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What is contracting out?

Contracting out was a method of building up private pension provision by giving up entitlement to the additional pension element of the State Pension (State Second Pension or its predecessor SERPS) for particular tax years.

Self-employed people weren't able to contract out as they didn't participate in the Additional State Pension.

Because a person who contracted out will have a lower State Pension entitlement, the Government reduced the National Insurance (NI) liability on earnings between the earnings thresholds and the upper accrual point for these individuals and their employers for the period of contracted out service.

The way this was done depended on what type of scheme the individual was contracted out under. There were three options:

• Defined benefit: contracted out salary related (COSR)
• Contracted out money purchase (COMP)
• Appropriate personal pensions (APP)

DB schemes: contracted out salary related (COSR)

COSRs were defined benefit occupational pension schemes that had been authorised by HMRC for use as a vehicles for employees to contract out of the Additional State Pension. 

These schemes had to provide a minimum level of benefit.

Being contracted out meant that, as well as offering all the normal capabilities of a defined benefit occupational pension scheme, it could accept transfers of contracted out rights from other pension schemes.

The nature of occupational pension schemes meant that when an employee joined a COSR, they were automatically treated as being in contracted out employment and were contracted out from that point onwards.

To stop being contracted out they would have had to leave the scheme, though some employers may also have ran a contracted in pension scheme that employees could have switched to.

Benefits provided by a contracted out DB scheme

In return for the NI savings provided by the Government, a COSR scheme had to provide a minimum level of benefit.

• Between 6 April 1997 and 5 April 2016 - it had to pass the ‘reference scheme test’*. These benefits are referred to as section 9(2B) rights
• Between 6 April 1978 and 5 April 1997 - it had to, amongst other standards, provide a guaranteed minimum pension (GMP)
• Between 6 April 1961 and 5 April 1975 - it had to, amongst other standards, provide an equivalent pension benefit

Even though contracting out on a defined benefit basis has been abolished, the requirements related to the contracted out benefits continue.

More information on these contracted out benefits is available in our guides ‘Guaranteed minimum pension’ and ‘Section 9(2B) rights’.

* Reference Scheme Test

From 6 April 1997 to 5 April 2016, if a defined benefit occupational pension scheme wanted to contract out, it had to meet a test of overall scheme quality - this was the 'reference scheme test'. The scheme had to provide a pension which was broadly equivalent to, or better than, the pension which would be provided under the reference scheme.

The reference scheme was a notional scheme which had:

• a normal retirement age of 65 for both men and women
• an accrual rate of 1/80th of average qualifying earnings in the last three complete tax years, for each year of service (up to 40)
• qualifying earnings were 90% of the amount by which earnings exceeded the weekly lower earnings limit multiplied by 52; and didn't exceed the weekly upper accrual point (or upper earnings limit for tax years before 6 April 2009) multiplied by 53
• 50% widow's/widower's/civil partner's pensions. The death in service pension was 50% of the amount the member would have received if the date of death had been their normal retirement date
• benefits - at least 90% of the members in each benefit category had to pass the test. This test covered active members' and their spouse's/civil partner's benefits in service, retirement and deferment
• the defined benefit scheme had to be a registered pension scheme (or a relevant statutory scheme)

The scheme actuary was responsible for certifying that the scheme complied with the test.

Contracted out money purchase (COMP)

This is a registered money purchase occupational pension scheme that was authorised by HMRC for use as a vehicle for employees to be contracted out of the Additional State Pension. As COMPs were classed as occupational pension schemes, they were established by an employer for the benefit of their employees.

When an employee joined a COMP scheme, they were automatically treated as being in contracted out employment. This meant that, as well as offering all the normal capabilities of a money purchase occupational pension scheme, it was able to be used:

• as an ongoing contracting out vehicle to accept NI rebates, and/or
• to accept transfers of protected rights or other contracted out rights (such as section 9(2B) rights or GMP) from other pension schemes

If someone was contracted out using a contracted out money purchase scheme, some of the NI savings made by them and their employer were invested in their pension. Those NI rebates formed the person's protected rights account within their pension fund. In addition to the usual HMRC rules on what benefits could be provided by registered pension schemes, there were special DWP rules setting out the benefits that had to be provided from the protected rights fund when an annuity was bought or on the member's death.

When contracting out under COMPs and APPs was abolished from 6 April 2012, the special rules for protected rights were removed and these rights became ordinary benefits.

Some money purchase occupational pension schemes were contracted out on a salary related basis. These schemes, which were relatively rare, were known as contracted out mixed benefit schemes (COMBs). But contracting out on a salary related (defined benefit) basis was abolished on 6 April 2016 to tie in with the introduction of the New State Pension.

COMBs had to provide a certain minimum level of benefit:

• From 6 April 1997 to 5 April 2016 it had to pass the reference scheme test
• Before then it had to, amongst other standards, provide a guaranteed minimum pension

Appropriate personal pension (APP)

An 'appropriate' personal pension was one that was authorised by HMRC for use as a vehicle for employees to contract out of the Additional State Pension. However, from 6 April 2012, contracting out for defined contribution schemes was abolished, and so members of an APP were automatically contracted back in at that point, with the scheme ceasing to be 'appropriate'.

