probably be paying to the scheme. However if you are a member of a contracted-out scheme but earn less than about £11,000 then you will still get some S2P. This reflects the extra help S2P gives to the low paid.  

individual opt-outs

If you are not a member of a contracted out occupational scheme (and not all employer-run schemes are contracted out) you can decide to opt out of S2P as an individual.

Paying into S2P is the default position. If you do nothing you will be a member of S2P.

If you opt out, you have to nominate a personal or stakeholder pension. This fund will then receive from the government part of your National Insurance contributions. This pension is called different things in different documents. You may find it called 'an appropriate personal pension' or - more straightforwardly – a SERPS or S2P opt-out pension.

It is like any other personal pension, except you have less choice about when and what kind of annuity you buy when you want to use your pension fund to provide a pension. This is to ensure that it provides similar benefits to those that you would get from an S2P pension.

In the past opting out was widely thought to be a good deal for younger and better paid people, but most experts now think that it is best to stay in S2P unless you have a very good reason not to.

So:

• if you stay in S2P you will receive a pension that depends on the number of years you contribute and your income (though it's not a straightforward calculation, and is more generous to the low paid).
• if you opt out of S2P (and are not a member of a contracted-out occupational scheme) you will build up an additional personal pension. This means that the pension you receive will depend on how well the investments that make up your pension fund perform, and what annuity rates are when you use your fund to provide a pension. Some of the contributions will be used to pay the scheme's charges.

There's more on workSMART about opting out here.

The Pension Service has a downloadable guide to all aspects of contracting out which also covers occupational pensions.

The FSA factsheet Contracting out of the State Second Pension is also very helpful.