In some circumstances employees can leave the State Second
Pension Scheme. This is called ‘contracting out’.
There are normally three ways of doing this:
1. Many occupational pension schemes are contracted out.
Contracted out employees pay lower National Insurance (NI)
contributions; so do the employers.
The difference between full rate and the contracted out rate is
called the NI contracted out rebate.
In order to contract out of the State Second Pension a defined
benefit scheme has to provide benefits better than the State Second
Pension. Normally it does make sense to be a member of an
occupational pension scheme rather than just be in the State Second
Pension.
Some occupational money purchase schemes are contracted out.
There is not the same guarantee to provide benefits better
than the State Second Pension, although there are age-related
rebates.
2. Stakeholder pensions and personal pensions can be used to
contract out, but need not be.
3. Some personal pensions operate on a rebate only basis.
This means that the only money paid into the scheme is the NI
rebate. The scheme is then called an ‘Appropriate Personal
Pension’ (APP).
For those people who contracted out via an APP, as they get
older contracting back in to the State Second Pension becomes a
better option because there is less investment time for their
National Insurance rebate to grow.
Some pension professionals believe that there is a break-even
age, above which they recommend people stop contracting out.
Most insurance companies and banks have advised all their
contracted out policyholders to contract back in once they are
above the break-even age.
There are a range of ages used as this break-even age. For women
the age range is usually 40-45 and for men it is 45-50.
Contracting out through defined contribution schemes (i.e. money
purchase, personal pension and stakeholder arrangements) is to be
abolished. The exact date this will happen has not yet been
confirmed but it is likely to be in 2012. At that time,
anyone contracted out of a Stakeholder Pension, Personal Pension,
APP or Occupational Money Purchase scheme will automatically be
contracted back into the State Second Pension.