Is It Worth Taking This Risk With Your Pension?

Is contracting-out the right thing to do? Or would you be better off sticking with the State Second Pension?

Pensions can be complex creatures. The decision to contract-out was once pretty clear-cut: As long as you weren't already too close to retirement, it probably made sense. But the current investment climate has muddied the waters.

What is contracting-out?

To understand contracting-out, you need to know about the State Second Pension, or S2P.

S2P is the second layer of State pension benefits which you may get on top of your Basic State Pension. The level of income you'll be entitled to from S2P will depend on your earnings during your working life and the amount of Class 1 National Insurance Contributions (NICs) you have paid. (S2P is not available to the self-employed.)

Contracting-out means you have chosen to opt out of S2P. In other words, you won't receive the top-up it provides to your Basic State Pension.

(Before April 2002 the additional State pension was known as the State Earnings Related Pension Scheme or SERPS.)

Why would you contract-out?

The responsibility for providing benefits under S2P is taken away from the government when you contract-out. To compensate you for giving up these benefits, you'll receive a rebate of some of your NICs. The rebate you'll get depends on your age and earnings.

The government will pay this directly into a pension scheme for you known as an Appropriate Personal Pension (APP) or Protected Rights.

An APP is invested in much the same way as any other personal pension. You can choose a provider who will invest the money on your behalf in the hope of providing you with a decent pension pot.

You can also contract-out through your employer's pension scheme. Here you'll pay a reduced amount of NICs, rather than receiving a rebate.

Contracting-out and SIPPs

Until now, pension rules prevented people from using their Self-Invested Personal Pension (SIPP) to contract-out. SIPPs have become popular as a way of bringing lots of pension pots together in one plan, but APPs always had to sit outside the main scheme.

However, since 1 October the regulations have changed. You are now able to contract-out via your SIPP. My Foolish colleague, Cliff D'Arcy, has written a summary of the new rules. Many APPs are invested in poor-performing with profits and managed funds, so the opportunity to transfer them into SIPPs -- which offer far more investment freedom -- is a welcome move.

Contracting-out versus contracting-in

Let's compare contracting-out of S2P through an APP with contracting-in to S2P:

*Normal retirement age is currently 65 years for men and 60 for women. The retirement age for women will gradually increase from 60 to 65 between 2010 and 2020.

On the face of it, contracting-out seems a better option, offering greater flexibility with the opportunity to invest the fund yourself, take tax-free cash and take your income earlier. But none of that really matters unless your APP provides better benefits than staying in S2P.

Is contracting-out a good idea?

At one time contracting-out was considered beneficial for many people. At that time, APPs had the potential to provide better returns than S2P.

But times have changed. Unless you're still pretty young (in your 20s or 30s), contracting-in would probably make more sense. 

Why?

The NIC rebates which are paid into your APP increase with age. If you contracted-out through a personal pension, these increases are capped once you reach 43. If you contracted-out through an occupational (money purchase) scheme, the rebates are capped between the ages of 48 and 50. So there's a strong argument contracting-out is not beneficial after these ages because there's too little time for the contracted-out pension to grow sufficiently for it to exceed the income provided by S2P.

Let's have a look at the figures. If you contract out, pension experts estimate that your APP would need to grow by around 7% a year  to provide the same benefits had you stayed contracted-in. 

It's very difficult to say whether this is still achievable over the long-term.

So, by contracting out or staying contracted out, you're taking on the risk that your pension income could be lower than S2P. If you don't feel comfortable with that, contract back in.

Still not sure what to do? A decision won't be necessary for much longer because in 2012, anyone who has contracted-out will automatically be contracted back in to S2P. In other words, APPs will no longer receive NIC rebates but the payments made so far will continue to be invested. (That applies unless you contracted-out through an occupational final salary scheme where the option to contract-out remains. This will be reviewed in the future). 

You'll then begin to build up new rights to S2P, which will move from being based on your earnings to a fixed amount for each year you work. 

What do you do between now and then?

It's a very tricky question to answer. I decided to contract-out over ten years ago because I wanted to choose where to invest the rebates myself. At that time the NIC rebates were invested in a FTSE All Share index-tracker fund.

I'll have even more investment freedom when I transfer my APP into my SIPP. I like the greater transparency this arrangement provides. I can check on the value of my APP as often as I like in the hope that it will perform well enough over the long-term to better S2P.

With S2P, I feel I have less control over my own retirement planning and I don't necessarily trust the government to provide the equivalent benefits by the time I retire. For these reasons, it's my intention to stay contracted-out for as long as possible.

Of course, this is only my opinion. Contracting-out may not be appropriate for you at all, particularly if don't want to take much -- or any -- investment risk. If you're having trouble deciding what to do, speak to a good independent financial adviser.

More: Save Your Retirement Savings! | Should You Pick A Personal Pension Or A SIPP