What changes to the state second pension will mean for employers

Impending changes to the state second pension will have consequences for employees at all levels, says Sarah Coles

If you read nothing else, read this…

  • At the moment, the state second pension (S2P) is linked to earnings, providing a compulsory earnings-linked pension for everyone in work.
  • From 2012, it will gradually switch to a flat-rate benefit, which will be much less generous for those employees on above-average earnings.
  • Staff in defined contribution schemes will no longer be able to contract out.
  • At the same time, workplace pensions will move to automatic enrolment and compulsory contributions, which is being billed as widening the provision of earnings-related pensions.
  • In reality, the changes to S2P mean that from 2012, fewer employees will have earnings-related pensions, and more will be relying on the bare minimum from the state.

If you are ever suffering from insomnia, there is a guaranteed cure: read pensions legislation. There is something about the endless acronyms, tortuous language and baffling rules that could send anyone to sleep. Unfortunately, such documents mean something major could be just around the corner, but few people would know it because it is too dull to read. That is exactly what is in danger of happening with the changes to the state second pension (S2P).

S2P (formerly Serps) is the top-up to the basic pension, linked to an employee’s earnings and the national insurance they have paid. It is the portion of state provision they are currently able to contract out of, and have the contributions paid into an occupational or private pension instead.

Flat-rate scheme

Buried in the 2007 Budget was the news this arrangement would gradually be phased out and replaced by a flat-rate scheme. So, instead of being linked to earnings, people will just get an extra pension of about £1.40 a week for every year they work (up to a maximum of 40 years). Steve Bee, head of pensions strategy at Scottish Life, says: “From April 2010, over time it will gradually switch to a flat-rate benefit.”

This is bad news for anyone other than low earners, says Bee. “They will still pay more national insurance, because that will still be linked to earnings, but they will not get any higher benefit back because it will be used to boost S2P for lower earners.”

Because of this, staff will no longer be allowed to contract out of defined contribution (DC) schemes, including employer- sponsored plans. “The higher earners are subsidising the lower earners, so it would not work if they were able to contract out, otherwise all the higher earners would leave the scheme,” he adds Contracting out has become less recommended in recent years. Tom McPhail, head of pensions research at adviser Hargreaves Lansdown, says: “Most people contract in because the rebates given to those opting out of S2P have fallen over the last 10 years, so they do not make contracting out worthwhile on financial grounds.”

Bee adds: “There has not been a good financial reason to contract out for a while. It has been more about being able to control your own investments or if you had concerns about the state system.”

But the change is not just bad news for higher earners and those who contracted out, says Bee. “S2P has been very good for people with no other pension scheme. It has been compulsory since 1961 and it provided everyone with an earnings-related pension at very little cost to the employer. From 2012, we will see the introduction of personal accounts with automatic enrolment, but it will be voluntary. So we are moving from a compulsory scheme to a voluntary one.”

Fewer savings

Because employees have the opportunity to opt out, says Bee, “people will be less likely to have an earnings-related pension, and it is highly likely we will end up with fewer people saving for the future”.

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McPhail points out: “Without S2P, if you get people opting out of the workplace pension, they will get to retirement and have nothing to live on. For someone retiring in 2007, state benefits represent, on average, 17% of retirement income. In future, this percentage may go up dramatically.”

So far, this issue has slipped under the radar, but employers must get to grips with the changes. If their staff fully understand the situation, the 2012 reforms will bring an opportunity to increase their pension provision. But if employees do not appreciate the full picture, they could easily end up saving even less for the future.