Contracting Out

Contracting out is where an individual either withdraws from the State Second Pension (S2P) (or previously the State Earnings Related Pension Scheme (SERPS)) and sets up their own private arrangement or is withdrawn from the S2P by their employer.

By withdrawing, an individual gives up their entitlement to the S2P in return for a rebate of National Insurance Contributions (NICs) to their own pension arrangement.

The way in which an individual is contracted out depends upon the type of pension scheme involved. This may be:

A final salary occupational pension scheme, in which case;
The decision to contract out is made by the employer, and
This type of scheme is known as a contracted out salary related scheme (COSRS);
A money purchase occupational pension scheme, in which case;
The decision to contract out is made by the employer, and
This type of scheme is known as a contracted out money purchase scheme (COMPS); and
A personal or stakeholder pension, in which case;
The decision to contract out is made by the individual, and
This type of scheme is known as an appropriate personal pension (APP).

An individual who is a member of a contracted in occupational pension scheme can choose to contract out via a personal pension plan. The decision to contract out on an individual basis is not irreversible. The individual can choose to contract back in at a later date and will become a member of the S2P again from that point onwards.

If an individual is contracted out, either individually or through an occupational pension scheme, a portion of their NICs will be used to provide the contracted out benefits. The way in which this is done depends upon the type of scheme being used to contract out.

Contracting out through a final salary scheme

In a final salary scheme which is contracted out, both the employer and the employee pay reduced NICs. In return the scheme must provide a certain level of benefits.

The employee will pay reduced NICs as follows:

For earnings between the primary earnings threshold (£110 per week for the current tax year (2010/11)) and the upper earnings limit (UEL) (£844 per week for the current tax year (2010/11)), the employee will pay Class 1 NICs at 9.4%;
This is a 1.6% reduction on the full contracted in rate of 11%.
There will be a further 1.6% rebate on earnings between the lower earnings limit (LEL) (£97 per week for the current tax year (2010/11)) and the primary threshold;
This further rebate is subtracted from the total NIC liability. The further rebate applies because S2P benefits are based on earnings from the LEL, despite NICs only being payable on earnings above the primary threshold.
For earnings above the UEL the employer will pay Class 1 NICs at 1%.

An employer will pay reduced NICs as follows:

For earnings between the secondary earnings threshold (£110 per week in the current tax year (2010/11)) and the UEL, the employer will pay Class 1 NICs at 9.1%;
This is a 3.7% reduction on the full contracted in rate of 12.8%.
There will be a further 3.7% rebate on earnings between the LEL and the secondary earnings threshold.
For earnings above the UEL the employer will pay Class 1 NICs at 12.8%.

Contracting out through a money purchase occupational pension scheme

For a money purchase scheme, NICs are reduced and it is the employer's responsibility to pay the NIC rebate into the scheme. This is called the flat rate rebate. There is also an additional second element of rebate, called the age related rebate. This is paid directly into the scheme at a later date.

The benefits provided by the contracted out element of a money purchase scheme (known as protected rights) are also on a money purchase basis and there are no guarantees.

The flat rate rebate

The flat rate rebate consists of the employee's and the employer's rebates. It is the employer's responsibility to pay at least the flat rate rebate into the scheme.

An employee will pay reduced NICs as follows:

For earnings between the primary earnings threshold and the UEL, the employee will pay Class 1 NICs at 9.4%,
This is a 1.6% reduction on the full contracted in rate of 11%;
There will he a further 1.6% rebate on earnings between the LEL and the primary threshold; and
For earnings above the UEL the employee will pay Class 1 NICs at 1%.

An employer will pay reduced NICs as follows:

For earnings between the secondary earnings threshold and the UEL, the employer will pay Class 1 NICs at 11.4%,

This is a 1.4% reduction on the full contracted in rate of 12.8%;
There will be a further 1.4% rebate on earnings between the LEL and the secondary earnings threshold; and
For earnings above the UEL the employer will pay Class 1 NICs at 12.8%.

The age related rebate

The age related rebate is paid directly into the scheme by the HM Revenue & Customs National Insurance Contributions Office (NICO).

Age related rebates are based on the age of the employee and range from 3.0% to 7.4%.

Contracting out through a personal or stakeholder pension scheme

If an employee is not a member of a contracted out occupational pension scheme, they can contract out through an APP. The decision to contract out is the employee's.

If an individual contracts out through an APP, their Class 1 NICs are not reduced. Age related rebates are still paid directly into the scheme by NICO.

The benefits provided by the APP (known as protected rights) are also on a money purchase basis and there are no guarantees.

Contracting out via an APP works as follows:

The employee and the employer continue to pay NICs at the contracted in rate;
At the end of each tax year NICO pay a contracted out rebate directly into the personal or stakeholder pension;
The rebates are age related and the rate of rebate paid is in three tiers:
on earnings between the LEL and the LET, the rebates vary from 9.4% up to 14.8%,
on earnings between the LET and the UET, the rebates vary from 2.35% up to 3.7%, and
on earnings between the UET and the UEL the rebates vary from 4.7% up to 7.4%;
The first tier of rebates equates to the S2P accrual rate of 40%;
The second tier of rebates equates to the S2P accrual rate of 10% band; and
The third tier of rebates equates to the S2P accrual rate of 20%.

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