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CONTRACTING OUT IN THE UKA PARTNERSHIPSHIP BETWEEN PUBLIC
AND PRIVATE PENSIONS
Chris Daykin
Government 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 rebate
Age-related
Cap 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
Ad
dit
ion
al p
ensi
on
acc
rued
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