Contracting Out

If you contribute to a personal pension scheme (see Personal Pensions), you may be offered the chance to contract out of the State Second Pension, or S2P (see State Second Pension). Essentially, this involves choosing to invest in a private additional pension scheme rather than invest in the state additional pension scheme. You choose not to invest in the State Second Pension through your National Insurance contributions (see National Insurance Contributions), but instead invest a part of your National Insurance contributions in a personal pension. You can choose to contract out if:

• you have a permanent National Insurance number
• you are working in the UK as an employee
• you are paying National Insurance contributions
• you are a member of a non-state pension scheme

It stands to reason that you can only contract out of the State Second Pension if you would have been eligible to receive it in the first place. Most UK employees are required to pay National Insurance contributions. Theoretically, these contributions are used to pay for any state benefits you are eligible to claim. On retirement you are eligible to claim State Pension, and if you have earned enough, State Second Pension.

State Second Pension is an additional pension paid to people earning more than the Lower Earnings Limit, or LEL, currently set at £87 a week or £4,524 a year. The exact amount of S2P you build up will depend on your salary. You do not have to make contributions to S2P, it builds up automatically if you are earning more than the LEL and thus paying National Insurance contributions. You can even build up S2P when you are not working, whether because you are currently unable or because you are caring for others.

Although you do not make specific contributions to the State Second Pension, it is assumed that a part of the National Insurance contributions you pay when you are earning go towards paying your State Second Pension on retirement. This means that you are entitled to a refund of a part of the National Insurance contributions you are making, if you decide to contract out of the State Second Pension. The National Insurance contributions that are refunded are known as the NI rebate, and this rebate will be paid directly into your alternative pension savings scheme. There is no option for you to receive your NI rebate as a cash sum: the idea of contracting out is that you choose to have more control over the way in which your money is being invested, by essentially choosing to invest in a personal pension rather than the state pension. Therefore the money you are refunded must be invested in some kind of pension scheme to help provide for you in retirement.

There are advantages and disadvantages to contracting out of S2P, and so it is important that you assess the risk on an individual basis and decide which system will be a better investment for you. Contracting out is due to be abolished in April 2012, so no one will be able to contract out after this date. People who are already members of contracted out pension schemes will be able to remain a member. There are no set rules regarding when you should or should not contract out, but it is generally accepted that older people and low earners will not be better off contracting out than they would have been had they stayed in the state system. Your pension scheme administrator or an independent financial advisor will be able to advise you based on your personal situation.

For more details see How to contract out and After contracting out.