PensionsSep 20 2018

How to help clients understand contracting out

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How to help clients understand contracting out

The issue around clawback affects pensioners who have been contracted out of occupational pension schemes. 

In a nutshell, Kay Ingram, director of public policy for LEBC, describes this as schemes where both employer and employee have paid a reduced rate of national insurance (NI) while the member was working. 

The state pension is made up of two tiers - the flat-rate basic state pension, and the second, earnings-related tier, which depends on earnings levels and NI contributions. This is the part which schemes or individuals could opt out of when they contracted out. 

Effectively the member gets a lower state pension, in return for the lower NI payment. But given the paucity of information often coming from employers' pension schemes, coupled with the sometimes interminable language around pensions, how do scheme members necessarily know whether they have been contracted out? 

Firstly, if the client knows when they were in a defined benefit (DB) scheme, this is a good place to start investigating, as there was a certain timeframe in which DB schemes could choose to opt out of the additional state pension. 

Most major schemes did it and sold it to the membership as a gold standard, when it's a bit of a con really. Phil McGovern

As Keeley Paddon, head of technical for the SimplyBiz Group, explains: "Between 1978 to 1997, DB schemes could choose to opt out of the additional state pension and accrue GMP instead.

"The benefit of doing so is that both the employee and employer paid reduced rates of NI in lieu of an additional guaranteed pension."

Ms Ingram explains: "Pensions accrued from 1978 to 1997 may be contracted out in this way and so pensioners who were in final salary pension schemes between these dates are affected. This applies to both public sector and private sector occupational schemes."

Documentation needed

Checking whether your client's scheme is affected therefore relies on dates, but rather than wait for a begging letter to land on the doorstep, there are ways of finding out whether individuals had indeed opted to contract out, or whether their scheme contracted them out of the earnings-related contributions.

John Lawson, head of policy for Aviva, points out: "A member should know they have been contracted out because they will have paid lower rates of NICs while contracted out and they will have received a lower state pension."

However, it's worth checking with the documentation provided by the pension scheme.

Because GMPs have valuable revaluation rates every year, up until the scheme's normal retirement age (NRA), there should be documentation from the end of each tax year available to show what entitlements individuals may have. 

Individuals who have been contracted out through such schemes will have an element of GMP shown on their benefits statements - if they still have the documentation, that is.

Ms Paddon adds: "The paperwork should state it is a contacted out scheme or this can be checked with HMRC/NICO."

Phil McGovern, managing director of MPA Financial Management, comments: "All schemes will say whether they are contracted-out or not. All statutory schemes, for instance, are contracted out."

As for his own view on forgoing the state earnings-related pension in exchange for a GMP - "Most major schemes did it and sold it to the membership as a gold standard, when it's a bit of a con really".

"If in doubt", Mr Lawson adds, "the member can check with the trustees of their former employer's pension scheme (or schemes). They can also request information from the Department for Work and Pensions regarding the state pension records held by the government, which should also indicate periods during which they were contracted out".

From simple ideas to complex execution

But, as ever, nothing is simple and straightforward. Not only may an individual have moved between different contracted-out schemes over that timeline, but also, as Ms Ingram points out, as contracting out is done on a tax year basis, individuals may have both contracted-in and contracted-out entitlements when they reach state pension age, so any paperwork will need to be gone through with a fine-toothed comb.

Moreover, there are two ways of being contracted out - either via an occupational pension scheme, or by accepting rebates of NI contributions into a personal pension (see box out) - as between 1988 and 2012, individuals could also choose to contract out.

They would pay full NI contributions in full but part of the NI would be paid rebated into a personal pension in the individual's own names. 

While this form of contracting out is not affected by the current HMRC reconciliation process (although who knows what plans the tax man has for personal pensions in the future?), those with such protected rights benefits may find this affects the level of their state pension if they have not already reached state retirement age (currently 65).

Given the complexity and potential mountain of paperwork involved, this can present a minefield for individuals trying to work out whether they were in final salary (DB) schemes that were affected, and whether their contracted-out benefits are correct, or whether HMRC's reconciliation process of its records with the pension scheme's records will throw up any anomalies. 

It is assumed the GMP element of a final salary scheme or the fund accrued in an appropriate personal pension will be sufficient to make up for the Cope deduction - but this is not actually tested at the time of retirement. Kay Ingram

The problem, as Sir Steve Webb, director of policy for Royal London, asserts, is that the rules that were put into place around GMPs are complex, and not easy for the lay member to understand, either at the time or now.

He says: "The rules around GMPs are complex, and a lot of these arrangements were put in place 30 years ago when computers were in their infancy and a lot of data was stored on paper with carbon copies - I kid you not - being sent to HMRC, etc."

So there is - somewhere - a vast raft of out-dated paperwork that needs to be checked, paperwork that the average scheme member may not even have copies of, which makes it harder for their advisers to spot any potential problems when they carry out their reviews.

Additionally, GMP reconciliation may mean if a problem is spotted, the scheme will have to amend its GMP figures, which affects all scheme members, including some who may already be retired.

State pension impact

Clients may well be asking whether any reconciliation will have a greater impact rather than a simple request for repayment. The answer, sadly, is yes, and the matter has been further complicated by the move to a higher flat-rate pension in 2016. 

Ms Ingram comments: "All who have had years of contracted-out service will have had this taken into account when they drew their state pension, starting after April 2016.

"From April 2016, the old two-tier state pension, which offered a basic one to everyone and an earnings-related top-up to higher earners, was replaced with a higher flat-rate pension for all. 

"To qualify for the full state pension, individuals must have had 35 years or more of NI contributions. Any earnings-related state pension built up before 2016 will be protected and paid in addition to the new state pension, and from 2016 there will be no further accrual of earnings-related pension."

So far, so good. But when individuals, who were contracted out, reached state pension after 2016, there will be a deduction made from the new higher state pension. This deduction is known as the contracted-out pension equivalent (Cope).

A lot of these arrangements were put in place 30 years ago when computers were in their infancy and a lot of data was stored on paper with carbon copies. Steve Webb

Ms Ingram says: "It is assumed the GMP element of a final salary scheme or the fund accrued in an appropriate personal pension will be sufficient to make up for the Cope deduction - but this is not actually tested at the time of retirement."

This means an individual could potentially be several years into retirement without the shortfall having been assessed, and any underpayment of the GMP could result in a reduction of the state pension entitlement.

Mr Webb explains: "If the state pension is too high, a pensioner can find that their state pension is reduced once the new GMP figure is used.  

"Likewise, a pensioner can find that their occupational pension is adjusted up or down, and in some cases schemes are asking for overpayments to be recovered."

Moreover, Mr Webb adds there is nothing to stop schemes from asking for overpayments to be recovered, though some schemes will waive them.

Try explaining this to the average pensioner. As Baroness Ros Altmann, former pensions minister, states: "Unfortunately, most people had no idea they were paying less NI than others with different pension arrangements. 

"They just see a deduction for NI and assume that is what is required by the government for everyone."

simoney.kyriakou@ft.com