CONTRACTING OUT IN THE UK A PARTNERSHIPSHIP BETWEEN PUBLIC AND PRIVATE PENSIONS

1. CONTRACTING OUT IN THE UKA PARTNERSHIPSHIP BETWEEN PUBLIC AND PRIVATE PENSIONS Chris Daykin Government Actuary Rome, 3 April 2003

2. 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

3. 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)

4. 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

5. 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

6. 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)

7. 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

8. 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

9. 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

10. 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

11. 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

12. CONTRIBUTION REBATES FOR FINAL SALARY SCHEMES

13. 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

14. POPULATION CONTRACTED-OUT

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

16. 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)

17. 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

18. 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

19. APP AGE-RELATED REBATES

20. 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

21. 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

22. 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

23. STATE SECOND PENSION ACCRUAL

24. 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)

25. 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