Contracting Out Of State Scheme
What is Contracting Out?
When we speak of “contracting out” we mean that you take the decision to leave the state earnings related pension (Your State Pension – S2P) in preference for your own private arrangement. Your state benefits come in two parts. The state old age pension and an earnings related part which sits on top of the old age pension. You can only contract out of the earnings related bit.
Why is it important?
The decision to contract out is an important one to consider because it can affect your overall pension at retirement age. You may not have had to consider this before as other pensions that you may have belonged to such as Final Salary schemes took the decision for you.
Owing to the aging population in the UK it is unlikely that the current level of state pension can carry on as costs seem to be spiralling out of control. The current level of state benefit is not high and is likely to reduce in the future. In reality people are living much longer than the scheme originally anticipated and the birth rate is in decline. This means that at present over 2/3rds of the UK population is aged over 45.
Should I contract out or contract back in to the State Scheme?
Contracting out was launched by Margaret Thatcher’s Tory government. The government was originally paying an attractive age related rebate to make the decision attractive and financially rewarding. The current Labour government have carried on with allowing contracting out but have renamed the issue contracting out of S2P or second state pension. The name change was not just cosmetic as some of the terms and conditions changed.
The biggest change has been to the age related rebate. In broad terms the rebates have been set at comparatively lower levels and so is now not so attractive and in many cases the financial incentive to contract out has been eroded.
Your decision to remain contracted out, become contracted out for the first time or to contract back in is a personal one. However you may be influenced by the following issues. Bear in mind that financially there may not be a clear cut answer, so your decision may be based on your view of the future.
Factors To consider in making your decision
1. Control – Once the S2P rebate is paid to you each year it becomes your money to invest for the future.
2. Flexibility – Since April 2006 it is possible to take tax-free cash lump sums out of the fund generated by the state rebate at retirement age. I.e. if your S2P state pension fund is £60,000 25% of it can be paid to you on retirement as a tax-free sum.
3. Political Risk – Successive governments of whatever persuasion are talking of reducing the state pension provision and possibly even means testing it at retirement age. It certainly will not get any cheaper to fund.
4. Level of Earnings – If you earn below £11,000 per annum it is almost certainly better to remain contracted in as you are given additional credit.
The above list is not exhaustive but covers some of the more important issues.
Will It cost me more money to Contract Out?
No. We are talking about money that you are already paying via National Insurance Contributions. The key decision is which home it goes to, either your own private fund or the general public state pool.
How do I contract Out?
Contact Favourites Finance Ltd: john.eburne@favouritesfinance.co.uk
What if I am not sure if I am contracted out?
Contact the Directorate of Work & Pensions quoting your National Insurance number
Who can I talk to about contracting out to see if it is right for me?
Call Favourites Finance 0845 602 6032
Thank you for taking the time to read this information
June 2006