Providing that a defined benefit pension scheme meets certain conditions, it can be used to contract employees out of the additional State Pension (also known as the State Second Pension). Employees who join a scheme that is contracted-out will automatically be contracted-out of the additional State Pension.
Employers providing such contracted-out schemes pay a lower rate of National Insurance Contributions (NICs) for those employees who join their schemes, and employees themselves also pay reduced-rate contributions. If the scheme is contracted out on a money purchase (or 'defined contribution') basis, HM Revenue & Customs (HMRC) will also pay an additional rebate direct to the scheme for investment on behalf of the employee. This is to compensate for the additional State Pension given up by the employee.
Where an employee contracts out of the additional State Pension with a stakeholder or personal pension plan, both the employer and employee continue to pay NICs at the full rate. At the end of each tax year, HMRC pays a rebate of NICs plus tax relief on the employee's share of the rebate directly into the pension fund for investment on behalf of the employee.
Since 2002, employees who contribute to a contracted-out occupational, personal or stakeholder scheme may get some additional State Pension for the year in which they contribute. This is because of more generous State benefits for lower-income earners and is intended to prevent them being put at a disadvantage when they contract out.
There is no guarantee that the contracted-out pension will be as good as or better than the additional State Pension given up as the level of a defined contribution pension payable is dependent on a range of things that can vary, such as contribution levels, investment returns, and annuity rates it is difficult for people to be certain about what they will get until they actually take benefits.
Contracting-out is ending on 6 April 2016
The Pensions Act 2014 and the Pensions Act (Northern Ireland) 2015 introduce a new State Pension in Great Britain and Northern Ireland for people reaching State Pension age on or after 6 April 2016.
The new scheme will replace the existing basic and additional State Pension and end contracting-out and the National Insurance rebate.
To assist employers and employees, factsheets and overviews in relation to the ending of contracting out have prepared by the Department for Work and Pensions and HMRC.
References in the guidance to the Pensions Act 2014 should be taken as including references to the Pensions Act (Northern Ireland) 2015.
Changes to contracted out pensions
As from 6 April 2012, employees are unable to contract out of the State Second Pension by joining:
- a personal or stakeholder pension scheme
- a defined contribution ('contracted-out money purchase') occupational pension scheme
Such employees were automatically brought back into the State system and accrue entitlement to additional State Pension instead. Employers and employees in defined contribution occupational schemes now pay the standard rate National Insurance contributions instead of the reduced rate.
HMRC also no longer pay the National Insurance rebate into their pension scheme in respect of earnings paid in tax years beyond this date. You can find information for individuals affected by the abolition of contracting on the nidirect website.
Additional Voluntary Contributions
Following reform of the tax regime on pensions, employers are no longer required to offer Additional Voluntary Contributions to employees who want to improve their pension provision, though some may continue to do so on a voluntary basis. See our guide on running a pension scheme.