The contracted out monies that the APP held were known as protected rights. The funds generated from personal or employer contributions are known as 'ordinary benefits', 'excess benefits' or non-protected rights.

In addition to the usual HMRC rules on what benefits could be provided by registered pension schemes, there were special DWP rules setting out the benefits that had to be provided from the protected rights fund when an annuity was bought or on the member's death.

When contracting out under COMPs and APPs was abolished from 6 April 2012, the special rules were removed and these rights became ordinary benefits.

When a personal pension had appropriate status it meant that, as well as offering all the normal capabilities of a personal pension scheme, it could be used:

• as a contracting out vehicle to accept NI rebates, and/or
• to accept transfers of protected rights or other contracted out rights (such as section 9(2B) rights or GMP) from other pension schemes

Contracting out and NI contributions

Contracted out salary related schemes

If someone was contracted out through a COSR, both they and their employer paid a reduced rate of Nl contributions on earnings between the earnings thresholds and the upper accrual point. This was known as the contracted out rebate - a flat rate reduction in the amount of NI paid.

Since 6 April 2012, the reduction in NI contributions had been 1.4% for the employee (down from 1.6% before that date) and 3.4% for the employer (down from 3.7%).

As contracting out through COSRs ended on 5 April 2016, both employees and employers now have to pay the full rate of NI. As a result, employers could make changes to recover their additional costs.

Recouping the increased NI costs

A statutory amendment power in the Finance Act 2014 allowed employers to recover increased NI contribution costs by reducing future service benefits and/or by increasing employee contributions - even without trustee consent.

• It wasn't possible to increase employee contributions and/or reduce scheme benefits for an employee by more than the employer's annual increase in NI contributions in respect of them
• The changes couldn't take effect before 6 April 2016
• Past service benefits couldn't be reduced
• The statutory amendment power couldn't be used for 'protected persons' (i.e. employees of previously nationalised industries)

The Government produced guidance to help sponsoring employers and trustees of these schemes plan for the change.

Contracted out money purchase schemes

Before 6 April 2012, contracting out through a COMP scheme meant both the individual and their employer paid a reduced rate of NI contributions on earnings between the earnings thresholds and the upper accrual point.

• This was known as the basic contracted out rebate - a flat rate reduction in the amount of NI paid. Since 6 April 2007, the flat rate reduction in NI contributions was 1.6% for the employee and 1.4% for the employer - a total saving of 3.0%.
• In practice, employees still paid their NI contributions at the full Class 1 rate, as did their employer. However, only the reduced NI after deduction of the basic contracted out rebate was paid to HMRC. Each month, the employer had to pay the NI savings from the basic rebate into the pension scheme.

On top of this, approximately six months after the end of any tax year in which the employee was contracted out, HMRC National Insurance Contributions Office (NICO) paid back a proportion of the employee and employer's NI contributions to the pension scheme.

These were known as 'age related rebates' and ranged from 3.0% to 7.4% (less the 3.0% basic rebate). The amount was determined by:

• the person's age on the last day of the preceding tax year (as the name suggests) and
• the person's earnings between the lower earnings limit and the upper accrual point

Appropriate personal pensions

Being contracted out through an APP scheme meant both the individual and their employer still paid NI contributions at the full Class 1 rate.

However, approximately three months after the end of any tax year in which the employee was contracted out, HMRC National Insurance Contributions Office (NICO) rebated a proportion of the employee and employer's NI contributions to their APP.

The rebates (known as minimum contributions) were based on the person's:

• age on the last day of the preceding tax year and
• earnings between the lower earnings limit (LEL) and the upper accrual point (UAP)

The rebates were calculated by applying age related rates to the different accrual bands used under State Second Pension. For example, the rates for tax year 2011/12 ranged from 9.4% to 14.8% for earnings between LEL and LET and 2.35% to 3.7% for earnings between LET and UAP. 

• The employee's share of the rebate was deemed to be 1.6%. Basic rate tax relief of 0.4% was added, bringing the total employee share of the rebate to 2%
• The employer's share was the balance of the figure for the appropriate age

Tax year 2011/12 was the final year to generate any rebates.

Abolition of contracting out

On 6 April 2012, contracting out was abolished for defined contribution schemes (COMP and APP), leaving COSRs as the only way to contract out from that point forward (although Section 32 buy outs were still able to received contracted out monies as transfers).

But contracting out was abolished for defined benefits too on 6 April 2016, to tie in with the introduction of the New State Pension.

Following the abolition of contracting out, COMP schemes automatically became contracted in. They continue as an occupational money purchase arrangement, but no further contracted out benefits will accrue and all existing protected rights became ordinary benefits.

Under APP schemes, after 5 April 2012:

• no further NI rebates were generated (other than the final payment for the 2011/12 tax year) and
• transfers of section 9(2B) rights or GMP can still be accepted by a personal pension, and will be allocated as ordinary benefits