Select Committee on Treasury Minutes of Evidence

Memorandum submitted by the Association of British Insurers


  The Association of British Insurers (ABI) is the trade association for Britain's insurance industry. Our 400 member companies provide over 94% of insurance business in the UK. We represent insurance companies to Government, regulatory and other institutions and are an influential voice on public policy and financial service issues. ABI member companies hold more than one-fifth of all the investments traded on the London Stock Exchange on behalf of savers and pensioners.

  Every five years, the Government Actuary's Department (GAD) reviews the level of rebates paid to contracted-out pension schemes. This review is necessary in order to ensure that contracted-out scheme members continue to receive a fair level of rebate in return for forgoing entitlement to the State Second Pension (previously SERPS).

  The last quinquennial review took place during 2005. This related to the level of rebates payable from 2007 and, in March 2006, the Government announced its response to the GAD's recommendations.

  This briefing paper focuses on the contracted-out rebate levels that have been announced by the Government for 2007 onwards and on the contracted-out rebates applicable to personal pensions. It does not consider the rebates applicable to salary-related pension schemes, although many organisations have comparable concerns—which we share—about the rebates payable to those schemes from 2007.

  There are three particular issues that are of concern to the ABI in relation to the contracted-out rebate levels for 2007 onwards:

    (i)  the assumptions used by the GAD;

    (ii)  the way in which the Government has chosen to implement the GAD's recommendations; and

    (iii)  the frequency of future reviews into the level of the rebates.


  The ABI has been a keen advocate of contracting out because we believe it:

    —    helps the Government to spread the cost of future pension liabilities;

    —    empowers individual savers, allowing them greater ownership and choice over their own savings;

    —    incentivises additional pension saving and, in boosting the overall level of saving, guards against financial exclusion;

    —    facilitates saving via the stock market and access to the benefits of long-term growth of the real economy; and

    —    supports salary-related schemes.

  These advantages are not currently being fully realised due to the relatively low level of the rebates in recent years. A low rebate level makes the decision to contract out very difficult because it is hard to assess the relative merits of being contracted in or contracted out. In the past, the rebates tended to be set at a level high enough to clarify the decision-making process. The current situation causes confusion for customers and makes it difficult for advisers to provide useful information.

  Insurance companies have sought to tackle this issue by communicating regularly with their contracted-out consumers. [1]However, we regret that the Government did not take the opportunity presented by the recent quinquennial review of the rebate levels to simplify the decision-making process by setting more attractive rebate levels for 2007 onwards.


  The Secretary of State for Work and Pensions has, in the main, accepted the recommendations of the Government Actuary on the rebate levels to be paid from 2007. This is unsurprising as the terms of the GAD review were set by the Government.

  Crucially, however, the Department for Work and Pensions has decided to reduce the cap on rebates from 10.5% to 7.4%. This means that contracting out will become financially unattractive for a much larger number of people than at present.

  We regret the Government's decision for two reasons.

    (i)  The assumptions made by the GAD are not as robust as they could be in order to ensure actuarial neutrality. In calculating the pre-vesting net yield, the Government Actuary allows for an estimate of the Equity-Risk Premium (ERP) expected for the period over which the rebates are invested. We strongly believe that the ERP should not be allowed for in calculating the rebate levels. It should not be assumed that the worker who contracts out is more risk tolerant than others.

    In our view, actuarial neutrality implies the use of a risk-free discount rate as represented by gilt yields. The FSA's Prudential Sourcebook and Accounting Standard FRS 17 support this conclusion. We believe rebates should be calculated using gilt yields that match the duration to State Pension Age.

    (ii)  Secondly, the reduction of the cap on rebate levels means that it will impact on far more people and at younger ages than the current cap. The 2007 cap will start to "bite" at age 43. At present, women over 54 and men over 60 receive rebates which are unlikely to match the State Second Pension they are giving up. We believe this is an arbitrary and unjustified reduction in the rebates.

  The table below shows the effect of the 7.4% cap on rebates and the consequent shortfall faced by people when compared to the un-capped rebate calculated by GAD.

  What this means in practice is that, if a 55-year old contracts out, then on GAD's best estimate, they will end up with 47% less pension than if they contract in. This is wholly a result of the Secretary of State's decision to cap the rebates at 7.4%.

  We have recommended that the rebate levels should be reviewed more frequently in the future (irrespective of whether contracting out is abolished for defined contribution schemes over the medium-term).

  The current legislation allows for more frequent reviews and a more responsive system would be welcome given the pace of change in the pensions environment and other factors.

  Finally, we recognise that the debate about the long-term future of contracting out is separate from the decision on the rebate levels for 2007 onwards. The recent pensions White Paper proposed the abolition of contracting out for defined contribution pension schemes in 2012 or soon afterwards. We do not support this decision. There is no clear consensus in favour of the proposal and, on its own, it is likely to depress the amount of money that would otherwise flow into pension savings. We have therefore argued that, if the Government were to press ahead with the abolition of contracting out for defined contribution pensions, then the short-term saving in public expenditure should be used to finance incentives to encourage private saving.

October 2006

1   In 2004-05 and 2005-06, the ABI-in conjunction with the Association of Independent Financial Advisers-produced consumer fact sheets for contracted-out customers. In earlier years, companies produced their own company-specific information. Back

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