House of Commons - Explanatory Note
Child Support, Pensions And Social Security Bill - continued          House of Commons

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The current position

SERPS and contracting-out arrangements

188. The UK pension system combines a contributory state scheme, consisting of *basic Retirement Pension and Additional Pension derived from the State Earnings-Related Pension Scheme (SERPS), with a private system of *occupational and personal pensions.

189. All employees and self-employed people, except the very lowest paid, pay *National Insurance contributions (NICs). These give entitlement to the basic state pension. In addition, employees – but not the self-employed – earn entitlement to an additional, second-tier pension (SERPS), unless they choose to “contract-out” of SERPs and join a pension scheme which gives them rights in place of their SERPs entitlement.

190. For those who are, or have been, members of SERPS, the amount of Additional Pension they will receive is based on the amount of their “surplus earnings” in the years since 1978 when SERPS was introduced. Surplus earnings are those between the *Lower Earnings Limit (LEL) and *Upper Earnings Limit (UEL). The surplus earnings are increased in line with average earnings to the year before a person reaches state pension age in order to maintain their value in earnings terms. The total amount is multiplied by an accrual rate of between 25% and 20% depending on the year in which the person reaches state pension age (for anyone reaching state pension age from 6 April 2009 onwards, the accrual rate is 20%). This amount is then divided by the number of years in the person’s working life since 1978 (up to a maximum of 49 for those who reach state pension age from 2027) to give the annual amount of that person’s Additional Pension derived from SERPS.

191. SERPS is an earnings-related scheme, with higher benefits accruing to those who have had higher earnings throughout their working life. Lower earners accrue lower benefits and it is possible to have worked and paid NICs throughout a working life and still receive a combined basic and Additional Pension which is less than is available through means-tested benefits. Those who have had breaks in their employment history for periods of caring or disability can be similarly affected.

192. Employers may choose whether or not to provide an occupational pension scheme and whether to contract-out of SERPS. For those who are contracted-out of SERPS, a NI rebate is given in recognition of the fact that there is a reduced liability on the state.

193. A person contracted-out of SERPS may be a member of:

  • a “salary-related” occupational pension scheme, where the pension received depends on the employee’s salary and service history. In such schemes employers and employees pay lower rate NICs;

  • a “money purchase” based occupational pension scheme. The contributions and any NI rebate are invested and, on retirement, can be used to buy an annuity. The final pension received depends on the investment performance of the scheme and the annuity rates available at retirement. Employers and employees pay a reduced rate of NICs and an age-related payment, which is increased with the age of the member, is paid to the pension scheme by the Inland Revenue; or

  • an “appropriate personal pension” (i.e. a contracted-out personal pension). In this case, employers and employees pay the full rate of NICs and an age-related payment is paid into their pension fund at the end of the *tax year.

194. Some occupational schemes are hybrid or “mixed benefit”, combining features of salary-related and money purchase schemes. All personal pensions are provided on a money purchase basis.

195. Occupational pension schemes which are contracted-out must satisfy conditions which are designed to ensure that employees in these schemes, who are benefiting from NI rebates, receive pensions from the scheme which at least equal what they would have received from SERPS.

196. Prior to April 1997, in order for a salary-related scheme to contract-out, it had to promise to provide a Guaranteed Minimum Pension (GMP) which is broadly equivalent to what the SERPS entitlement would have been had the individual not contracted-out.

197. From April 1997, contracted-out salary-related schemes have had to satisfy a scheme-based test (reference scheme test). This requires schemes to meet a statutory standard laid down in the Pension Schemes Act 1993. The scheme actuary will certify that the test is met if the scheme provides benefits broadly equivalent to, or better than, those of the reference scheme.

198. Employees who join occupational pension schemes which have not contracted-out of SERPS, or non-appropriate personal pension schemes, accrue SERPS benefits as well as benefits under the scheme, but they do not receive NI rebates.

Occupational and personal pensions regulatory framework

199. There is a framework designed to protect the interests of scheme members within which occupational and personal pensions have to operate. This includes provisions to ensure that those who leave schemes before retirement can transfer or preserve their accrued rights, that pensions in payment receive some protection against price increases, that schemes are properly run and assets safeguarded and that the benefits scheme members expect to receive are secure.

200. The Occupational Pensions Regulatory Authority (Opra) was established by the *Pensions Act 1995 to regulate key aspects of the occupational pensions framework. The sale of personal pensions is regulated by the Financial Services Authority 7 (FSA).

Recent developments

201. The Government’s proposals for the reform of the pensions system in Britain were set out in the Green Paper A new contract for welfare: PARTNERSHIP IN PENSIONS (Cm 4179), published in December 1998.

