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BeeHive  >  BeeLines  >  Contracting-Out and the Pensions Commission

Contracting-Out and the Pensions Commission

Iím just picking up on one aspect of the Pensions Commissionís report now that the dust is beginning to settle a bit and thatís regarding the comments made in the report about contracting-out of the State Second Pension scheme (S2P) and about contacting-out in general.

Contracting-out has been a feature of UK state pensions since 1961.That was when a second, earnings-related, state pension was first provided to supplement the Basic State Pension (BSP).It was called the Graduated Pension Scheme and the idea was that it would provide additional pensions through the National Insurance system for people earning more than a certain amount a week.Those in company pension schemes (as nearly half the UK working population was by 1963)1 were able to contract-out of the Graduated Pension Scheme if their company schemes provided equivalent benefits.

The state Graduated Pension Scheme eventually died a death in the mid-1970s as the benefits it provided didnít allow for inflation and for most people the pensions didnít amount to a row of beans. It was eventually replaced in 1978 with another state second pension, the State Earnings-Related Pension Scheme (Serps), which provided much higher prospective pension benefits, but that of course came at a cost. What the government at the time were trying to do was to provide something like a company pension scheme, but through the National Insurance System, for those who did not have access to company pension schemes. In 1979 still only approximately half the working population were in company pension schemes 1.

The long-term costs of the Serps scheme were politically unacceptable and it too began the process of its own death by a thousand cuts through the 1980s and 1990s until it became a shell of its former self and was eventually replaced by what we now call S2P. S2P is the latest in the line of state second pensions aimed at providing pensions for approximately half of the UK workforce who are still not covered by private funded pensions 2.

In between the death of the Graduated Pension Scheme and the birth of Serps a politician guy called Keith Joseph put a new and different kind of second pension scheme onto the statute books. This was called the State Reserve Scheme and was predicated on the premise that pensions backed by money would be of more use to people than pensions backed by political promises. This scheme didnít actually get off the ground before it was gunned down on a change of government in 1974, but the idea didnít die completely 3.

The Serps scheme was a scheme paid for by National Insurance contributions and therefore backed by government promises rather than funding, but it retained the right for people in sufficiently good final-salary company schemes to contract-out and have their promises backed by money instead. This right was extended in 1988 to those in money-purchase schemes including people with individual private pensions.

So, much of the money that was supposed to fall into government coffers through the National insurance type of taxation for the second pension has in practice actually ended up in funded company and individual pension schemes instead. Contracting-out has ensured that millions of people now have pensions backed by money rather than government promises. I like that and think contracting-out has been good for the UK as, unlike other European Union countries, we are not so reliant on pay-as-you-go state pension promises.

Here, at the start of the twenty-first century, we are still struggling with the same problems that confronted us way back in 1963. Approximately half of the UK working population today still have no pension provision to look forward to other than the Basic State Pension and the State Second Pension provided by the state through the National Insurance tax system. These pensions are inadequate in the main and this means that approximately half the retired population in the future is set to become dependent on additional means-tested handouts from central government. Not a pretty picture (or a good position for us to have ended up in), but hardly surprising to those who have followed the stateís constantly changing attempts over the last forty years to provide benefits through state machinery as a way of compensating for the lack of enough company sponsored pensions.

This latest suggestion from the Pensions Commission is that the state machinery can be used in some way to facilitate funded pensions for half the UK workforce. Iím a bit on the cynical side on that. On the one hand it looks like the Commission is in favour of pensions backed by money rather than government promises which is good, but on the other it requires the state machinery to do things it doesnít really have a good track record for. At the same time Iím very surprised that the Commission is suggesting that contracting-out should go immediately for money-purchase schemes and be phased out over time for final-salary schemes. That will mean an increase in the number of pensions backed by government promises in future and a decrease in the amount backed by money. These two ideas seem to me to be inconsistent.

Steve Bee

7 December 2005


1. European Consortium for Political Research, Turin, March 22nd-March 27th 2002 - Workshop 21: The Politics of Pension Reform - Pension Reform in the UK: re-casting the public/private mix in pension provision 1997-2000
2. The First Report of the Pensions Commission - Pensions: Challenges and Choices published on 12 October 2004
3. Pension Schemes and Pension Funds in the United Kingdom, second edition†by David Blake published by Oxford University Press

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