Appropriate Personal Pension / Stakeholder Pension Contracting-Out Rebate Calculator - work out the current years rebate into an Appropriate Personal Pension.

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As well as the Basic State Pension, the UK State Pension System has for many years offered some form of top-up pension that has been linked to earnings to some shape or form. Earlier examples included the Graduated Pension which was replaced by SERPS (State Earnings Related Pension Scheme) that was operative from 1975 to 2002.

This was replaced in 2002 by the State Second Pension (S2P). Like SERPS, S2P is a career average pension scheme, with accrual based upon 'bands' of earnings to an upper ceiling. This is added on top of the basic state pension, and increases each year in line with indexed retail inflation (RPI).

For the 2009/2010 tax year, the bands are:

Band 1 - earnings between the Lower Earnings Level (£4,940.00) and the Lower Earnings Threshold (£13,900.00)
Band 2 - earnings between the Lower Earnings Threshold (£13,900.00) and the Secondary Earnings Threshold (£31,800.00)
Band 3 - earnings between the Secondary Earnings Threshold (£31,800.00) and the Upper Earnings Limit (£43,888.00)

The percentages of earnings are respectively 40%, 10% and 20% of earnings for each band. For individuals earnings above the Lower Earnings Level and the Lower Earnings Threshold, they will be treated as if they earned the Lower Earnings Threshold for S2P purposes. This is an intentional mechanism to help the lower paid.

As with SERPS, S2P is effectively a career average scheme, with entitlements from each tax year based on earnings subject to annual revaluation thereafter until retirement.

The percentages represent the entitlement as percentage of salary for a scheme member will a full working life's membership (typically 49 years). Entitlements for members with lesser membership periods are reduced pro-rata.

A member's full working life for the purposes of S2P pension is defined as the number of years between age 16 and State Pension Age. If the member was over age 16 on 6 April 1978, their working life is defined as the number of years between 6 April 1978 and their State Pension Date.

Contracting Out

Occupational Schemes

It is possible to contract-out of via an employer's occupational pension scheme (although this calculator does not deal with this, as it is much simpler to calculate, along with the fact that many schemes contract-out all employees by default as a condition of membership). Under these arrangements, both the employer and employee pay reduced National Insurance contributions, and at retirement, part of the additional pension is paid via the occupational pension scheme, and partly from the State Pension system (as the employee has still been paying some National Insurance contributions).

Appropriate Personal Pensions / Stakeholder Pensions

A person can also contract out of S2P with a stakeholder pension or a personal pension plan available from a variety of Insurance Companies. This vehicle is then known as an Appropriate Personal Pension, or APP. If they do this, instead of their paying lower National Insurance contributions, once a year HM Revenue & Customs will pay directly into their APP a rebate, sometimes known as a Minimum Contribution. This rebate is intended to provide benefits broadly the same as the Additional Pension given up - that is, full S2P. Because rebates are paid annually in arrears, and individual can contract back into the system at any time.

If an individual has contracted out via a Personal Pension or Stakeholder plan, it should in theory give them roughly the same amount one would get from the Additional Pension. Whether it does is dependent on the investment returns from the rebate being sufficient to match the benefits available if they were still contracted back in (usually in the form of an annuity.)

Pros and Cons of Contracting Out

Although the National Insurance rebate is intended to provide benefits broadly the same as the S2P Pension given up, there has long been debate over whether the rebates are sufficient based on current projections for investment returns and annuity rates. Many Personal Pension providers have for some years been encouraging some or all of their customers to contract back in.

Some would argue that because governments are always changing the rules and entitlements for State Pensions, once you have taken the rebates, it is money under your control, and you are not at risk of a future government changing the rules to your detriment.

However, others would argue that you will receive a known level of pension that is not determined by investment returns or annuity rates but lose the flexibility to take their pension before state pension age, receive a tax-free lump sum payment on retirement.

Future of the State Second Pension:

In 2006 the government announced changes to both the Basic and the Additional Pension:

Contracting out through APPs would be discontinued from 2012. Thereafter contracting out would only be available through an employer.
S2P would gradually cease to be 'earnings related' and become a flat rate scheme.
Entitlement to a 'full' Basic State Pension will require just 30 qualifying years from April 2010, instead of the 44 (women) or 49 (men) at present.
State Pension Age would be raised approximately 1 year per decade from the age 65 (for both men and women) in 2023 to 66, then 67 and then 68. However, any entitlements built up from contracting out can be taken between the age of 55 and 75 (as at present), and it is possible to commute up to 25% of the fund value for a tax-free lump sum.

Use of this calculator does not constitute a recommendation for or against using an Appropriate Personal Pension for contracting-out purposes. If in doubt, you should seek professional advice.