Low earners gain as second state pension replaces SERPS
From this month, accrual of SERPS ceases. Those who are earning sufficient begin accruing additional pension under the state second pension. The new scheme leaves higher earners unaffected but low earners are significantly better off. Here we explain how the new pension works, with the aid of worked examples.
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SUMMARY OF KEY POINTS |
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In essence S2P works in very much the same way as SERPS as amended by the Pensions Act 1995. |
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The key difference between SERPS and S2P is that, for S2P purposes, the surplus earnings factor is subdivided into three further earnings bands. |
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The first operational low earnings threshold (LET) has been set for 2002/03 at £10,800. The LET is used to define the top of the lowest of the three S2P earnings bands. The top of the middle earnings band is set at £24,600. |
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S2P provides a pension that represents a higher proportion of average revalued surplus earnings factors for those on lower earnings than for those on higher earnings. |
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Those employees earning at least as much as the lower earnings limit but earning less than the LET are treated for S2P purposes as if they were earning at the level of the LET itself. |
The low earnings threshold is an important new term for the pensions lexicon, denoting the top of the lowest of the three earnings bands used to calculate an employee's entitlement to additional pension from the state second pension. Additional pension is the term used to describe that component of the state retirement pension that until this year has been provided by the state earnings related pension scheme (SERPS). But from 6 April, rights to future additional pension will begin to accrue under a new scheme known as the state second pension (S2P).
Additional pension already accrued from SERPS is unaffected by the change. When claimants reach state pension age in future, any additional pension they have built up at any time from 6 April 1978 to 5 April 2002 inclusive will be calculated under the current rules.
S2P was introduced by the Child Support, Pensions and Social Security Act 2000 (See Child Support, Pensions and Social Security Act 2000 and Child Support, Pensions and Social Security Act 2000 receives royal assent). Like SERPS, S2P will, initially, operate as an earnings-related pension. For younger pensioners it may become a second flat-rate pension in a few years' time, depending on the number of employees on moderate earnings who take up stakeholder pension schemes.
The earnings factor
In many ways, S2P is very similar to SERPS, at least in the way the additional pension entitlement of those who have reached state pension age since 6 April 2000 is calculated. This is the date when a measure introduced in the Pensions Act 1995 came into force and changed the way additional pension was calculated.
Entitlement to both SERPS and S2P depends on there being a "surplus" in the claimant's earnings during a tax year on which Class 1 primary (employee) national insurance (NI) contributions have been paid. The earnings taken into account exclude those above the NI upper earnings limit (UEL) in force during the pay period in which the earnings arose. Such earnings are known as the claimant's "earnings factor".
There is a surplus in a claimant's earnings factor in any particular tax year if that earnings factor exceeds the qualifying earnings factor (QEF) in a specified tax year. The QEF is simply 52 times the weekly level of the NI lower earnings limit (LEL) in force during that specified tax year. The surplus is the amount of the earnings factor in excess of the QEF calculated separately for each pay period.
Before 6 April 2000 the QEF used to calculate additional pension entitlement was the QEF in the tax year before the tax year in which the claimant reached state pension age. Since 6 April 2000, the QEF used to calculate additional pension entitlement has been the QEF in the tax year that the earnings factor arose. National average earnings have, historically, risen by a greater percentage than prices, and the LEL and the UEL are revalued in line with prices. The effect of applying earnings revaluation to a smaller slice of the employee's earnings in each tax year (ie after deducting the LEL), rather than to a larger slice and then deducting an LEL amount in the year prior to retirement that in general has not increased as much as the earnings slice from which it is to be deducted, is to reduce the amount of additional pension payable.
In other words, since 6 April 2000, SERPS has been calculated for those reaching state pension age on or after that date by calculating the annual amount of earnings of the claimant in each tax year since 1978/79 (or since the tax year the claimant became 16, if later) but ignoring any earnings that exceed the weekly or monthly UEL in any pay period in that year. Then the QEF for the same year is subtracted from this total. This amount is known as the claimant's "surplus earnings factor" for that particular tax year. It is revalued between the year when it was earned and the tax year before the individual reaches state pension age.
S2P adopts exactly the same definition of the surplus earnings factor as has operated under SERPS for the past two years.
Three earnings bands
The key to the difference between SERPS and its successor, S2P, is that for SERPS the calculation of an employee's additional pension entitlement depends on one single band of earnings - the surplus earnings factor itself - while for S2P the surplus earnings factor is subdivided into three separate earnings bands.
On 17 January this year, the Social Security Pensions (Low Earnings Threshold) Order 2002 (SI 2002/36) was laid before Parliament. It comes into force on 6 April. The Order specifies the first operational low earnings threshold (LET), which serves to mark the top of the lowest of the three earnings bands (band 1) used to calculate employees' entitlement to additional pension under S2P. It is also, naturally, the bottom of the next band (band 2). The LET for 2002/03 is set at £10,800.
