Why have ‘contracting out’ savers ended up with less state pension?

According to recent statistics, the official number crunchers have revealed that the estimates for “contracting out” benefits for extra National insurance is incorrect. As a result, it has left many losing money.

The Government Actuary Department have previous files which clearly point out the predictions they have regarding government bonds. It also included investment returns and life expectancy. Through the analysis, it was revealed that all of these information are wrong.

The data was carefully examined by Steve Webb who is a former Pensions Minister. He is now the policy director of Royal London. He uncovered the false data while he was answering questions for his This Is Money column which is part of his regular tasks.

Webb assigned a Royal London senior actuary to analyze the paperwork he wanted to have clarified. He specifically wanted to find out if the Government’s predictions were accurate. He focused on what people who have private pension would be able to build up, having their benefit in hindsight. In this article, we clearly explain what “contracting out” means and how it impacts the forecasts of GAD.

The meaning of “contracting out” & how it affects pensions

Most people who receive a state pension forecast realize that the figure is lower than the full flat rate which was recently implemented. It is £155.65 per week since the pensioners weren’t able to give enough contributions for the National Insurance over the past few years. This is mostly due to them being “contracted out” of paying for any additional top ups for state pension. Additionally, it’s also because of underpaid NI while they were still working. As a result, the money is being given to them through the use of rebates. These rebates were part of the people’s private and work pensions which they thought would help them gain a higher rate in the end. Employees who were part of final salary pension schemes were assured a guarantee to make sure that they wouldn’t lose out. However, it wasn’t the case for employees who were in workplace or personal defined contributions. In 2016, “contracting out” was fully eliminated from final salary schemes. In 2012, the other types were eliminated first.

As of now, the Department for Work and Pensions takes away individual deductions from state pensions. This is also called the Contracted Out Pension Equivalent (COPE). It is solely based on the additional funds which it assumes the pensioners have built up using their rebates after they have been contracted out. It was the Government who decided the size of the original rebates. They based it on the estimates they have gathered from studying GAD’s documents. This is the main reason why there is still some interest in the accuracy of those documents.

What did GAD predict in their forecasting?

Neil Walton who is the senior actuary of Royal London have carefully analyzed the GAD documents. According to his findings, the documents were very technical. He found out that in order for GAD to calculate the appropriate contracting out rebates, they had to forecast what will happen in the future. It was between 1987 and 2012 when the rebates were reviewed for a total of six occasions. In each of those reviews, they had to assess three important factors which are:
1) How much investment returns the pension will achieve at the end of the entire period
2) The range of government gilts which the pension will be priced on
3) How long the pensioner will live after retirement

What was GAD’s prediction?

For investment returns, they have predicted that the money purchase pensions would be able to achieve an investment return of 1.5% per year. The real results showed that since the 1988 RPI inflation, the investment return is at 3.4% annually. Their assumed investment mix has reached 9% on average. For gilt yields, they have predicted that the retirement yield would be 3.75% each year which will then decrease to 2% in the 2000s. They expected it to come back up to 3.5% after 2017. The real results showed that since 1981, the assets real return was at 2% each year until the mid 2000s. For how long the pensioner will live after retirement, GAD used the population mortality tables which resulted in the 10 yearly censuses. In reality, longevity rates have been constantly improving over the past few decades.

What was the DWP’s calculations?

They are mainly responsible for calculating the deduction which is called the Contracted Out Pension Equivalent (COPE). It directly affects the impact of being contracted out on the person’s eventual state pension in the future. According to Waites, the COPE calculation takes into consideration a deduction accumulated within specific periods of time when the pensioner was contracted out. This means that persons who are near their state pension age, they will get less than the new full state pension. If the individual has been contracted out within a defined benefit scheme, it will be able to fill the gap. For individuals who have been contracted out while they were in a defined contribution scheme, they will come to find that their private pension will be much less than the deduction which has been take off from the starting amount. In both of these cases, if a pensioner is at least eight years from their state pension age and they continue to make National Insurance contributions, they will most likely be okay. This is because the contracting out deduction wouldn’t be able to reduce the original amount of the basic state pension.

Is there something that can be done to help these pensioners?

In his most recent column, Steve Webb said that he doesn’t believe that the Government Actuary made their assumptions willfully during the 1980s until the 1990s which would turn out wrong. However, as a result of those assumptions many people who have reached their pension age now have to lower their total pension compared to if they had remained in the state scheme. He added that as of right now the assumptions made by GAD cannot be changed easily. The taxpayers during the 1980s to the 1990s agreed to follow those assumptions because at that time it was the best guess of the Government Actuary. Taxpayers in our world today are very unlikely to become fully prepared to do good amidst the shortfall, specifically when the individual pensions’ investment weren’t as they hoped it would be.