The State Second Pension Explained
From 6 April 2012, it is no longer possible to contract out of S2P using a money purchase or appropriate personal pension/stakeholder plan, meaning it is currently only possible to contract out of S2P using a final salary scheme.
State pensions have over time become more and more complicated. This analysis explains the ‘nuts and bolts’ of the State Second Pension (S2P). First though, and to put this all in context, a brief look at SERPS, the State Earnings Related Pension Scheme and the predecessor of S2P.
SERPS - an overview
SERPS was introduced by the Social Security Pensions Act 1975 and began on 6 April 1978. It was a state pension in addition to the basic state pension for employed individuals (the self-employed were not eligible) and was based on earnings between the lower and upper earnings limits (LEL and UEL) commonly known as ‘middle band earnings’.
When it was first introduced the benefit under SERPS was calculated as 1.25% of middle band earnings (which were revalued each year in line with national average earnings (NAE)) for each year of your working life, up to a maximum of 20 years. It is worth noting that you could use the best 20 years. The maximum was therefore 25% (1.25% x 20) of middle band earnings. This applied to everyone with a State Pension Age (SPA) before 6 April 1999.
After changes announced in the Social Security Act 1986, if your SPA was 6 April 1999 or later you were entitled to a reduced benefit of 20% of average revalued lifetime earnings in respect of accrual from 6 April 1988. So, you were no longer able to use the best 20 years. The 20% restriction would apply in full to those with a SPA on or after 6 April 2009. If your SPA was in the period 6 April 1999 to 5 April 2009 you would get between 20% and 25% for post 6 April 1988 accrual only.
SERPS accrual ended on 5 April 2002 when it was replaced by the State Second Pension.
State Second Pension (S2P)
Introduced by the Child Support, Pensions and Social Security Act 2000, S2P is the successor to SERPS and was effective from 6 April 2002. As well as providing an additional state pension for the employed, S2P gives an additional state pension based on earnings of £15,100 (2014/15) to:
- those with earnings above £5,772 but below £15,100
- carers with no earnings or earnings below £5,772 for any year that they;
- receive child benefit for a child under 12 or
- are looking after someone with a qualifying disability for at least 20 hours a week, or
- have an entitlement to Invalid Care Allowance (even if the benefit is not claimed because of entitlement to another greater benefit
- those who are entitled to long term incapacity benefit or severe disablement allowance, provided that they have worked for and paid Class 1 NI contributions for at least one tenth of their working life since 6 April 1978
- registered foster parents claiming carer's credit.
S2P is not available to those earning less than £5,772, the unemployed, students, those caring for children older than 12 and the self-employed.
S2P is based on an earnings-related system similar to SERPS but with different accrual rates.
S2P in detail
As previously mentioned S2P is earnings-related (similar to SERPS). To ensure that the principal aim of Government was met, that is that low and non-earners received a greater benefit from S2P, there were originally three bands of accrual. To accommodate three bands a Low Earnings Threshold (LET) and a Secondary Earnings Threshold (SET) were introduced in addition to the LEL and UEL that were used for SERPS. Since 6 April 2010 there are two bands.
Before 6 April 2010
Band 1 - covers earnings from the LEL up to the LET. Benefit accrues at a rate of 40% (twice what SERPS provided). As previously mentioned those earning less than the LET are treated as though they had earned the LET.
Band 2 - earnings between the LET and the SET. The accrual rate is 10% for earnings within this band (half what SERPS provided).
Band 3 - covers earnings from the SET to the Upper Accrual Point (UAP). Benefit in this band accrues at 20% (the same as SERPS).
Prior to tax year 2009/10 the UEL was used instead of the UAP.
Note - The LET is announced each year by Government in the same way that the LEL and UEL are. The SET is calculated separately using these figures and is the sum of (3 times the LET) less (2 times the LEL rounded to the nearest £100 rounding down any exact sum of £50)
So, if your SPA was before 6 April 2009 you would not have received less under S2P than you would have done under SERPS.
From 6 April 2010
The Pensions Act 2007 put in place legislation which aimed to reform the State Second Pension so that it would become a flat-rate top-up to the Basic State Pension by 2030. This has now been superseded by draft legislation which intends to replace the basic State Pension with a single-tier pension from April 2016. From this date it will no longer be possible to contract out of S2P. The remainder of this article explains S2P as it currently works until the single-tier pension is introduced in April 2016.
The upper accrual is cash fixed at £40,040 from the point it was introduced on 6 April 2009. This meant that from 6 April 2009 employers and employees with occupational pension schemes contracted-out of State Second Pension receive contracted-out rebates on earnings between the lower earnings limit and the upper accrual point (UAP). Employers and employees pay National Insurance contributions at 13.8% and 12% respectively on earnings between the upper accrual point and upper earnings limit (UEL). The UEL is £41,865 for the 2014/15 tax year.
From 6 April 2012, contracting out on a defined contributions basis is no longer possible so these schemes will no longer receive contracting out rebates, apart from those due in respect of service before that date.
Band 1 - covers earnings from the LEL (£5,772) up to the LET (£15,100). Benefit accrues at a rate of 40% (twice what SERPS provided). As previously mentioned those earning less than the LET are treated as though they had earned the LET.
Band 2 - earnings between the LET (£15,100) and the UAP (£40,040). The accrual rate is 10% for earnings within this band.
S2P - the benefit calculation
The benefit calculation is based on a three-step process which is detailed below.
- Earnings for each tax year from 2002/03 onwards are split across the bands and revalued from the tax year in question up to the tax year before the employee reaches SPA (earnings in the tax year before SPA are not revalued)
- The revalued earnings at SPA in each band are then multiplied by the accrual rate applicable to that band
- These revalued earnings are divided by the total number of years in the individual’s working life since 1978 to give the S2P benefit. Working life is defined as being from age 16 to SPA.
The examples below show how this works in practice for post 6 April 2010 accrual, assuming earnings are revalued to State Pension Age at approximately 2.5% per year.
John, age 55 and a builder, has earnings of £42,000 and a working life of 46 years.
Band 1 – (£15,100 - £5,772) = £ 9,328
Assume that the revalued earnings are £11,941 and £31,925 respectively.
Band 1 - £11,941 x 40%/46 = £103.83
Total S2P benefit for 2014/15 tax year is £173.23.
Julie, age 55 and a nurse, has earnings of £22,000 and a working life of 46 years.
Band 1 – (£15,100 - £5,772) = £ 9,328
Assume that the revalued earnings are £11,941 and £8,833 respectively.
Band 1 - £11,941 x 40%/46 = £103.83
Total S2P benefit for 2014/15 tax year is £123.03.
Note - In both examples the S2P benefit would be converted into a weekly amount.
Interaction with SERPS
SERPS and S2P will be calculated separately and individuals will be entitled to both a SERPS and a S2P benefit at SPA, assuming of course that they were in both SERPS and S2P.
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice.
Published 27 April 2004
Updated 6 April 2014
For professional advisers only