What happens in a 'contracted-out' scheme?
The state provides both the basic State Pension and a second pension, which is based to some extent on your earnings. The second pension until recently was known as SERPS and is now known as the State Second Pension or S2P.
A 'contracted out' pension scheme contracts its members out of the state's second pension. Instead of getting your second pension from the state you effectively get it from your employer's occupational pension scheme. (Individuals can also contract out of the State Second Pension. You can find more about this in the state benefits and pensions section of this site here).
If your scheme is contracted out, both you and your employer pay reduced National Insurance contributions, but you are only eligible to get the basic State Pension.
You will not build up any State Second Pension while you are a member of a contracted out scheme. You do not have any choice about this if your scheme is contracted out. You cannot individually contract in.
To be able to contract out, an occupational pension has to meet certain standards – basically these aim to make sure that you get a better deal from your occupational pension than you would from the State Second Pension, though there are no guarantees.
The different types of occupational pension can all contract out. Each has a set of conditions it must satisfy before it can contract out. They are rather complicated, and made more so by big changes in 1997 that mean that contracted out pensions built up before and after the changeover from SERPS to S2P are protected in different ways.
There are therefore three types of contracted out schemes (and a whole new set of initials!):
You may only want to know that the purpose of the contracting out rules is to try and make sure that you gain – rather than lose out – from giving up your State Second Pension, though this is not guaranteed. The important thing to know if you are planning your pension is whether you will get a State Second Pension or not. If you do not, then you will need more from your own and your occupational pension.
Contracted-out salary related schemes
Before April 1997, COSRS had to pay their members a 'guaranteed minimum pension' (GMP) when they retired. A GMP is roughly the same as the amount of SERPS you would have got if you had not been in your employer's contracted-out scheme. The rules changed in April 1997, although any pension you built up before then is still covered by the GMP rules.
Since April 1997, COSRS have had to do better than something known as the reference scheme – that is why it is known as the 'reference scheme test'. To pass this test, schemes must do better than the reference scheme, which basically means it must have an accrual rate of at least 1/80th and provide a half pension for surviving spouses. The scheme's actuary will certify this. He or she will look at the scheme as a whole, however, not at individual circumstances. Both contracted-out and contracted-in schemes must uprate by inflation the pension built up since April 1997 up to a maximum of five per cent. Schemes can still pass the reference scheme test even if ten per cent of their members' benefits fall below the legal standard.
Contracted-out money purchase schemes
The test for money purchase schemes is simpler. Your employer must guarantee that all the National Insurance rebates saved from contracting out are paid into the scheme. In addition, some of the money you would normally have paid in National Insurance contributions is paid into the scheme by the Inland Revenue. This amount depends on your age.
The money in your pension pot that comes from National Insurance rebates from contracting out is covered by a specific set of rules. It is known as the Protected Rights pension, and mimics the State Second Pension so that:
- you cannot use it to get a pension before you are 60
- you cannot use any of it to get a lump sum
- it must be equal for men and women
- there are rules about the kind of annuity you can buy with it
Contracted-out mixed benefit schemes
These are for hybrid schemes and those that offer a choice of savings routes. As you might expect they basically work by making the scheme pass the salary related pension test for the salary related elements of the scheme and the money purchase test for the money purchase elements.
More info
There's a very clear leaflet on contracting out available from the Pension Service website and an overview here.
The OPAS website is also helpful.
