'Extra £2bn needed to make contracting out of S2P worthwhile'

The Government needs to set aside an extra £2bn a year to persuade Britain's savers to continue contracting out of the state second pension (S2P), according to a report out today.

Watson Wyatt, the pensions consultancy, says the assumptions which the Government uses to calculate the current S2P rebate are "woefully outdated", and result in almost all employees being better off if they contract into the scheme.

The intervention comes amid mounting criticism of the Government's muddled stance, which recent reports have suggested could be costing savers up to £800 a year in retirement income. It also comes just before a Government consultation on changes to the level of the rebate from 2007.

Watson Wyatt believes the annual rebate needs to be increased by more than two-thirds before the benefits of staying outside the scheme will outweigh those of staying in. That would raise the annual cost to the Government from £3bn to £5bn.

S2P replaced Serps three years ago and is an earnings-related state pension scheme, paid on top of the basic state pension. During the 1980s, the Thatcher government gave savers the option to contract out of the scheme, paying them an annual rebate into their own private pension, to compensate them for not being part of the government scheme. The move was designed to reduce the future financial burden of pensions on the Govern-ment. In recent years, the Labour government has reduced the size of the rebate substantially, with most insurers now advising their clients to contract back into the scheme.

Watson Wyatt says the current rebate fails to take into account increased life expectancy and uses unrealistic assumptions of investment returns, particularly now many funds have switched from equity investments to bonds.

Nigel Bodie, a senior consultant at Watson Wyatt, said: "Although contracting out will remain part of the UK pension scene in the short term, a better long-term solution would be to simplify the state pension and allow companies more freedom and flexibility in providing for pensions above the state pension level."

This month, the Financial Services Authority and Which?, the consumer watchdog, issued reports advising people to contract back into S2P.

The consumer body claims that about 4.5 million people are still contracted out of the scheme, with some losing as much as £800 a year as a result.