Millions warned to opt back into state second pension

Advisers warn that more than six million savers may be worse off in retirement. David Prosser reports

Millions of savers may end up worse off in retirement unless they return to the State Second Pension, independent financial advisers warned this week. The alert follows Monday's announcement from Norwich Union that it is automatically to move 40,000 pension savers back into the state system later this year.

More than six million savers who have contracted out of the State Second Pension (S2P) and Serps, the scheme it replaced last year, are potentially at risk. Savers who contract out are still entitled to claim the Basic State Pension, but they don't qualify for S2P in the years they're out of the scheme.

Instead, the Government rebates some of their National Insurance contributions into a private pension. The idea is that once invested, these rebates will eventually produce a higher pension than the state would offer.

However, NU believes it is increasingly difficult for private pension providers to beat the state system. The recent poor performance of world stock markets has meant that rebates invested in pension funds have fallen in value in relation to the benefits on offer from S2P.

To compound the problem, the Government has cut the value of rebates in the past decade: at present, it aims to make them equal to the benefit of staying in S2P whereas, when contracting out was first an option, there were extra financial incentives.

The rebates are unlikely to get any more generous. For David Blunkett, the new Secretary of State at the Department of Work and Pensions, the challenge is to reform state pensions without increasing spending. Most insurers think that S2P rebates are more likely to fall in the future than to rise.

There is also a third difficulty for those who choose private pensions ahead of the state scheme. To convert a private pension fund into a regular income on retirement, savers have to buy an annuity. The cost of these products has been steadily rising in recent years, so the same amount of pension fund now buys less pension income than it did five years ago.

NU wrote to all its pension savers last year, warning them about the pitfalls of staying out of S2P, but it is now taking action on their behalf because so few responded to the mailing. "Changes in the economic environment have eroded the potential financial benefits of contracting out for the vast majority of people," says NU's operations director Mike Kirsch.

Harpal Karlcut, the head of pensions at HSBC Bank, which took a similar decision on behalf of 57,000 savers in 2003, says NU's move vindicates its policy. "We review the contracting out decision on a yearly basis as rebate levels and state pension terms change," he says. "As yet, we have not seen any indication to reverse our decision."

Insurers including Axa and Standard Life have also warned pension savers about the issue, although so far neither firm has automatically transferred people back into S2P.

The Association of British Insurers began publishing a fact sheet for savers last year, giving basic advice on deciding whether to contract back in (contact 020-7600 3333; www.abi.org.uk).

However, the consumer group Which? believes insurers, which have earned commissions on the NI rebates they invest on behalf of savers, need to do more. It says that, in the worst cases, savers will be 60 per cent worse off by remaining contracted out of S2P.

Principal researcher Tereza Fritz says: "If personal financial advice could be given in the past in order to make a sale, it must be possible to give advice now." In some cases, Which? believes pension providers and advisers may even have wrongly advised savers to contract out in the first place, in which case they should pay compensation.

However, Which? and the ABI agree that the contracting-out decision is not straightforward. Savers who are prepared to risk being worse off may end up doing better if their private pensions perform well. By contracting back into S2P, you miss out on the chance to beat it.

Also, it is possible that the rules governing S2P will change in the years ahead, to savers' detriment. For example, the Government already plans to allow people to start drawing private pensions earlier than they would have access to benefits from S2P.

Tom McPhail, the head of pensions at the independent financial adviser Hargreaves Lansdown, says many people will prefer to stay contracted out, rather than risk investing in the state scheme. "S2P needs reforming, but it is impossible to say how that might work out," McPhail says. "Contracting out, if you are happy to accept investment risk, at least gives you a chance to outperform."