This figure is approximately equal to one half of the level of national average earnings for a full-time employee. The LET for 2002/03 was in fact obtained by revaluing the LET of £9,500 which was set originally by the Child Support, Pensions and Social Security Act 2000. This earlier figure for the LET was revalued by the percentage increase in the average earnings index between 1 October 1998 and 30 September 2001, with the result being rounded to the nearest whole £100.
For future tax years, the LET will be uprated annually in line with the year-on-year percentage increase in the national average earnings index as at 30 September in the previous year tax year, again as rounded to the nearest whole £100.
The second earnings threshold, which is used to define the top of the S2P's middle earnings band in any tax year (and the bottom of the top band), is a figure derived from the QEF and LET in force in the same year. The calculation, which ensures that the second earnings band covers twice the range of earnings of the first earnings band, is set out in the note to table 1. In 2002/03 the second earnings threshold is £24,600.
S2P has been designed with three earnings bands in order that additional pension can accrue at different rates in respect of a claimant's earnings in each of these bands. Under SERPS, because there was only one band, there could be only one accrual rate. In particular, the aim has been to design S2P so that the additional pension it provides is proportionally greater for lower earners than for higher earners. This feature is explored in further detail below.
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Band 1 |
above the level of that tax year's QEF but below that tax year's LET |
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Band 2 |
above the LET but below an amount equal to (3 x LET - 2 x QEF)1 |
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Band 3 |
above (3 x LET - 2 x QEF)1 but below the UEL2 |
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1 The expression (3 x
LET - 2 x QEF) is, when calculated, rounded in a particular way. The
amount produced by doubling the QEF is rounded to the nearest £100 with
any exact amount of £50 being rounded down. | |
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2 Band 3 is bounded in most cases either by 52 x the weekly UEL or 12 x the monthly UEL because the claimant's "earnings factor" in any pay period during the tax year does not include any earnings in excess of the weekly or monthly UEL for that pay period. | |
Revalued surplus earnings factors
The method of revaluing surplus earnings factors under S2P is the same as has always been adopted under SERPS. The factor for each tax year is revalued in line with the Social Security (Revaluation of Earnings Factors) Order. This comes into force on 6 April of the tax year before the tax year in which the claimant reaches state pension age. The process ensures that each surplus earnings factor maintains its original value by revaluing it in line with the increase in national average earnings over the period until the tax year before the claimant reaches state pension age. The surplus earnings factor in this final year is taken as it stands. No surplus earnings factor arises in the year a claimant reaches state pension age.
Under SERPS, a single revalued surplus earnings figure is obtained for each tax year from 1978/79 until 2001/02 inclusive during the claimant's working life. Under S2P, three revalued surplus earnings figures are obtained for each tax year from 2002/03, corresponding to how much of the claimant's surplus earnings factor falls in each of the three bands.
Accrual and career averaging
The next stage in calculating the claimant's additional pension is to multiply each revalued surplus earnings factor by a specified accrual percentage. This depends on which year the claimant reaches state pension age. The accrual percentages for both SERPS and S2P are listed in table 2.
The final stage in calculating the actual additional pension entitlement from SERPS and S2P involves adding together each amount obtained by applying the appropriate accrual percentage to each of the revalued surplus earnings factors. The aggregate amount is then divided by the total number of years in the period:
beginning with the 1978/79 tax year, or, if later, the year the claimant reached age 16, and
ending with the tax year before the tax year in which the employee reaches state pension age.
This gives the annualised additional pension entitlement payable during the tax year the claimant reaches state pension age. The weekly amount payable is found by dividing this annualised entitlement by 52. Once in payment, the additional pension entitlement is increased each April by the year-on-year rise in the retail prices index in the previous September.
A worked example of how these calculations apply for the final year of SERPS and the first year of S2P are set out in table 3.
Strong redistributive effect
At present, the vogue is for simplicity in pensions. S2P, with its three earnings bands, is undeniably more complicated that SERPS. Certainly, those running contracted-out occupational pension schemes did not want any rebate system to incorporate the effect of these three bands (see Occupational Pensions, July 2001). This is why those individuals earning less than the top of the second of S2P's three earnings bands will build up residual rights to S2P even if they are contracted out of S2P. The providers of appropriate personal pensions had no such problems accepting the more generous rebates payable in return for their policyholders forgoing more state pension. But it is also true that very few employees would be able to explain how their additional pension is calculated under SERPS, let alone under S2P. In fact, the increased complexity of S2P confers on it a key advantage. S2P in contrast to SERPS benefits lower-paid employees proportionately more than higher-paid employees. As can be seen in table 2, for those reaching state pension age on or after 6 April 2009, the rate of build up of pension on earnings in band 1 is four times higher than on earnings in band 2 and twice as high as on earnings in band 3. This has been achieved without reducing the additional pension accrual rate of higher earners.
