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Contracting Out

CONTRACTING OUT

 

If you are an employed earner and earn above a certain amount (£4,680 in 2008/09) you can if you wish, choose to leave the additional State Pension scheme and join a private pension scheme instead. This is called 'contracting out'.

You can choose to contract-out by joining your employer's contracted-out occupational pension scheme, both you and your employer will pay lower, reduced rate National Insurance contributions. You can also contract out by joining a stakeholder pension scheme or a personal pension scheme. If you do this, instead of paying lower National Insurance contributions, once a year HM Revenue & Customs will pay a rebate of your National Insurance contributions directly into your pension. The rebate is intended to provide benefits broadly the same as the additional State Pension given up.
 
Occupational Schemes – employer run schemes
An occupational pension is a private pension scheme run by some employers and is also known as a works pension, company pension or superannuation. If your employer runs an occupational scheme you should find out if you are eligible to join it. Occupational pensions are paid on top of any State Pension that you may be eligible for.    There are two different types of Occupational Schemes and they function in very different ways.
Final Salary also called Defined Benefits
 
A final salary pension scheme means that your resulting pension benefit is a formula of your final salary. These schemes are becoming more expensive for employers to run and are not nearly as common as they were several years ago; very few employers now offer these.
 
The formula depends on the scheme that you are a member of. For example if your scheme is a 1/80th  scheme then you receive 1/80th of your final salary as pension for every year of pensionable service, and a lump sum which equates to 3/80th of your final salary for each year of pensionable service. Therefore if you retired on £40,000 and had worked for 30 years you would be entitled to a UK tax free lump sum of:
 
3/80 * 40,000 * 30 years = £45,000 and a pension of  1/80 * 40,000 *30 years = £15,000
 
There is the option to take less UK tax free cash and a higher pension, or alternatively more UK tax free cash (subject to an upper limit) and a lower pension
 
Money Purchase – defined contributions
 
A money purchase scheme is very different to a final salary scheme. Your pension income in retirement is not a formula of your final salary, but is based on the value of your accrued pension fund and annuity rates at the time you retire. The value of your accrued pension fund will depend on how much has been paid into your pension and the performance of the investments within the plan. For example, based on annuity rates in July 2008 a pension fund of £200,000 could buy a 60 year old women a single life level pension of around £14,000 a year.
 
Personal Pensions
Personal pensions can take a number of forms, however they all have the same premise, which is they work in the same way as the above explained money purchase schemes: your resulting pension will depend on the how much has been contributed, the performance of the underlying investments and the annuity rates at retirement. Stakeholder pensions, personal pensions and Self Invested Personal Pensions all work in this way, however they all have different investment options.

This information has been underpinned by our Expert, Lorna Shields, Financial Adviser, CTFS Limited
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National Insurance
Pensions Overview
Types of Pensions