Chancellor announces plans to end contracting-out for all pensions

2012 reduction in contracting-out rebates will save over £600m a year, but abolishing contracting-out altogether could save over £6bn a year

by Dr. Ros Altmann

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Ending contracting-out is long overdue and could bring in much-needed revenue:
At last, the Chancellor has taken the decision that our system of contracting out of state pension system is not fit for purpose. Following recommendations from the Office of Tax Simplification and in line with the agenda of simplifying the tax system, the Government wants to end the system of contracting out of state second pension. Although the Office for Tax Simplification recommended contracting-out should be abolished for all pension schemes from 2012, the Chancellor is not following that advice and will consult first with employers and schemes. He indicated he will abolish contracting out in future years, perhaps to coincide with the introduction of the flat rate £140 a week state pension. This will bring in a huge amount of revenue to the Exchequer. Abolishing it completely would save over £6bn a year.

Workers and employers with contracted-out schemes will pay higher NI:
It will also mean, however, that workers and employers who currently have contracted-out pension schemes will have to pay higher National Insurance rates. Currently, members of contracted out pension schemes and their employers pay less national insurance than everyone else. Instead of paying the full 11%, members of contracted out schemes pay 9.4% (a 1.6% of salary rebate) and their employers pay 9.1% instead of the full 12.8% (a 3.7% rebate). The justification for paying less NI is that the State (i.e. future taxpayers) will not have to pay any additional State Pension when the workers retire, as the payments will be replaced by the pension scheme instead. So the State will only be liable for the Basic State Pension, not the Second State Pension.

Contracting out rebates for Defined Benefit schemes to be cut from 2012, will save £600million a year:
The DWP has announced that from 2012, the contracting-out rebate rates will be reduced. Employees will only get a 1.4% rebate, instead of the current 1.6% and employers will get a 3.4% rebate, instead of the current 3.7%. The Budget (Red Book, Table 2.1 line 25) shows that the reductions in these rebates will save over £600m a year each year from 2012 to 2016. By getting rid of the entire rebate, the saving would be more than an extra £6bn a year extra.)

Contracting out was already being abolished for DC schemes:
The Pensions Commission in 2005 had already proposed removing contracting out for Defined Contribution pension schemes from 2012. The Government has now indicated it will remove it for all pension schemes but we do not know exactly when as this will be subject to consultation.

Simplification – contracting-out is most complex part of most complex pension system in the world:
The rules for contracting-out are the most complex part of our whole pension system, which is itself the most complex system in the world. By sweeping this away, future pensions will be far simpler. Also, of course, workers and employers will all then pay the same rate of National Insurance, regardless of what kind of pension arrangements they have, which is far fairer. For an explanation of contracting-out see
http://www.parliament.uk/briefingpapers/commons/lib/research/briefings/snbt-04822.pdf

Ending contracting-out should improve pension scheme funding, costs employers more in short-run but saves money in long-run:
Some employers may be concerned about paying higher National Insurance, however the rebates of NI are not high enough to replicate the value of the pension the scheme needs to provide in order to be approved for contracting-out, so actually this move should save employers money in the longer-run, albeit having some short-term costs. The funding of their pension schemes will improve as a result of no longer having to pay contracted-out benefits in future, and this means lower long-term costs for employers running final salary schemes.

Essential to abolish contracting out for simplification of State pension system:
Abolishing contracting out has to happen in order to be able to simplify the state pension system. The Government wants to merge the Basic and Second State Pensions together and, therefore, there will be nothing to contract-out of in future. Therefore, contracting-out will have to be abandoned and should lead to a much fairer, less complex state pension system as well as simplifying private pensions.

Ends the hidden subsidy for public sector pension schemes
The current situation is that public sector pension schemes are all contracted out of the state second pension. This means all public sector workers and employers pay the lower National Insurance rates. But most of the schemes (except for local Government and MPs) are entirely unfunded, which means that future taxpayers will have to pay these workers their state second pension equivalent anyway! The pension scheme has to replace the second state pension benefits in order to contract out, the idea is supposed to be that paying less NI saves taxpayers money in future by not having to pay the second state pension, yet in an unfunded scheme future taxpayers have to pay this anyway. Permitting unfunded public sector pension schemes to contract out of the second state pension was a hidden subsidy for public sector employment. Both workers and employers pay the lower rate of NI, which is an anomaly that will now be corrected.

Will ending contracting-out feature as part of 3% rise in public sector workers’ pension contributions?
The Chancellor says he will accept John Hutton’s public sector pension reforms and also called for an average 3% rise in employee contributions to their pension schemes. Once contracting out is abolished, workers will also have to pay an extra 1.4% in NI contributions to bring them onto the full rate, rather than the lower rate. Will this be counted as part of the 3% contribution rise? This is likely to form a big part of the negotiations on public sector pensions. Announcements will be made in the Autumn.