ANNEX A
Summary of note from the Government Actuary to the
Department for Work and Pensions in response to recommendation (r)
In the letter to the Second Clerk of the Select Committee (see Annex B), the Government Actuary's Department set out the State Second Pension (S2P) parameters needed to ensure a single person retiring in 2051, who had earned between the lower earnings limit (LEL) and the lower earnings threshold (LET) for each year of their working life, would have a total state pension at least equal to the Minimum Income Guarantee at the point of retirement and for 5 or 10 years after retirement. The required parameters are:
 Changing the 40% accrual rate on the first band of earnings to either 42.5%, 47.7% or 53.4%
 Changing the LET (£10,800 pa in 200203) to either £11,200pa, £12,300pa, or £13,500pa.
Section 1 of this paper estimates the cost of changing the accrual rate and section 2 considers the cost of changing the LET. All costs are based on the projections contained in the report by the Government Actuary on the Financial Effects on the National Insurance Fund of the Child Support, Pensions and Social Security Bill 1999 (Cm 4573). They are therefore consistent with published figures.
In each section two tables are given. The first considers the effects on S2P benefit payments, the second the effects on contracted out rebates. Options to change the accrual rates for S2P, or to increase the LET affect the level of rebates paid to people who are contracted out through APPs (appropriate personal pension schemes) or Stakeholder Pensions (but not through occupational schemes).
For consistency with the Report on the Bill, costs are given under two different assumptions about the additional level of contracting out following the introduction of Stakeholder Pensions. These are labelled "Assumption 2" and "Assumption 3".
Broadly, assumption 3 assumes S2P moves to being a flatrate scheme in 200607, with a large consequential increase in the level of contracting out at that point, whereas assumption 2 assumes S2P does not move to being a flatrate scheme. More details on these assumptions can be found in paragraph 3.5 of the Report on the Bill.
(1) Changing the accrual rate on the first band of earnings
Table 1 shows the effect on projected S2P expenditure of increasing the accrual rate for the first band of earnings above 40%.
If the accrual rate for the first band of earnings were to be increased, then it may be the case that:
 The earnings limit for the top of the second band of earnings would also be increased to the new level such that people earning above the top of the second band of earnings would accrue the same S2P as they would have accrued SERPS (State Earnings Related Pension).
 The accrual rate on the second band of earnings would be decreased.
 There would be no changes to the accrual rates for the other bands of earnings, or to the earnings limit for the top of the second band.
For the purposes of these costings, it has been assumed that there would be no changes to the accrual rates for the other bands of earnings, or to the earnings limit for the top of the second band (that the accrual rates for the second and third bands of earnings would remain at 10% and 20% respectively, and that there would be no change to the top of the second band of earnings).
On contracting out, it has been assumed that rebates to APPs and Stakeholder Pensions would reflect the increased accrual rate on the first band of earnings. For people contracted out through COSRS (contractedout salary related schemes) and COMPS (contracted out money purchase schemes), it has been assumed that rebate rates would continue to be based on SERPS accrual rates, as now, with benefit expenditure topups meeting any difference. Therefore, under these options, anyone who is contracted out through an occupational scheme and who earns above the top of band 2 would get an S2P State topup after retirement, which is not currently the case.
Table 1  Effect on S2P benefit expenditure of increasing the accrual rate on the first band of earnings  £ billion, 199900 price terms

SP Assumption 
2010 
2020 
2030 
2040 
2050 
2060 
Increase in expenditure from S2P accrual of 42.5% on first band of earnings 

Assumption 2 
0.1 
0.2 
0.7 
1.2 
1.9 
2.8 

Assumption 3 
0.1 
0.2 
0.7 
1.2 
1.8 
2.5 
Increase in expenditure from S2P accrual of 47.7% on first band of earnings 

Assumption 2 
0.2 
0.7 
2.0 
3.8 
6.0 
8.7 

Assumption 3 
0.2 
0.7 
2.0 
3.6 
5.5 
7.6 
Increase in expenditure from S2P accrual of 53.4% on first band of earnings 

Assumption 2 
0.3 
1.3 
3.5 
6.6 
10.4 
15.1 

Assumption 3 
0.3 
1.3 
3.5 
6.3 
9.5 
13.3 
Table 2 shows the corresponding effects on the costs of contracted out rebates.
Table 2  Effect on contracted out rebates of increasing the accrual rate on the first band of earnings  £ billion, 199900 price terms

SP Assumption 
2010 
2020 
2030 
2040 
2050 
2060 
Increase in rebate costs from S2P accrual of 42.5% on first band of earnings 

