326.The UK pension system combines a contributory state scheme, consisting of basic Retirement Pension* and Additional Pension, derived from the State Earnings-Related Pension Scheme (SERPS), with a private system of occupational and personal pensions*.
327.All employees and self-employed people, except the very lowest paid, pay (or are treated as having paid) National Insurance contributions* (NICs). These give entitlement to the basic state pension. In addition, employees – but not the self-employed – earn entitlement to an additional, second-tier pension (SERPS), unless they choose to “contract-out” of SERPS and join a pension scheme which gives them rights in place of their SERPS entitlement.
328.For those who are, or have been, members of SERPS, the amount of Additional Pension they will receive is based on the amount of their “surplus earnings” in the years since 1978 when SERPS was introduced. Surplus earnings are those between the Lower Earnings Limit* (LEL) and Upper Earnings Limit* (UEL). The surplus earnings are increased in line with average earnings to the year before a person reaches state pension age in order to maintain their value in earnings terms. The total amount is multiplied by an accrual rate of between 25% and 20% depending on the year in which the person reaches state pension age (for anyone reaching state pension age from 6 April 2009 onwards, the accrual rate is 20%). This amount is then divided by the number of years in the person’s working life since 1978 (up to a maximum of 49 for those who reach state pension age from 2027) to give the annual amount of that person’s Additional Pension derived from SERPS.
329.SERPS is solely an earnings-related scheme, with higher benefits accruing to those who have had higher earnings throughout their working life. Lower earners accrue lower benefits, and it is possible to have worked and paid NICs throughout a working life and still receive a combined basic and Additional Pension which is less than is available through means-tested benefits. Those who have had breaks in their employment history for periods of caring or disability can be similarly affected.
330.Employers may choose whether or not to provide an occupational pension scheme and whether to contract-out of SERPS. For those who are contracted-out of SERPS, a NI rebate is given in recognition of the fact that there is a reduced liability on the state.
331.A person contracted-out of SERPS may be a member of:
	a “salary-related” occupational pension scheme, where the pension received depends on the employee’s salary and service history. In such schemes employers and employees pay lower rate NICs;
	a “money purchase” based occupational pension scheme. The contributions and any NI rebate are invested and, on retirement, can be used to buy an annuity. The final pension received depends on the investment performance of the scheme and the annuity rates available at retirement. Employers and employees pay a reduced rate of NICs and an age-related payment, which is increased with the age of the member, is paid to the pension scheme by the Inland Revenue; or
	an “appropriate personal pension” (i.e. a contracted-out personal pension). In this case, employers and employees pay the full rate of NICs and an age-related payment is paid into their pension fund at the end of the tax year*.
332.Some occupational schemes are hybrid or “mixed benefit”, combining features of salary-related and money purchase schemes. All personal pensions are provided on a money purchase basis.
333.Occupational pension schemes which are contracted-out must satisfy conditions which are designed to ensure that employees in these schemes, who are benefiting from NI rebates, receive pensions from the scheme which at least equal what they would have received from SERPS.
334.Prior to April 1997, in order for a salary-related scheme to contract-out, it had to promise to provide a Guaranteed Minimum Pension (GMP), which is broadly equivalent to what the SERPS entitlement would have been had the individual not contracted-out.
335.From April 1997, contracted-out salary-related schemes have had to satisfy a scheme-based test (reference scheme test). This requires schemes to meet a statutory standard laid down in the Pension Schemes Act 1993. The scheme actuary will certify that the test is met if the scheme provides benefits broadly equivalent to, or better than, those of the reference scheme.
336.Employees who join occupational pension schemes which have not contracted-out of SERPS, or non-appropriate personal pension schemes, accrue SERPS benefits as well as benefits under the scheme, but they do not receive NI rebates.
Part II: Pensions. Background – State Second Pension and Occupational and Personal Pensions SERPS and contracting-out arrangements