If you have ever been ‘contracted-out’ then your entitlement to the new State Pension will be affected.
In the past , while everyone has been obliged to pay NI contributions to pay for their Basic State Pension, it has been possible for employees to be ‘contracted-out’ of the additional state pensions which have supplemented that.
From 1978-2002 the additional pension was called SERPS (the State Earnings Related Pension Scheme) and from 2002-2016 it became known as State Second Pension (or S2P).
When a person is contracted-out they do not earn any additional state pension. However, they have only been allowed to contract-out if they are instead earning benefits either in an employer scheme or in a personal pension scheme. Benefits earned in those schemes are deemed to replace any entitlement to additional state pension.
When a person who is, or has been, contracted-out reaches state pension age a calculation is done as to what additional pension they would have earned during their working life, had they always been contracted-in and then a ‘contracted-out deduction’ is applied to reflect the benefits they are deemed to have earned during any periods they have been contracted-out.
This contracted-out deduction (COD) will still apply when employees’ entitlements to the new State Pension are calculated, but may be re-titled as the contracted-out pension equivalent (COPE)
Which schemes have been contracted-out ?
(a) Defined Benefit or DB schemes
From 1978-2016 employees in employer DB schemes have, in most cases been contracted-out. DB schemes include Final Salary and CARE schemes.
Both the employee and their employer have, as a result of this, paid a lower rate of NI contributions. This has been allowed provided that the benefits of the employer scheme were in excess of a prescribed minimum level (which was an approximation of the value of additional state pension).
The decision to contract-out was taken by the employer. In effect, the employee by agreeing to be in the employer scheme accepted that (though prior to 1988 it was possible for employers to compel employees to be members of their schemes).
For employees in contracted-out DB schemes a part of their scheme benefit is a replacement for additional state pension, although it will not be separately identified as such.
(b) Defined contribution or DC schemes
From 1998 to 2012 it was possible for employees to be contracted-out if they were in a DC scheme.
In this event both the employee and employer paid full rate NI contributions but a part of that contribution was diverted into their DC pension.
The benefits of the DC pension scheme, derived from those NI rebates, are deemed to be the replacement for the additional pension the employee would otherwise have built up.
Many employer DC schemes have never been contracted-out but, where schemes were not, it was possible for employees to contract-out by their own decision either as an option within the employer scheme or by establishing a separate DC pension.
How much your new State Pension will be affected
Most people have a number of different jobs during their working life and many will have seen the pension arrangements associated with a particular employer change whilst they were working for them. In recent years, for example, a lot of employers have ended (contracted-out) DB pension schemes and replaced them with (contracted-in) DC schemes.
Even people who have most of their career with one employer may perhaps have had a number of other jobs before settling down to that career and/or worked for a period in other jobs after their main career ended.
At the inception of the New State Pension is 2016 all employees currently in the workforce will be assessed for their ‘starting amount’ (see the main ‘New State Pension’ briefing) and a part of that calculation is what their contracted-out deduction is.
If they have never been contracted-out then this deduction would be zero.
If they have always been contracted-out then the deduction would be such as to reduce their starting amount to something close to the proportion of the Basic State Pension which their NI contributions so far would have qualified them for.
Many people will fall somewhere between these two extremes.
Prior to the inception of the new State Pension the Government plans to send a statement to all those people aged over 55, in which their contracted-out pension equivalent (COPE) will be specified.
Where a person’s COPE is such as to mean that their starting amount is less than the standard level of the New State Pension (£155.65) then each full year of NI paid from April 2016 onwards up to State Pension Age will increase the amount of their state pension by £4.45 a week.
For a person who had always been contracted-out it would require a further nine years of NI contributions, after April 2016, before they qualified for the full new State Pension.
Opportunity for those retiring before state pension age
People who retire early before their state pension age may not be able to top up their state pension as much as those who carry on working to state pension age.
However, this disadvantage can be remedied if they elect to pay class 3 NI contributions for their years before state pension age. These contributions are a reduced flat rate of £14.10 a week or £733 a year. Paying this contribution for one year could add £4.45 a week or £231 per year to their state pension paid for life.
This is extremely good value and an attractive option for members retiring earlier than state pension age who do not qualify for the full rate of the New State Pension.
This link gets you to information about how to pay extra class 3 contributions: https://www.gov.uk/pay-voluntary-class-3-national-insurance
An extended article about this can be accessed: http://paullewismoney.blogspot.co.uk/2016/10/target-155-boost-your-new-state-pension.html