The State Second Pension

Published on:

December 1, 2010

The Basic State Pension replaces your lowest slice of income. Depending on how much you've earned over the years, you may also qualify for an Additional State Pension, such as the State Second Pension (S2P). 

Prepare to be baffled though as S2P is possibly the most ridiculously overcomplicated benefit on the face of this planet. It was introduced in 2002, replacing a similar system called the State Earnings-Related Pension Scheme (SERPS). 

Both schemes allow you to build up an additional state pension, depending on how much you earn and how much Class 1 National Insurance Contributions you've paid. Note that self-employed workers do not pay this type of national insurance and, therefore, are not entitled to SERPS or S2P.

The contracting out conundrum

S2P is compulsory for all employees, except for those workers who decide to 'contract out'. If you contract out the government pays you a rebate each year. This rebate has to be invested with a pension or insurance company (or into a company pension scheme), and the intention is that it will eventually produce a similar pension income than S2P would provide. Of course, your investments could do worse than average meaning that your pension income lower than it would have been under S2P.

These days it's very hard to make any sort of sensible decision of whether it makes sense to contract out. Rebate levels have been reduced in recent years, lessening the attractiveness of contracting out. Essentially, your decision is governed by three main factors:

  • Your age. The younger you are, the longer your invested rebates have to grow and, therefore, the greater their potential for growth. Very roughly speaking, once you're over 45, contracting out becomes less attractive.

  • Your salary. The more you earn, the more attractive it is to contract out. Conversely, low-paid workers will usually benefit from remaining in S2P.

  • Future investment returns. Over periods of twenty years or more, investing in shares is likely to produce superior returns than putting your money in cash or bonds. Hence, if you're not comfortable with stock-market risk, contracting-out probably isn't for you.

So, if you're a fairly young, above-average earner and a great believer in the stock market for long-term investing, contracting out may be right up your street. However, if you're over fifty, on a modest wage and wary of investing in shares, contracting in is probably your best option. For everyone else in between, the calculation is fiendishly difficult!

One piece of good news is that no one will have to worry about making these decisions for much longer. From 6 April 2012, the practice of contracting out will be abolished. Everyone who is presently contracted out, will then be brought back into the main S2P pension.

As with all things state pension related, the future of S2P is somewhat uncertain at the moment. As mentioned in the previous article, the government is proposing to introduce a universal state pension from 2015 onwards and it seems likely that this will replace S2P for people who retire after that date.

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