image

What is pension contracting out?


Pension contracting out is where an individual receives private pension provision in place of some or all of their entitlement to additional state pension (S2P or its predecessors SERPS and the state graduated pension) for particular tax years. Contracting out does not affect an individual's entitlement to the basic state pension.

An individual's employer can decide to contract them out using either a:

  • Defined benefit pension scheme contracted out on a salary related basis (COSR); or
  • Contracted out money purchase occupational pension scheme (COMP).

If their employer does not do this, an individual can choose to contract out using an:

  • Appropriate personal pension scheme (APP).

Because a contracted out individual has a lower state pension entitlement, the Government reduces the NI liability for these individuals and their employers.

Self employed individuals do not participate in the additional state pension so they cannot contract out.

How does pension contracting out affect an individual's state pension entitlement?

When an individual is contracted out, they lose some or all of their entitlement to additional state pension (S2P or its predecessors SERPS and the state graduated pension).

The way an individual's additional state pension entitlement is affected depends on whether they are contracted out under an:

  • Appropriate personal pension scheme (APP); or
  • Occupational pension scheme (such as a contracted out salary related pension scheme (COSR) or
  • Contracted out money purchase occupational pension scheme (COMP).

How does pension contracting out affect national insurance contributions?

Part of the national insurance contributions (NI) paid by an individual and their employer pays for their state pension. When an individual is contracted out, they lose some or all of their entitlement to additional state pension (S2P or its predecessors SERPS and the state graduated pension) and make alternative private pension provision.

In recognition of this, the Government reduces the NI liability on earnings between the lower earnings limit and the upper accrual point for these individuals and their employers. The way this is done depends on whether the individual is contracted out under a:

  • Defined benefit pension scheme contracted out on a salary related basis (COSR); or
  • Contracted out money purchase occupational pension scheme (COMP); or
  • Appropriate personal pension scheme (APP).

How has the introduction of the upper accrual point affected state pension entitlement and pension contracting out?

With the introduction of the upper accrual point from 6 April 2009, an individual's entitlement to state second pension (S2P) is now based on their earnings between the lower earnings limit and the upper accrual point, rather than on earnings up to the upper earnings limit.

  • A knock on effect of this change is that, since 6 April 2009, earnings between the upper accrual point and the higher upper earnings limit have been subject to the full contracted in rate of national insurance contributions (NI) - even though they do not qualify for state pension entitlement.
  • Similarly, NI reductions or rebates provided in respect of individuals contracted out under private pensions (including contracted out salary related pension schemes) are now only based on earnings up to the upper accrual point.

There were two stated reasons for introducing the upper accrual point:

  1. To harmonise the upper earnings limit for an individual's NI contributions with the threshold at which higher rate tax becomes payable; and
  2. To help facilitate the Government's long term plan to make the state second pension a flat rate pension by around 2030, as by then the lower earnings threshold (which increases each year in line with national average earnings) should be as large as the upper accrual point.

What is the future of pension contracting out?

The Government has confirmed that contracting out, under both money purchase occupational and personal pension schemes, will be abolished from 6 April 2012, under provisions contained in the Pensions Act 2007. Those contracted out through these schemes will automatically be brought back in to the State scheme.

The Government plan that existing protected rights accrued within a defined contribution scheme will cease to be classed as protected rights and can be treated the same as other pension benefits.

Defined benefit pension schemes will still be able to contract out on a salary related basis, although this will be reviewed by the Government at some point in the future.