State Pension – deductions for contracting-out

The old State Pension had two parts, the basic State Pension (paid at a flat rate, based on the individual’s National Insurance record) and the additional State Pension (which was earnings-related). From its introduction in 1978, it was possible to contract-out of the additional State Pension into a workplace pension that met set requirements. Between 1978 and 1997, this was that the scheme provided a Guaranteed Minimum Pension (GMP) intended to provide at least what the individual would have got had they remained contracted in. From 1997, contracted-out defined benefit (DB) schemes had to satisfy a ‘reference scheme test’, intended to achieve broadly the same result.

The option to contract-out into a defined contribution (DC) scheme was introduced in 1988. In this case, the requirement was to make a minimum contribution. The benefits from this had to meet a ‘protected rights’ test but there was no guarantee to provide what the individual would have got had they remained contracted-in.

Individuals who were contracted-out paid a lower rate of National Insurance (NI), in recognition of the fact that they were forgoing additional State Pension rights for that period and building up rights to a workplace pension instead. Contracting-out therefore had the effect of reducing entitlement to the additional State Pension (Pension Schemes Act 1993, s46).

Whether the individual will always receive an amount from their pension scheme equivalent to reduction will depend on the type of scheme they were contracted-out into. For example, in the case of a defined contribution (DC) scheme (such as a personal pension), the “actual pension amount you get will depend on the performance of your investments […] and the choices you make when you decide how to take your fund”(DWP Guidance, April 2017).

The new State Pension (nSP) introduced in April 2016 is single-tier. There is no longer an additional State Pension and the option to contract-out has therefore ended. However, transitional arrangements to deal with past records include a deduction for people who were contracted-out during working life. This was intended to be broadly equivalent in value to the workplace pension the rebate funded and consistent with the rules of the old system. (DWP leaflet 2017, p3; factsheet 2013 p9). As a safeguard, a comparison was made in April 2016 of the amount an individual had built up under the old system and the amount they would have built up under the new system, had it been in place throughout. The higher of the two formed their starting amount for the new State Pension. People who continued to make NI contributions after April 2016 can increase their nSP above the starting amount – by £4.82 pw for each year worked, up to the maximum of £168.60 pw (2019/20 rates).

These arrangements mean that people who have been contracted-out are on average gainers from the new State Pension reforms, compared to the position if the old system continued (Evidence to W&P Committee, 1 Dec 2014, Q24). The National Audit Office found that impact of the reforms was particularly complex for people with Guaranteed Minimum Pension (GMP) entitlement, and varied widely depending on their circumstances.

This briefing paper looks at how the rules on contracting-out and the impact of State Pension entitlement have changed over time.  Other relevant notes include Library Briefing Paper CBP 7414 The new State Pension – transitional issues (Feb 2019) and CBP 4956 GMP increases