April 6th 2016 should be a date with a red circle round it on any pension’s office calendar. It’s the day when contracting-out officially comes to an end- “cessates” – is no more.
It is also the date when the two tier state pension becomes a single state pension. With the help of a fully functional Government computer system, we should all be able to access (online-ish) our entitlement to this single state pension.
Recently Ros Altmann and the DWP have been dampening down the expectations, only about a third of people retiring in 2016 will find they have a full entitlement (worth just over £150 a week) for the other two thirds there will be various deductions calculated by means of a contracting-out deduction (COD). We all have a national insurance payment record stretching back to our youths. Years in which we paid full national insurance earn us a full entitlement to the new “foundation pension” , but many of us did not pay full contributions, either because we were out of the country or paying at the reduced woman’s rate or because we were contracted out of the second state pension (formerly known as SERPS).
The way the COD is calculated is a matter for much discussion among pension geeks. The suspicion is that the Government are working hard to balance the books by working within a black box to rip people off. There is no evidence for this but it is clear that no system as broad and complex as UK pensions is going to be totally fair, we will hear much about the losers and the winners will be remarkably quiet.
Where the equation is between national insurance contributions paid and benefits received, life is relatively simple. The Government Actuary wields a mighty spreadsheet with many inputs, chief of which are time/money, inflation and changes in life expectancy.
But where the equation is between NI and the accumulated value of a pensions savings pot, or even a revalued defined benefit promise made by an employer through an occupational scheme, things get more tricky. For years, trustees have known they will have to reconcile the guaranteed minimum pensions (GMP) they are and will pay to pensioners with people’s state pension entitlements. It is a fiendishly complicated business as the division of responsibilities, especially over the payment of pension increases in retirement, changes over time.
Those members of occupational pensions relying on a combination of State Pension and GMP do at least have a simple sum, add the two together and you should get to £150 or thereabouts (all else being equal)
But what about those who contracted out with their money being paid into a savings pot. There were two ways of doing this, either your employer did it for you and invested the money into the occupational trust, or you did it for yourself and invested the money into a personal pension (usually with the help of a financial advisor). Here it is the investment value of the pension savings pot that matters. To convert this value to state pension you need to divide it by a number (a GAD factor).Let’s say for a 65 year old that number is 30. So let’s say you have a £30,000 savings pot from contracting out, that’s worth roughly £1,000 pa in terms of extra state pension. Doing rough numbers, if you have £30,000 in your contracted out pot and a state pension entitlement of £130, you’re about evens.
The problems start occurring when the numbers don’t add up. If in this example the state pension was £120 pw then there would be a shortfall of around £10pw which in cash terms equates to about £15,000, that’s a lot of money to be short of.
Why might there be a shortfall? Well it’s invariably because the investments within the fund did not perform as well as was needed to meet the guarantees from the state. When I sold contracting out, I remember people looking at performance figures and choosing Japanese funds (past performance). But even if you got the fund choice right, you still had charges. Personal pensions “Appropriate” for contracting out (APP’s) typically paid flat rate commission of 5% of the annual contribution each year but occupational pension schemes could invest in policies where the total contribution paid indemnified commission of up to 60% of the first year’s contribution (collectively)! These Contracted-Out Money Purchase schemes (COMPS) could have a charge on units purchased in the first two years of contracting out of over 5% pa.
A combination of poor investment choices and high charges means that some of these COMPS and APPs are miles off meeting the shortfall in state pension calculated by a COD for the period they were being used. That’s going to be a tough one to explain.