The benefits of returning to a state pension

Recent changes to legislation have slashed the value of contracting out of the state pension scheme. Andrew Verity finds that millions of personal pension holders could be better off back in Serps.

If picking a pension were like doing a dance, there would be just one name for the annual routine of deciding whether to be in the state earnings related pension scheme (Serps) or not. The hokey-kokey.

Every year, the 6 million holders of personal pensions, plus another half a million in company-run money purchase schemes, are expected to make a crucial decision which can have a profound effect on their wealth - or poverty - in retirement. Should they be in, or out, of the state earnings-related pension scheme?

Currently, most of the millions of private pension savers are out of the scheme. By "contracting out", the saver forgoes the benefits of Serps in exchange for a rebate of national insurance contributions which then goes into a private scheme.

If the rebate to the private scheme is large enough, and the return on the investments it buys is high enough, personal pension holders will be better off with a private scheme until they reach a "pivotal age", usually 47 for women and 52 for men.

But for future pensioners, the whole question of contracting out to a private scheme has been thrown into confusion by two recent events, triggering warnings that millions may be better off returning to the state scheme earlier. And actuaries are warning that some may be better off staying in the state scheme - full stop.

The first event was the July decision of Gordon Brown, the Chancellor of the Exchequer, to abolish tax credits on dividends, reducing the return on investments which a pension fund can expect to earn. If a pension fund is expected to grow by less, then it is less likely at retirement to pay benefits to match Serps.

Second, in April, when the 1995 Pensions Act came into force, rebates were in effect slashed. While every saver formerly received a rebate worth 4.8 per cent of their earnings, these now change with age. Personal pension savers under 30 now get a rebate worth 3.1 per cent of their earnings: at 50 they get 9 per cent.

According to leading actuaries Bacon & Woodrow, the seemingly generous spirit behind the new rebates was a phantom. Even the Government Actuary noted that the new rebates were too small to cover the amount that went out to most private pension providers in flat-rate monthly fees and other expenses. Far from making it easier to stay out of Serps, it made it harder.

Bacon & Woodrow warns that unless the Government considers raising the level of rebates - an exercise that could cost hundreds of millions of pounds - millions of savers should not be contracting out. Potentially, savers who have been contracting out for just a few years could see their private savings, worth hundreds of pounds, whittled away to nothing by the flat-rate fees.

Brian Wilson, a B&W expert on contracting out, said: "My suspicion is that the Budget changes probably knock out contracting out of Serps as an option for most people. I'm surprised that so many people are contracted out; I would have thought that the Budget change would be the killer blow."

Worst of all, there are 3.5 million holders of personal pensions, mostly on incomes of less than pounds 10,000 a year, who make no extra contribution of their own above the rebate. The average amount that goes into their pension every year is just pounds 350 - an amount so small that fees could erode it to nothing by the time the saver retires.

Since the Budget, the Government has declined to say whether it will revise rebates upwards. The IFA Association, which represents independent financial advisers, last week told the Government that its members would be forced to advise millions of clients to return to Serps unless more information was available.

Last week, John Denham, the pensions minister at the DSS, bowed to relentless pressure from the pensions industry by announcing he would instruct the Government Actuary to look at rebates. He added: "We are committed to ensuring that individuals have good quality second pensions and wish to enable as many people as possible to achieve this through [private] provision."

However, even if a change is considered necessary, it will not happen until April 1999 at the earliest. The IFA Association wants to know as soon as possible whether a rise in rebates will occur in order that its members can give informed advice. Savers concerned about their pension should expect advice from their adviser or company early next year - and should not accept a refusal.