State pensions: should I stay or should I go?

Under 53? Staying in the State Second Pension is a finely balanced choice, writes James Daley
Click to follow

Pension companies have spent much of the last 12 months begging the Government to significantly increase the National Insurance rebates it pays to people who opt out of the State Second Pension (S2P), using a private pension scheme. But last week, the Department for Work and Pensions rejected those calls.

As a result, the decision over whether to stay in S2P remains finely balanced for savers, particularly those under the age of 50. Pension companies and employers with money purchase schemes, where benefits are not linked to salaries, are increasingly worried about what advice to give savers.

At the end of last year, the Financial Ombudsman Service upheld a complaint against Prudential for advising a customer to contract out of S2P without explaining the risks of doing so. Although the cost of compensation amounted only to a few pounds a week, pension providers are concerned that more cases could follow. Many savers will therefore have no choice but to make a decision about S2P for themselves.

Start by finding out whether you are currently contracted in or out of the state scheme. If you're not sure, HM Revenue and Customs' telephone hotline can help (call 0845 915 0150 - you will need your National Insurance number to hand).

If you are contracted out, whether to contract back in depends partly on your age. Tom McPhail, the head of pensions research at financial adviser Hargreaves Lansdown, says that if you're currently over the age of 53, the financial arguments for being an S2P member are strong.

This is because while the NI rebates on offer increase as you get older, there is a cap - the increases effectively stop when you reach around 53. Also, the closer you are to retirement, the less time investment returns have to work on your rebates.

For people in this older age bracket, it's really only worth contracting out if you have a very strong conviction that the Government will not keep its promise to pay your pension when you hit the state retirement age in 12 years' time or less.

McPhail also points out that the Government plans to lower the cap by next year, which means it will make sense to be contracted in from the age of 50 onwards.

If you're under 50, your decision comes down to whether you are optimistic about the investment returns your rebates might earn in the years you have remaining before retirement - and the extent to which you are prepared to trust the Government not to tinker with S2P. Although the contracting-out rebate paid to savers in their 20s or 30s is relatively small, you may feel you can make it work harder for you in a private pension. But even at this age, using standard assumptions for the returns likely from a regular investment portfolio, you're better off contracting back in - on the numbers, at least.

One other potential advantage of contracting out is that any money in your private pension will increase the amount of tax-free cash you can withdraw when you reach the age of 50 (or 55, from 2010). If you're contracted in, you'll only be able to get at your S2P fund once you begin drawing your state pension.

Finally, if you're lucky enough to be in a final salary pension scheme, your decision to contract out will be made for you. Most final salary schemes contract all of their members out of S2P. However, the more generous benefits that these schemes pay will more than compensate for any potential loss.

The dilemma: state or private pension?

S2P is an earnings-related state pension, paid on top of your basic state pension - it replaced Serps two years ago. Savers accumulate S2P as they make National Insurance contributions, but since 1988 everyone has had the option of contracting out of the scheme - either into an individual plan such as a personal or stakeholder pension, or a company scheme, if they are members of a money purchase plan.

Those who do opt out get a rebate of some of their NI contributions. The theory is that, over time, as this money is invested, it should grow to produce more pension than the state scheme would pay.

Unfortunately, in recent years, investment returns have fallen while life expectancy has risen, so pensions cost more. As the rebates paid to contracted-out savers have not been increased, the odds of getting more from a private pension than from S2P and Serps have fallen. Many pension providers now say all savers would be better off staying in S2P or returning to the scheme.

On the other hand, savers face an additional conundrum. While independent financial advisers calculate that everyone would be better off contracting into S2P, this assumes the scheme will not become any less generous. In other words, savers must trust the Government - and future Governments - not to save money by cutting back on S2P benefits. It's a big leap of faith.

Many pension analysts suspect S2P will be axed or significantly overhauled within the next few years. In which case, there is a risk that by the time today's savers reach retirement, their S2P rights will be worth much less than they appear to offer right now.

Looking for credit card or current account deals? Search here