CONTRACTING OUT IN THE UK
A PARTNERSHIPSHIP BETWEEN PUBLIC
AND PRIVATE PENSIONS
Chris Daykin
Government Actuary
Rome, 3 April 2003
STRUCTURE OF PROVISION
FOR RETIREMENT IN UK
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compulsory flat-rate first pillar (basic pension)
compulsory earnings-related second tier
voluntary occupational or personal provision
personal savings
means-tested guarantee credit & pension credit
BASIC PENSION
• flat-rate pension (i.e. independent of earnings)
• entitlement is based on contribution record
• pension age is 65 for men and 60 for women
- 60 to rise to 65 between 2010 and 2020
• currently set at about 16% of average earnings
(26% for man with dependent wife)
REASONS FOR INTRODUCING
CONTRACTING OUT IN 1978
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desire to introduce earnings-related pension
occupational pension schemes already existed
typically these were good final salary schemes
wanted to avoid duplication of provision…
…and to avoid reducing funded provision
…and to keep down future social security costs
GENERAL PRINCIPLES OF
CONTRACTING OUT
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earnings-related benefits are compulsory…
…up to Upper Earnings Limit (1¼ av.earnings)
private provision may substitute for SERPS
choice of several ways of contracting out
contributions are reduced if contracted out
reduction (“rebate”) should be actuarially fair
EARNINGS-RELATED PENSION
• compulsory second pillar
• covers earnings from £77 to £595 a week
(500 to 3900 € a month)
• choice of:
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* state-earnings related pension scheme (SERPS)
* final salary pension plans (COSRS)
* money purchase pension plans (COMPS)
* personal pensions (APPs)
* stakeholder pensions (from April 2001)
FINAL SALARY SCHEMES
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trust-based, defined benefit plans
sponsored by employers
trustees responsible for investments
employees usually pay contributions
employer finances the rest
about 100,000 such plans in the UK
PERSONAL PENSIONS
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individual account, defined contribution plans
marketed by insurance companies
mostly pure investment-linked
restrictions on form of benefit
– up to 25% as cash lump sum
– annuity or drawdown for rest
• employers generally do not contribute
CURRENT TAX REGIME (DB and DC)
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contributions out of pre-tax income
contributions by employer not taxable
investment returns largely free of tax
tax free lump sum (25% of rights)
pension taxable as earned income
CONTRIBUTION REDUCTIONS
• contribution reduction (or “rebate”) represents
value of benefits substituted
• rebate recommended by Government Actuary…
• …on the basis of equivalent value
• final decision made by Minister…
• …may include incentive to make it attractive
• effect is to shift provision from public to private
EFFECT OF REBATES
• for DB schemes the rebate helps with funding
• … and benefits both employee and employer
• for DC schemes the rebate determines the
minimum amount which is saved…
• …and needs to be sufficient, relative to state
benefits forgone, for sale to be recommended
CONTRIBUTION REBATES FOR
FINAL SALARY SCHEMES
1978-83
1983-88
Employee
rebate
2.5%
2.15%
Employer
rebate
4.5%
4.1%
Total
rebate
7.0%
6.25%
1988-93
2.0%
3.8%
5.8%
1993-97
1.8%
3.0%
4.8%
1997-2002 1.6%
3.0%
4.6%
2002-07
3.5%
5.1%
1.6%
CONTRACTING OUT TESTS
FOR FINAL SALARY SCHEMES
• initially the pension scheme had to pass a test
• and Guaranteed Minimum Pension had to be
provided for each individual contracted out
• also a funding test (with actuarial certification)
• GMP requirement ceased after March 1997
• now there is just a test that the pension scheme
meets certain standards
POPULATION
CONTRACTED-OUT
APPs (3.7m)
COMPS
(0.3m)
COSRS
(8.1m)
SERPS (8.1m)
EFFECT OF CONTRACTING OUT
SERPS/S2P expenditure in £bn at 1999/2000 prices
60
50
40
30
20
10
0
2000
2010
Gross SERPS/S2P
2020
2030
Net SERPS/S2P
2040
Cost of rebate
2050
CONTRACTING OUT WITH
DC PLANS
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Appropriate Personal Pensions from 1987
rebates were initially the same as for DB
this made it attractive for younger people
2% additional payment from 1987 to 1993 for newly
contracted-out
• 1% of relevant earnings from 1993 to 1997 for those
over 30 with an APP
• rebate goes to individual account (protected rights)
PROBLEMS OF
CONTRACTING OUT - 1
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PAYG costs have to be met anyway…
…so standard contribution rises if more c-out
flat-rate rebate is rather broad-brush…
…so not suitable for all schemes
complexity arising from GMPs and other tests
PROBLEMS OF
CONTRACTING OUT - 2
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APP rebates must be high enough for selling…
…so they include higher expense loadings
flat-rate rebates created certain incentives
age-related rebates are fairer but less incentive
high rebates subsidise inefficiency
…..and penalise those not contracted out
contracting-out arbitrage
APP AGE-RELATED REBATES
12
10
8
COSR rebate
Age-related
Cap on rebate
6
4
2
0
20
25
30
35
40
45
50
55
60
STATE SECOND PENSION - 1
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introduced from April 2002
revalued career average (as SERPS)
no further change to pension age
higher accrual on lower bands of earnings
special protection for low paid and carers
STATE SECOND PENSION - 2
• differential accrual rates on earnings bands:
< £11,200 a year : 40% for full working life
£11,200 to £25,600 : 10% for full working life
>£25,600 a year : 20% for full working life
• thresholds uprated in line with average earnings
STATE SECOND PENSION - 3
• employees earning <£11,200 credited at £11,200
• carers and disabled given credits
– for looking after disabled persons
– and for looking after children aged 5 and under
• may eventually become flat-rate
• higher earners expected to have private pension
STATE SECOND PENSION ACCRUAL
20 % accrual
Additional pension accrued
10 % accrual
40 % accrual
QEF
Band 1
LET
Band 2
3LET - 2QEF
Band 3
UEL
Earnings
State Second Pension, including effect of deemed earnings at low earnings threshold for low earners
Benefits given up by members of contracted-out occupational schemes (as for pre-2002 additional pension benefits)
Benefits given up by members of APPs (State Second Pension ignoring deeming of earnings to low earnings threshold)
CONTRACTING OUT OF S2P
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APP rebate in bands based on S2P forgone
rebates for COSRS based on SERPS accrual
S2P top-up for higher accrual rates
S2P top-up for low earners and carers
stakeholder available for contracting out…
…but little take-up (most stakeholder pensions
are contracted in)
WHERE NEXT WITH
CONTRACTING-OUT?
• some form of contracting-out was necessary
because of widespread final salary schemes
• with switch from DB to DC there is a tendency
now to contract back in
• stakeholder and other DC schemes are regarded
as topping up state benefits
• some of savings will be lost, but risk profile of a
mix of S2P and DC is reasonable