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Tax year claimant reaches state pension age |
Accrual percentage |
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SERPS |
S2P |
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1978/79- 1987/88 earnings factors % |
1988/89- 2001/02 earnings factors % |
Earnings factors from 2002/03 |
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Band 1 % |
Band 2 % |
Band 3 % |
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Before 2000/01 |
25 |
25 |
n/a |
n/a |
n/a |
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2000/01 |
25 |
24.5 |
n/a |
n/a |
n/a |
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2001/02 |
25 |
24 |
n/a |
n/a |
n/a |
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2002/03 |
25 |
23.5 |
n/a |
n/a |
n/a |
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2003/04 |
25 |
23 |
46 |
11.5 |
23 |
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2004/05 |
25 |
22.5 |
45 |
11.25 |
22.5 |
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2005/06 |
25 |
22 |
44 |
11 |
22 |
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2006/07 |
25 |
21.5 |
43 |
10.75 |
21.5 |
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2007/08 |
25 |
21 |
42 |
10.5 |
21 |
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2008/09 |
25 |
20.5 |
41 |
10.25 |
20.5 |
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2009/10 |
25 |
20 |
40 |
10 |
20 |
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After 2009/10 |
25 |
20 |
40 |
10 |
20 |
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n/a = not applicable. |
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The redistributive effect of S2P is even more marked for those employees who have annual earnings at least at the level of the QEF but below the level of the LET. This is achieved by a new s.44A inserted into the Social Security Contributions and Benefits Act 1992 by the Child Support, Pensions and Social Security Act 2000. This section provides that, if such employees' surplus earnings factors are less than the LET, they will be treated, for S2P purposes, as if they were actually earning at the level of the LET itself. The effect has a dramatic effect on the contributory, non-means-tested state pension of very low earners.
Again looking at the surplus earnings factors earned by an employee in 2001/02 and 2002/03, it is possible to point up the difference between SERPS and S2P by contrasting the amounts of additional pension that are derived from each of these two tax years in the case of a low earner.
The calculations for an example employee are set out in table 4.
Government's intention
The philosophy behind the government's thinking was explained when the relevant clauses of the Child Support, Pensions and Social Security Bill were being debated in Committee1. The then pensions minister, Jeff Rooker, said: "The state second pension reforms and enhances SERPS. It is not a brand new benefit in that sense. It is an existing additional pension that is being modified, specifically for the purpose of providing the low paid with better pensions. Even when it was started in 1978, SERPS was no good for the low paid, so defending SERPS to the last is not on."
Yet the redistributive effect of S2P, although substantial, does not solve the problem. Jeff Rooker added: "I asked [the department's civil servants] whether I would be able to say that nobody in 2050 who had a decent working life would retire on the means test. I was told, 'No, you can't say that, because the proposals aren't even that good.' However, the figure [of those projected to retire on means-tested benefits] reduces to 20% from 33%. We are talking about millions of people. Twenty per cent of pensioners in 2050 will be a much greater number than it is now. The number of pensioners may have increased by 50% from 10 million to 14.5 million, so our objective is to keep pensioners off the means test for as long as possible."
