CONTRACTING OUT IN THE UKA PARTNERSHIPSHIP BETWEEN PUBLIC

AND PRIVATE PENSIONS

Chris DaykinGovernment Actuary

Rome, 3 April 2003

STRUCTURE OF PROVISION FOR RETIREMENT IN UK

• compulsory flat-rate first pillar (basic pension)• compulsory earnings-related second tier• voluntary occupational or personal provision• personal savings• means-tested guarantee credit & pension credit

BASIC PENSION• flat-rate pension (i.e. independent of earnings)• entitlement is based on contribution record• pension age is 65 for men and 60 for women

- 60 to rise to 65 between 2010 and 2020• currently set at about 16% of average earnings

(26% for man with dependent wife)

REASONS FOR INTRODUCING CONTRACTING OUT IN 1978

• desire to introduce earnings-related pension• occupational pension schemes already existed• typically these were good final salary schemes• wanted to avoid duplication of provision…• …and to avoid reducing funded provision• …and to keep down future social security costs

GENERAL PRINCIPLES OF CONTRACTING OUT

• earnings-related benefits are compulsory…• …up to Upper Earnings Limit (1¼ av.earnings)• private provision may substitute for SERPS• choice of several ways of contracting out• contributions are reduced if contracted out• reduction (“rebate”) should be actuarially fair

EARNINGS-RELATED PENSION• compulsory second pillar• covers earnings from £77 to £595 a week (500 to

3900 € a month) • choice of: • * state-earnings related pension scheme

(SERPS)* final salary pension plans (COSRS)

* money purchase pension plans (COMPS) * personal pensions (APPs) * stakeholder pensions (from April 2001)

FINAL SALARY SCHEMES

• trust-based, defined benefit plans• sponsored by employers• trustees responsible for investments• employees usually pay contributions• employer finances the rest• about 100,000 such plans in the UK

PERSONAL PENSIONS

• individual account, defined contribution plans• marketed by insurance companies• mostly pure investment-linked• restrictions on form of benefit

– up to 25% as cash lump sum– annuity or drawdown for rest

• employers generally do not contribute

CURRENT TAX REGIME (DB and DC)

• contributions out of pre-tax income• contributions by employer not taxable• investment returns largely free of tax• tax free lump sum (25% of rights)• pension taxable as earned income

CONTRIBUTION REDUCTIONS

• contribution reduction (or “rebate”) represents value of benefits substituted

• rebate recommended by Government Actuary…• …on the basis of equivalent value• final decision made by Minister…• …may include incentive to make it attractive• effect is to shift provision from public to private

EFFECT OF REBATES

• for DB schemes the rebate helps with funding• … and benefits both employee and employer• for DC schemes the rebate determines the

minimum amount which is saved…• …and needs to be sufficient, relative to state

benefits forgone, for sale to be recommended

CONTRIBUTION REBATES FOR FINAL SALARY SCHEMES

Employeerebate

Employerrebate

Totalrebate

1978-83 2.5% 4.5% 7.0%1983-88 2.15% 4.1% 6.25%1988-93 2.0% 3.8% 5.8%1993-97 1.8% 3.0% 4.8%1997-2002 1.6% 3.0% 4.6%2002-07 1.6% 3.5% 5.1%

CONTRACTING OUT TESTSFOR FINAL SALARY SCHEMES

• initially the pension scheme had to pass a test• and Guaranteed Minimum Pension had to be

provided for each individual contracted out• also a funding test (with actuarial certification)• GMP requirement ceased after March 1997• now there is just a test that the pension scheme

meets certain standards

POPULATION CONTRACTED-OUT

APPs (3.7m)COMPS (0.3m)

SERPS (8.1m)

COSRS (8.1m)

EFFECT OF CONTRACTING OUTSERPS/S2P expenditure in £bn at 1999/2000 prices

0

10

20

30

40

50

60

2000 2010 2020 2030 2040 2050

Gross SERPS/S2P Net SERPS/S2P Cost of rebate

CONTRACTING OUT WITH DC PLANS

• Appropriate Personal Pensions from 1987• rebates were initially the same as for DB• this made it attractive for younger people• 2% additional payment from 1987 to 1993 for newly

contracted-out• 1% of relevant earnings from 1993 to 1997 for those

over 30 with an APP• rebate goes to individual account (protected rights)

PROBLEMS OF CONTRACTING OUT - 1

• PAYG costs have to be met anyway…• …so standard contribution rises if more c-out• flat-rate rebate is rather broad-brush…• …so not suitable for all schemes• complexity arising from GMPs and other tests

PROBLEMS OF CONTRACTING OUT - 2

• APP rebates must be high enough for selling…• …so they include higher expense loadings• flat-rate rebates created certain incentives• age-related rebates are fairer but less incentive• high rebates subsidise inefficiency• …..and penalise those not contracted out• contracting-out arbitrage

APP AGE-RELATED REBATES

0

2

4

6

8

10

12

20 25 30 35 40 45 50 55 60

COSR rebateAge-relatedCap on rebate

STATE SECOND PENSION - 1

• introduced from April 2002• revalued career average (as SERPS)• no further change to pension age• higher accrual on lower bands of earnings• special protection for low paid and carers

STATE SECOND PENSION - 2

• differential accrual rates on earnings bands: < £11,200 a year : 40% for full working life £11,200 to £25,600 : 10% for full working life >£25,600 a year : 20% for full working life• thresholds uprated in line with average earnings

STATE SECOND PENSION - 3

• employees earning <£11,200 credited at £11,200• carers and disabled given credits

– for looking after disabled persons– and for looking after children aged 5 and under

• may eventually become flat-rate• higher earners expected to have private pension

Earnings

Add

ition

al p

ensi

on a

ccru

ed

State Second Pension, including effect of deemed earnings at low earnings threshold for low earners

Benefits given up by members of contracted-out occupational schemes (as for pre-2002 additional pension benefits)

Benefits given up by members of APPs (State Second Pension ignoring deeming of earnings to low earnings threshold)

QEF LET UEL3LET - 2QEFBand 1 Band 3Band 2

40 % accrual

10 % accrual

20 % accrual

STATE SECOND PENSION ACCRUAL

CONTRACTING OUT OF S2P

• APP rebate in bands based on S2P forgone• rebates for COSRS based on SERPS accrual• S2P top-up for higher accrual rates• S2P top-up for low earners and carers• stakeholder available for contracting out… • …but little take-up (most stakeholder pensions

are contracted in)

WHERE NEXT WITH CONTRACTING-OUT?

• some form of contracting-out was necessary because of widespread final salary schemes

• with switch from DB to DC there is a tendency now to contract back in

• stakeholder and other DC schemes are regarded as topping up state benefits

• some of savings will be lost, but risk profile of a mix of S2P and DC is reasonable