August 2005

  1. The additional State Pension1 is an important part of retirement planning for many consumers. Around eight million people have been contracted out of the additional State Pension into an Appropriate Personal Pension (APP) for periods at some point in the past; of these, around three million are currently contracted out.2
  2. Earlier this year, in response to concerns identified both by us and by commentators such as Which?, we commissioned a report from OAC plc (Oxford Actuaries and Consultants). This aims to examine the financial impact to date for consumers who have contracted out of the additional State Pension scheme through an APP, compared to the position they would have been in if they had remained contracted in.
  3. The OAC study follows an earlier report commissioned by the Securities and Investments Board (SIB) in 1996. The report for SIB assessed the financial impact to consumers who had contracted out of the State Earnings Related Pension Scheme (SERPS), the predecessor to the State Second Pension (S2P). The report found that most consumers could expect to be financially better off if they contracted out of the state system. See a copy of the report for SIB.

The OAC Report

  1. The OAC report compares, across a range of model case studies, the current estimated financial position of consumers who contracted out of the additional State Pension over various periods since 1988 with the position that they would have been in had they remained in the state scheme. The study seeks to distinguish between consumers with different age, sex, income and marital status characteristics. It then further analyses how these indicative results may vary for a range of contracting out periods, past investment returns, APP charging structures, and future economic scenarios.
  2. The OAC actuarial work is based, necessarily, on a series of assumptions, as set out in section three of the report. These assumptions include future investment returns, annuity rates at the time of retirement, and an assumption that government policy on future pension entitlements under the State Second Pension and retirement ages remains unchanged. The results are inevitably sensitive to changes in these underlying assumptions. The calculations are therefore not definitive for the financial position of individual consumers, which can only be known when they reach state pension age. Ultimately, the benefits that can be secured in return for an APP fund will be dictated by market conditions during the period to retirement and market annuity rates at that time.
  3. A copy of the OAC report can be found on our website.
  4. The results show that there is a wide range of potential outcomes depending on, among other things:

    • when individual consumers contracted out of the additional State Pension;
    • their age when they did so;
    • the period over which they contracted out; and
    • the performance and charges of the personal pension fund they invested in.
  5. The OAC report shows that, on average, APP funds are estimated to provide a lower pension than consumers might otherwise have expected to receive, had they remained in the state scheme. The median potential underperformance is equivalent to a reduction in pension of £4 a week for those who have contracted out at various times over the period since 1988 and who have remained contracted out until 2005. The median potential underperformance is equivalent to a reduction in pension of £2 a week for those who contracted out for five years and then contracted back in. There is a wide range of results around the median.
  6. Such calculations do not take account of features in contracted-out pensions which may be of particular value to some consumers. These features include:

    • the ability to take some of the contracted-out pension as a tax free lump sum (after 6 April 2006);
    • more flexibility about when a pension can be taken; and
    • the possibility for single people to bequeath a contracted-out pension pot to their heirs.
    Nor do the calculations take full account of the characteristics of those who are likely to have contracted out. The figures are only valid for the example cases and may not reflect the median differences in the general population affected.
  1. The findings of the OAC report may help provide a general indication of the current estimated financial position of contracted-out policies. However, we would caution against individual consumers using the OAC report to provide any definitive guide to their relative financial position, as that will depend on several factors not necessarily considered within the report. Also, the results only look at the position now; the results may change over time as economic and demographic conditions alter, or because of changes in government policy.

Further FSA Work

  1. It is important not to equate a potential underperformance with mis-selling. Performance risk is an inherent feature of personal pensions, but remaining in the State Second Pension is also subject to potential uncertainty about future government policy. So both options available to consumers are subject to uncertain outcomes arising from unpredictable events. The fact that a consumer may receive less pension at retirement, compared with their position had they taken a different choice many years previously, is not evidence of mis-selling and does not therefore constitute valid grounds for a complaint. When considering whether mis-selling may have occurred, the rules and standards to be enforced will continue to be those in place at the time of the sale and not some retrospective reconstruction.
  2. However, the likelihood that significant numbers of consumers may face relative underperformance at retirement as a result of having contracted out of the additional State Pension does make it important that we consider whether there has been any significant mis-selling.
  3. We have therefore contacted a sample of product providers and advisory firms active in the market to inform this work and to consider how industry practice has evolved. This work highlighted that, generally, there was a considerable degree of commonality of approach within the industry. For example, until 1997 most firms used age and salary criteria as the basis for recommending whether a consumer should be contracted in or out, although we also noted a number of differences in practices at individual firms.
  4. We have also looked carefully at the evolving regulatory requirements that were in place during the relevant period, against which the behaviour of firms at the time has to be judged. This work is continuing.
  5. We have discussed with the Financial Ombudsman Service complaints about contracting out raised by individuals. To date, there have been only a small number of complaints, with the Financial Ombudsman Service recording fewer than 100 cases. Complaints levels at individual firms are also generally low.

Future Decisions for Consumers on Contracting Out

  1. The OAC report suggests that, working on current market assumptions, there has been a change in the balance of risks and benefits from contracting out since the findings of the earlier report for SIB. There will be further developments in the coming period which are likely to affect this balance. In particular, the Government is currently engaged in a number of reviews which could result in changes in the policy surrounding the State Second Pension.
  2. There are also wider factors affecting their personal circumstances that consumers need to take into account when making a decision about contracting out. These include the ability to take some of a contracted-out pension as a tax free lump sum (after 6 April 2006) and the ability for single people to bequeath a contracted-out pension pot to their heirs – neither option is open to those in the state scheme.
  3. Consumers need to consider the decision to contract in or out every year as circumstances change: factors such as investment returns, government policy and individual circumstances need to be considered. These are complex decisions and many consumers will need help in taking them. For further information, see our guide to pensions 1 'Starting a Pension' and our factsheet 'Contracting out of the State Second Pension'.
  4. The Association of British Insurers (ABI) and the Association of Independent Financial Advisers (AIFA) last year produced a factsheet for providers to send to all policyholders who are currently contracted out of the State Second Pension through a personal pension, to encourage them to review their position. ABI intends that its member firms send a revised version of the factsheet in relation to the year 2005/2006, to encourage consumers to review their decision on whether to be contracted in or out of the state scheme.
  5. In February this year, we issued a consumer alert to remind people to give careful consideration to their contracting out decision each year. We will work with industry and consumer bodies to establish what relevant information can be provided to consumers to help them with their decisions before April 2006.

1The additional State Pension means the State Earnings Related Pension Scheme (SERPS) and its replacement the State Second Pension (S2P).
2The following analysis applies only to individuals who have contracted out into APPs. It does not address the different situation of those contracting out through an occupational pension scheme. Figures for 2002/03 are taken from the DWP website.