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By concentrating exclusively on the surplus earnings factors earned by an example employee in 2001/02 and 2002/03, the differences between SERPS and S2P can more easily be compared by contrasting the amounts of additional pension derived from each of these two tax years. | ||||||||
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The following example makes the following assumptions: | ||||||||
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the employee was born on 6 May 1956 and therefore reaches state pension age on 6 May 2021; | ||||||||
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the employee's earnings in 2001/02 are £15,000; | ||||||||
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the employee is not contracted out; and | ||||||||
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national average earnings rise by 4% pa, and in 2002/03 the employee's earnings also increase by 4% to £15,600. | ||||||||
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Additional pension from SERPS | ||||||||
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Step 1: In 2001/02 the QEF (the annual LEL) is
£3,744. | ||||||||
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Step 2: The employee's surplus earnings factor in
2001/02 is £15,000 - £3,744 = £11,256. | ||||||||
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Step 3: Allowing for a 4% pa increase in national
average earnings, the employee's revalued surplus earnings factor (derived
from 2001/02 earnings) in 2020/21 (the tax year before the employee
reaches state pension age) is £11,256 x 1.0419 = £23,715. | ||||||||
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Step 4: The relevant accrual percentage applying
to an employee reaching state pension age in 2021/22 is 20% (see table 2). Taking
this percentage of the revalued surplus earnings factor of £23,715 =
£4,743. | ||||||||
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Step 5: Since the employee was born on 6 May 1956
but SERPS began on 6 April 1978, the number of working years runs from 6
April 1978 to 5 April 2021 inclusive: ie 43 years. | ||||||||
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Step 6: The annual amount of additional pension
derived under SERPS from the 2001/02 tax year payable to the employee in
May 2021 is £4,473 ÷ 43 = £110.30. | ||||||||
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Additional pension from S2P | ||||||||
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Step 1: In 2002/03 the QEF is £3,900, the LET is
£10,800 and the secondary earnings threshold is £24,600. | ||||||||
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Step 2: The employee's surplus earnings factor in 2002/03 falls into the three S2P bands as follows: | ||||||||
Step 3: In 2020/21(the year before the employee reaches state pension age), the employee's revalued surplus earnings factor (derived from 2002/03 earnings) falling into the three S2P bands is as follows: | ||||||||
Step 4: The relevant accrual percentages applying to an employee reaching state pension age in 2021/22 are: | ||||||||
Taking these percentages of each revalued surplus earnings factor gives: | ||||||||
Step 5: The number of working years remains
43. | ||||||||
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Step 6: The annual amount of additional pension
derived under S2P from the 2002/03 tax year payable to the employee on
retirement in May 2021 is £6,563.60 ÷ 43 = £152.64. | ||||||||
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From the above, it can be seen that the value of this particular employee's additional pension derived from the last year of SERPS, ie £110.30, compares to an additional pension from the first year of S2P of £152.64. This amounts to an increase of over 38%, despite the employee's earnings having risen by just 4%. |
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TABLE 4: COMPARISON OF SERPS AND S2P FOR A
LOW-EARNING EMPLOYEE | ||||||||
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Our assumptions are the same as in the previous example in table 3 except that the employee's earnings in 2001/02 are £5,000. | ||||||||
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Additional pension from SERPS | ||||||||
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Step 1: In 2001/02 the
QEF (ie the annual LEL) is £3,744. | ||||||||
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Step 2: The employee's
surplus earnings factor in 2001/02 is £5,000 - £3,744 = £1,256. | ||||||||
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Step 3: Allowing for a 4%
pa increase in national average earnings, the employee's revalued surplus
earnings factor (derived from 2001/02 earnings) in 2020/21 (the year
before the employee reaches state pension age) is £1,256 x 1.0419 = £2,646. | ||||||||
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Step 4: The relevant
accrual percentage applying to an employee reaching state pension age in
2021/22 is 20% (see table 2). Taking this percentage of the
revalued surplus earnings factor of £2,646 = £529. | ||||||||
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Step 5: The number of
working years remains 43 years. | ||||||||
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Step 6: The annual amount
of additional pension derived under SERPS from the 2001/02 tax year
payable to the employee in May 2021 is £529 ÷ 43 = £12.30. | ||||||||
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Additional pension from S2P | ||||||||
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Step 1: In 2002/03 the
QEF is £3,900, the LET is £10,800 and the secondary earnings threshold is
£24,600. Since the employee's earnings (£5,200 in 2002/03) are above the
QEF but less than the LET, the employee's earnings are taken as being
equal to the LET. | ||||||||
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Step 2: The employee's surplus earnings factor in 2002/03 falls into the three S2P bands as follows: | ||||||||
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Band 1: £10,800 (assured level of earnings) - £3,900 = £6,900 | ||||||||
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Band 2: no earnings above £10,800 | ||||||||
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Band 3: no earnings above £24,600 | ||||||||
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Step 4: The relevant accrual percentages applying to an employee reaching state pension age in 2021/22 are: | ||||||||
Taking these percentages of each revalued surplus earnings factor gives: | ||||||||
Step 5: The number of working years remains
43. | ||||||||
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Step 6: The annual amount of additional pension derived under S2P from the 2002/03 tax year payable to the employee in May 2021 is £5,591.20 ÷ 43 = £130. | ||||||||
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It can be seen therefore, that the value of this particular employee's additional pension derived from the last year of SERPS, ie £12.30, compares to an additional pension from the first year of S2P of £130.00. This increase is despite the employee's earnings having risen by just 4%. |
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OUR RESEARCH |
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This feature is based on a reading of the Social Security Contributions and Benefits Act 1992, as amended by more recent legislation, including those measures relating to S2P introduced by the Child Support, Pensions and Social Security Act 2000. It also draws on the Explanatory Notes to the 2000 Act and official reports of parliamentary debates. |
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1Standing Committee F, 10 February 2000 (morning), available on the internet at www.publications.parliament.uk/pa/cm199900/cmstand/f/st000210/am/00210s04.htm.