202. Key principles set out in the Green Paper were that the new pensions system should:

203. Some of the measures to achieve the above aims were introduced in the *Welfare Reform and Pensions Act 1999. These include the legislative framework for the introduction of stakeholder pensions. It is intended to implement stakeholder pensions from April 2001. These schemes will offer money purchase benefits to members, providing benefits related to the contributions paid by the members, together with the investment returns on those contributions (less charges). The charges will be subject to an upper limit.

204. Stakeholder pension schemes will be targeted at those with moderate earnings (around £9,500 to £21,600 a year) who want to save more for retirement but who do not have access to an occupational scheme and for whom many existing personal pensions can be unsuitable or expensive. They will be set up within an approved governance structure (the arrangements for the management and oversight of a pension scheme) and meet minimum standards intended to encourage more moderate earners to save for their retirement. However, everyone will be able to pay into such a pension scheme, regardless of whether they are in work or not.

205. The Welfare Reform and Pensions Act 1999 also included legislation on several detailed proposals on occupational and personal pension schemes which were contained in the consultation document Strengthening the Pensions Framework that accompanied the 1998 Green Paper.

The measures in the Bill

State Second Pension

206. The State Second Pension will reform SERPS by boosting the Additional (second tier) Pension of low earners and providing Additional Pension for the first time for carers and some long-term disabled people with broken work records.

207. State Second Pension will be calculated by reference to the surplus in an individual’s earnings factor. An individual’s earnings factor corresponds to the whole of his earnings up to the Upper Earnings Limit and the surplus to the amount of those earnings between the Lower Earnings Limit and the Upper Earnings Limit.

208. The State Second Pension regime will provide for a new Low Earnings Threshold, which will be uprated in line with increases in national average earnings. In 1999/00 terms this Low Earnings Threshold will be £9,500. Anyone earning less than £9,500 but at or above the annual Lower Earnings Limit (£3,432 in 1999/00) will be treated for State Second Pension purposes as if they had an earnings factor of £9,500.

209. Carers, who have no earnings or earnings below the annual LEL, will be treated for State Second Pension purposes as if they had earnings of £9,500 for any year throughout which:

210. Those entitled to long-term *Incapacity Benefit or *Severe Disablement Allowance throughout a tax year will also be treated for State Second Pension purposes as if they had an earnings factor of £9,500 in that year, provided they meet a simple labour market attachment condition when they reach state pension age. This condition requires that they have worked and paid Class 1 National Insurance contributions for at least one tenth of their working life since 1978, when Additional Pension was introduced.

211. There will be two stages to the State Second Pension. The first will be earnings-related. On the surplus in an earnings factor (actual or treated) of £9,500 (that is £9,500 less the prevailing annual Lower Earnings Limit), everyone will earn at least twice as much entitlement to Additional Pension as they did under SERPS. Where there is a surplus in the earnings factor corresponding to the amount of a person’s earnings above £9,500 but not exceeding £21,600, the accrual rate on that surplus will be half what it would have been under SERPS. This will have the effect of recouping some of the increased accrual that everyone will receive on the surplus in the earnings factor of £9,500. However, everyone earning under £21,600 will receive more than they would have done under SERPS, with the largest proportionate gains going to those with the lowest earnings. No-one will receive less than they would have done under SERPS, with those earning £21,600 and above receiving the same as under SERPS.

212. In the second stage, to be introduced when stakeholder pension schemes have become established, State Second Pension will become a flat-rate scheme for those with a significant part of their working life ahead of them (for example, those aged under 45 at the point of change). Everyone in the second stage of State Second Pension will be treated as if they had earnings of £9,500 (or corresponding to the prevailing Low Earnings Threshold at that time), regardless of the level of their actual earnings. Qualifying carers and long-term disabled people with broken work records will continue to be treated as if they had such an earnings factor. State Second Pension will continue to be calculated by reference to the surplus in that earnings factor. National Insurance rebates to those in contracted-out pension schemes will continue to be earnings-related.

Contracting-out arrangements

213. The contracting-out regime is central to the success of private pension provision and the Government is keen to ensure that any changes made to the arrangements for contracting-out to reflect the introduction of the new State Second Pension, continue to support and encourage private pension provision. In recognition of the level of importance the Pensions Industry attaches to the contracting-out regime, it has been decided to consult on two approaches for revising the arrangements.

214. When individuals contract-out they do so on the basis that their pension arrangements will give them, broadly speaking, what they would have received from the state had they not contracted-out. As there is a reduced liability on the State, individuals and employers running occupational schemes receive a contracted-out rebate, which is calculated by reference to the cost of State benefit given up. As the new State Second Pension is designed to boost the pension of low and moderate earners, the contracting-out arrangements will need to be changed to ensure that members of contracted-out pension schemes are not better off contracting back in. The consultation document explores two options for achieving this.

