In the 1980s during Margaret Thatcher’s time as Prime Minister, when I was in my 20s, we were advised to ‘contract out’ our pensions.
What does this mean in real terms for my pension? Was it beneficial or not to do so?
Ask Steve Webb your question. Email pensionquestions@thisismoney.co.ukÂ
Steve Webb replies: Like you, I was also in my 20s during the 1980s and I well remember the publicity encouraging people to take out personal pensions.
Such was the level of interest that an estimated eight million people – myself included – took out these pensions and a report published in the early 1990s by the Institute for Fiscal Studies was called ‘the Personal Pensions stampede’.
But, looking back, was it a good idea?
To answer this it is worth giving a bit of context about how the pension system worked at the time.
Steve Webb: Scroll down to find out how to ask him YOUR pension question
Why did people contract out their pensions?Â
If we go back to the workplaces of the 1970s, only a privileged minority of people were building up an earnings-related pension to top up their state pension.
These were typically run on a ‘final salary’ basis, with a pension linked to your length of service and your salary when you finished.
In the 1970s, the Government of the day thought that salary-related pensions were a good thing and more people should have them.
So in 1978 they created a state equivalent – the State Earnings-Related Pension Scheme (Serps) – whereby people paid earnings-related National Insurance contributions and built up an earnings-related pension on top of their basic state pension.
For those who already had a workplace pension this would have amounted to ‘double provision’.
They would have built up a basic state pension, an earnings-related state pension and a company pension on top. Given the high quality of most work pensions at the time, this was unnecessary.
So the Government gave employers the opportunity to run their schemes on a ‘contracted out’ basis.
In simple terms, this was a deal between the scheme and the Government.
In return for workers and employers paying a reduced (‘contracted out’) rate of National Insurance, schemes would opt out of Serps, provided that the workplace scheme would provide something at least as good.
This promise was known as a Guaranteed Minimum Pension or GMP.
At the same time, some workers were building up rights in a different type of workplace scheme.
These were known as ‘defined contribution’ or ‘pot of money’ pensions. In this case, there was no pension guarantee.
Instead, employers and employers would pay money in, it would be invested, and then at retirement used to buy an income for life – an annuity.
Initially it was not possible to ‘contract out’ into this type of pension but in the mid 1980s the law changed to make this possible. The idea was to give a boost to the amount of non-state pension provision and reduce the cost of Serps.
But what about people whose workplace didn’t offer any pension? Why should such people miss out?
In response, the Government decided that it would also be possible to ‘contract out’ of Serps into what was called an ‘appropriate personal pension’.
These were portable pension products run on a defined contribution or pot of money basis.
To deal with the ‘double provision’ issue, people who contracted out into DC pensions – either workplace pensions or personal pensions – also received a rebate on their NI contributions.
For workplace pensions this rebate came through the pay packet in the form of lower NI contributions. But for personal pensions the NI rebate was paid by the Government (from the worker’s NI contributions) directly into the pension pot.
Indeed, it was possible to have a ‘rebate only’ personal pension where the only thing going in was part of the worker’s NI contributions.
The level of this NI rebate for people who were contracted out into DC pensions was designed at the time to be broadly ‘fair’ to the worker and to the state for the population as a whole.
The Government Actuary worked out how much money you would need to invest to build up a pot at retirement that would buy an annuity roughly equal to the Serps pension you were no longer going to get, averaged over the whole population. The rebate was set on this basis.
In addition, to kick start the take-up of personal pensions, for the first ten years from 1988-89, the Government paid an additional rebate for personal pensions over and above the ‘fair value’ rebate that the Government Actuary had worked out.
These extra incentives led to something of a gold rush to take out personal pensions.
One group of workers heavily targeted by some parts of the financial services industry was workers in big public sector schemes such as teachers and nurses.
These people were already in high quality schemes with a generous contribution from their employer, but some were tempted to opt out in favour of a personal pension with government incentives.
 Those who gave up high quality final salary pensions to switch to personal pensions almost all lost out as a result
Unfortunately, for most of these people this was a very bad idea and led to what became known as the ‘personal pension mis-selling’ scandal.
Many received compensation or were admitted back into their employer’s scheme and had their benefits reinstated.
For people who didn’t have any pension at all, the outcomes have been more mixed.
When we look back now at the calculations done at the time, the assumptions made about how the pot would be invested and grow turned out to be pretty realistic, particularly for those who retired before the financial crash of 2008.
But what didn’t turn out as expected was future annuity rates.
When rebates were set in the 1980s and 1990s it was assumed that annuity rates would be relatively generous. But by the time people retired in the 2010s, annuity rates had collapsed.
This was mainly because of the low interest rate environment that had become the ‘new normal’ and also because people were living significantly longer than was expected decades earlier.
In summary, those who gave up high quality final salary, also known as defined benefit, pensions to switch to personal pensions almost all lost out as a result.
But for those who may have had no occupational pension at all before personal pensions came along, the results have been more mixed.
Some, whose personal pensions were well invested and grew rapidly, boosted by generous government rebates, and who locked into an annuity before rates slumped, may have benefited overall.
But others, who may have experienced much lower annuity rates, may find that they get less in personal pension than they would have done if they had simply stayed in the Serps scheme.
Ask Steve Webb a pension question
Former pensions minister Steve Webb is This Is Money’s agony uncle.
He is ready to answer your questions, whether you are still saving, in the process of stopping work, or juggling your finances in retirement.
Steve left the Department for Work and Pensions after the May 2015 election. He is now a partner at actuary and consulting firm Lane Clark & Peacock.
If you would like to ask Steve a question about pensions, please email him at pensionquestions@thisismoney.co.uk.
Steve will do his best to reply to your message in a forthcoming column, but he won’t be able to answer everyone or correspond privately with readers. Nothing in his replies constitutes regulated financial advice. Published questions are sometimes edited for brevity or other reasons.
Please include a daytime contact number with your message – this will be kept confidential and not used for marketing purposes.
If Steve is unable to answer your question, you can also contact MoneyHelper, a Government-backed organisation which gives free assistance on pensions to the public. It can be found here and its number is 0800 011 3797.
Steve receives many questions about the state pension and ‘contracting out’. If you are writing to Steve on this topic, he responds to a typical reader question about the state pension and contracting out here
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