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