New Changes For The State Second Pension

In 2012, many people will be automatically contracted back into the additional State Pension.

Many of the recent changes to the tax system have been concerned with personal pensions, and the level of public sector pension commitment is a thorny election issue. But with next year’s 1% hike in National Insurance rates looming ever nearer, what exactly do we get for our money in terms of additional state pensions?

SERPS and S2P

Of course, if you are as old as me you will remember SERPS, the State Earnings Related Pension Scheme. Provided you were ‘contracted in’ to the scheme, you built up an entitlement for additional State Pension payments from the government.

However, this scheme was deemed to be in need of reform. In April 2002, SERPS was replaced with the new State Second Pension, usually shortened to S2P.

If you are ‘contracted out’ of S2P, a rebate is paid into a separate pension scheme for your benefit (the same thing happened with SERPS). By contracting out in this fashion, you are effectively betting that your rebates would grow over time and provide a larger annual payment than you would have received had you stayed in S2P.

In practice, working out whether this will actually be the case is horrendously complex and many people have been advised that they would be better off contracting back in to the additional State Pension as a ‘safer’ option.

All change in 2012

From 6 April 2012 though, many people will no longer have this choice. From this date, you will no longer be able to contract out of S2P using a personal/stakeholder pension or a company pension or occupational pension scheme which is contracted out on a ‘money purchase’ or ‘defined contribution’ basis. Instead, you’ll be contracted back in and you will build up an entitlement to the additional State Pension instead.

The government justified this change by emphasising just how complicated it was to work out whether it was worth contracting out. You can’t argue with that. However, in reforming the S2P system, they have also shifted its focus in favour of lower earners at the expense of the better off.

So how exactly does the new scheme work, and what proportion of your hard-earned and grudgingly paid National Insurance contributions actually go towards your own future benefits?

The new S2P system

Between the lower earnings limit of £5,044 a year and £14,100, entitlement accrues at 40% of earnings. However, provided you earn at least £5,044, your S2P entitlement will be based on £14,100 rather than your actual earnings. This is known as Band 1.

In 2012, Band 1 income will earn you a flat rate of £1.60 in additional State Pension instead (which is much the same result as using the current calculation method).

Between £14,100 and the upper accruals point of £40,040, entitlement to the additional State Pension accrues at the less generous rate of 10% of earnings. This is known as Band 2. It is intended that this upper accruals point will be frozen in cash terms, so this 10% entitlement would become eroded by inflation over time.

In 2030/31 this 10% rate will be abolished and there will then be a flat rate across all income amounts up to the upper accrual point. So everyone who qualifies for the additional State Pension will then earn the same amount each year.

Great news for lower earners

One point to note is that S2P entitlement kicks in before any actual National Insurance contribution are payable at the primary threshold of £5,715. This means that if you just so happen to earn, say, £5,600, you would pay no National Insurance, but would earn entitlement to S2P.

Even better, this entitlement would accrue not at that very low salary level, but at the £14,100 assumed income as mentioned above.

David Heaton, Employment Tax Specialist at Baker Tilly illustrates the unusual effect this can have by way of an example. If a taxpayer earns £7,000, he will pay National Insurance of £141 (being £7,000 less the primary threshold of £5,715 at 11%). However, his S2P will be calculated on the maximum £14,100 less the lower earnings limit of £5,044, namely £3,622. This could translate to an annual S2P of £105 in exchange for an annual contribution of just £141.

It seems highly likely that this system will be tinkered with again before 2030/31. But there’s a clear message being sent — if you want a decent income in retirement, then you’ll have to provide it yourself.

For pension advice contact Credencis.

We are situated near to Derby, Leicester, and Nottingham.

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