215. The first approach suggests that all rebates be increased to reflect the three-part accrual rate within the new State Second Pension. This will go some way to ensuring that individuals are not worse off remaining contracted-out. However, a problem remains because the State Second Pension will treat those earning under £9,500 as if they were earning that amount. For a variety of reasons, schemes could not be asked to replicate this provision so the first approach proposes that individuals earning below £9,500 receive a top up via the State Second Pension to that amount to make sure membership of their scheme remains viable.

216. One further problem remains, and that is how to ensure that for increased rebates salary-related schemes provide extra pension benefits. The first approach therefore puts forward a number of proposals for increasing benefit for low paid individuals who leave their scheme before pension age. This is because they are at risk of being better off in the state scheme rather than remaining in their scheme due to the difference in the way contracted-out scheme benefits and State Second Pension benefits are revalued. All proposals focus on revaluing low paid early leaver benefits in line with earnings rather than prices as is the case now.

217. The second approach proposes a somewhat different route. It suggests that rebates for occupational schemes remain as they are now, so they would be based on a universal SERPS-style accrual. But to overcome the difficulties associated with individuals being better off in the state scheme, a State Second Pension top-up to £21,600 is proposed. This avoids schemes having to change their benefit provision. However, contracted-out personal pension schemes would have rebates based on the three-part accrual within the State Second Pension and a state top-up limited to £9,500.

218. The consultation document Structure of Rebates for the State Second Pension was issued on 29 November. The consultation period will run to 14 January 2000. The Government hopes to bring forward legislation to implement the preferred way forward during the Bill's committee stage.

Improving the framework for occupational and personal pensions

219. Besides the reform of the National Insurance rebate, there are four main parts to the reform of occupational pensions in the Bill:



State second pension

Clause 28: Earnings from which pension is derived

220. Subsection (1) inserts section 2A into section 22 of the *Social Security Contributions and Benefits Act 1992 (the "Contributions and Benefits Act")which sets out the earnings on which Additional Pension (in the State Earnings-Related Pension Scheme or SERPS) is calculated. Under State Second Pension, Additional Pension is to be calculated on those earnings on which Class 1 employee National Insurance contributions have been paid or treated as paid.

221. From April 2000 employees earning below a new Primary Threshold will no longer pay National Insurance contributions. Those employees with earnings between the prevailing Lower Earnings Limit (LEL) (£66 a week in 1999/00) and the new Primary Threshold10 will be treated as if they had paid National Insurance contributions on those earnings. Provided their annual earnings are at least 52 times the weekly LEL (£3,432 in 1999/00), the year will qualify for contributory benefits such as basic Retirement Pension. If their earnings exceed this amount, employees will accrue entitlement to Additional Pension on the amount by which their earnings exceed 52 times the LEL.

222. The self-employed do not accrue entitlement to Additional Pension. Their flat-rate Class 2 National Insurance contributions entitle them to flat-rate contributory benefits, such as basic Retirement Pension. However, someone may be both an employed earner and a self-employed earner in the course of a year. In such a case, and if they are a member of SERPS, their Class 2 contributions are currently taken into account when calculating the amount of surplus Class 1 contributions on which their entitlement to Additional Pension is based. If they are contracted-out of SERPS into an occupational pension or personal pension scheme, they receive a rebate of National Insurance contributions which is based solely on their Class 1 employee contributions. This section has the effect of treating members of State Second Pension in the same way as those contracted-out by taking account only of their Class 1 earnings when calculating the amount of their State Second Pension entitlement or the amount of their rebate.

223. Subsection (2)(a) inserts new paragraph (za) into section 44(6) which sets out how earnings factors are to be determined for State Second Pension purposes. For State Second Pension the earnings factor will be the total of the earnings on which Class 1 employee National Insurance contributions have been paid or treated as paid, unless the person concerned is regarded as having an earnings factor for one of the reasons set out in subsection (3) below.

224. Subsection 2(b) amends section 44(6)(a) to limit the current method of determining earnings factors for Additional Pension under SERPS to the period before “the first appointed year”, which is the year from which State Second Pension will take effect.

225. Subsection (3) inserts new section 44A into the Contributions and Benefits Act.

New section 44A: Deemed earnings factors

226. Subsection (4) provides for someone to be treated as if they had an earnings factor of £9,500 in a qualifying year if they are paid Severe Disablement Allowance (SDA) throughout the year and they meet the labour market attachment test set out in new section 44A(3) and (4). SDA is being withdrawn for new claimants from April 2001 but those already receiving the benefit will continue to do so.

Clause 29: Calculation

227. Subsection (1) amends subsection (2) of section 45 of the Contributions and Benefits Act, which sets out the way Additional Pension is calculated. It provides for Additional Pension to be the sum of entitlement accrued under SERPS and entitlement accrued under State Second Pension.

228. Subsection (2) inserts new section 45ZA after section 45 of the Contributions and Benefits Act. It sets out the way in which State Second Pension is to be calculated.

New section 45ZA: The additional pension in a Category A retirement pension

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Prepared: 2 December 1999