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
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
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 concernswhich
we shareabout the rebates payable to those schemes from
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
facilitates saving via the stock
market and access to the benefits of long-term growth of the real
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.
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
(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.
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