State Earnings-Related Pension Scheme

The State Earnings Related Pension Scheme (SERPS) is a UK Government pension arrangement. The scheme ran from 6 April 1978 to 5 April 2002.

Everybody who paid full class 1 National Insurance at some point between 1978 and 2002 earned a pension entitlement. If an individual was a member of an occupational pension scheme, they could pay a reduced NI sum ("Contracting Out"), and their entitlement to SERPS was very much reduced.

General Principle

The main aim of the scheme was to provide a pension related to earnings in addition to the Basic state pension.

The original principle of the scheme was that the retiree would receive a pension of 25% of his earnings (above a minimum level or earnings) as a pension when he retired provided he completed a minimum number of years within the scheme. The required minimum years to obtain the full pension depended on the individual’s age when the scheme started (younger people had to complete a greater number of years). This ensured that older people at the start of the scheme, who had comparatively few years before retirement, could build up a reasonable pension. However, younger people had to work for a longer period to achieve the same pension, which controlled the overall cost of the scheme.

After 6 April 1988 the target pension was reduced from 25% of earnings to 20% of earnings.

Detailed Calculations

* The pension earned is calculated by taking the earnings between the lower earnings limit and the upper earnings limit in each tax year. This amount is referred to a ‘surplus earnings’.
* These ‘surplus earnings’ are then increased in line with national average earnings until the individual reaches state pension age.
* The total earnings between 6 April 1978 and 5 April 1988 are then divided by 4 (to achieve a target of 25% of earnings), whilst earnings between 6 April 1988 and 5 April 2002 are divided by 5 (to achieve a target of 20% of earnings).
* Finally this amount is divided by the number of tax years between the 1978/79 tax year and the tax year the individual will reach state pension age. The number of years was subject to a minimum of 20 years.

Contracting Out

When the scheme was established final salary pension schemes could choose to opt-out of SERPS, provided they gave the scheme members a Guaranteed Minimum Pension. In return for opting out of SERPS the employer would pay a lower rate of National Insurance Tax.

Many pension schemes already provided generous benefits and the introduction of SERPS would have provided members with a larger pension benefit. Therefore the option of paying less National Insurance and providing the member with their existing pension arrangement proved attractive and many schemes chose to opt-out despite the administrative burden.

In 1988 the rules for opting out were changed and money purchase pension schemes were allowed to opt-out for the first time. Instead of providing a Guaranteed Minimum Pension these schemes had to pay the difference between the full rate of national insurance and the lower rate of national insurance into the pension arrangement. To encourage the take up of this arrangement the Government paid an extra incentive payment into each pension scheme where somebody contracted out using this route.

After 2002

In April 2002 SERPS ended and was replaced by the State Second Pension. The main reason for the change was to provide a larger pension to people of low earnings.

In general, pension companies call contracted out fundsa protected rights policy.

Controversy

There is little question that the UK Government's Pensions Policy, over the last decade or more, has been controversial - see almost any [UK] weekly or monthly broadsheet newspaper's finance sections since about 2004.How much of the changes have been deliberate, and how much have been side-effects, must be a matter for their originators.

External links

* [http://www.thepensionservice.gov.uk/atoz/atozdetailed/addstatepen.asp Official description of SERPS Pension Scheme]

* [http://www.landg.com/podcast 3 minute podcast explaining contrating out for tax year 2006/7]