Assumption 2 
0.3 
0.3 
0.4 
0.4 
0.5 
0.5 

Assumption 3 
0.3 
0.5 
0.6 
0.7 
0.8 
0.9 
Increase in rebate costs from S2P accrual of 47.7% on first band of earnings 

Assumption 2 
0.8 
1.1 
1.1 
1.2 
1.4 
1.7 

Assumption 3 
1.1 
1.5 
1.7 
2.0 
2.4 
2.8 
Increase in rebate costs from S2P accrual of 53.4% on first band of earnings 

Assumption 2 
1.4 
1.9 
1.9 
2.1 
2.5 
2.9 

Assumption 3 
1.8 
2.5 
3.0 
3.5 
4.2 
4.8 
(2) Changing the LET
Table 3 shows the effect on projected S2P expenditure of increasing the LET above £10,800 pa (in 200203).
If such a change were to be made there are a number of options regarding possible consequential changes to the rest of the S2P structure. In this case it has been assumed that if the LET were to be increased, the top of the second band of earnings would also be increased, using the formula (3 x LET  2 x LEL), unless the resulting limit is above the UEL (Upper Earnings Limit) in which case it is capped at the UEL.
As before, it has been assumed that contracted out rebates for people contracting out through APPs and Stakeholder Pensions would be increased as a result of increasing the LET. For people contracted out through occupational schemes, there would be no change to the amount of rebates paid, with any difference being paid through S2P topups after retirement.
Table 3  Effect on S2P benefit expenditure of increasing the LET  £ billion, 199900 price terms

SP Assumption 
2010 
2020 
2030 
2040 
2050 
2060 
Increase in expenditure from increasing LET to £11,200 pa 

Assumption 2 
0.0 
0.2 
0.4 
0.8 
1.4 
2.0 

Assumption 3 
0.0 
0.2 
0.4 
0.8 
1.4 
2.0 
Increase in expenditure from increasing LET to £12,300 pa 

Assumption 2 
0.2 
0.6 
1.6 
3.1 
5.2 
7.7 

Assumption 3 
0.2 
0.6 
1.6 
3.1 
5.1 
7.6 
Increase in expenditure from increasing LET to £13,500 pa 

Assumption 2 
0.3 
1.1 
3.2 
6.0 
9.8 
14.3 

Assumption 3 
0.3 
1.1 
3.2 
6.0 
9.7 
14.2 
Table 4 below shows the corresponding effects on the costs of contracted out rebates.
Table 4  Effect on contracted out rebates of increasing the LET  £ billion, 199900 price terms

SP Assumption 
2010 
2020 
2030 
2040 
2050 
2060 
Increase in rebate costs from increasing LET to £11,200 pa 

Assumption 2 
0.1 
0.1 
0.1 
0.1 
0.1 
0.0 

Assumption 3 
0.0 
0.1 
0.1 
0.1 
0.1 
0.1 
Increase in rebate costs from increasing LET to £12,300 pa 

Assumption 2 
0.2 
0.3 
0.2 
0.2 
0.2 
0.2 

Assumption 3 
0.2 
0.4 
0.3 
0.2 
0.2 
0.2 
Increase in rebate costs from increasing LET to £13,500 pa 

Assumption 2 
0.5 
0.6 
0.4 
0.4 
0.4 
0.3 

Assumption 3 
0.4 
0.7 
0.5 
0.4 
0.4 
0.4 
Please note that the increases in rebate costs from increasing the LET as shown in Table 4 above are smaller than the increases shown in Table 2. The reason for this is that it has been assumed that an increase in the LET also reduces the level of additional contracting out following the introduction of Stakeholder Pensions. In the baseline costs which appeared in the Report on the Bill, it was assumed that all additional contracting out following the introduction of Stakeholder Pensions is among people with earnings above the LET. Therefore, an increase in the LET reduces the potential pool of people who could contract out through a Stakeholder Pension, reducing the assumed numbers contracting out. This effect reduces expenditure on contracting out rebates, which partially offsets the increased expenditure from increasing the LET.
Finally, please note the difference in approach between the options for increasing the accrual rate on the first band of earnings, and the options for increasing the LET. In the first case, no consequential changes were made to the other parameters of S2P (accrual rates or earnings limits). In the second case, the increase in the LET was accompanied by an increase in the top of the second band of earnings. This approach reflects the current legislation, where the top of the second band of accrual depends on the LET and the LEL but not on the S2P accrual rates. However, this difference in approach should be borne in mind when considering the projected costs of the different options.
