Pension savers who were wrongly advised to opt out of the state second pension (S2P) could have lost out on £780 million. This figure was released by Which?, the consumer group, this week after the Financial Services Authority (FSA) said that there was no widespread mis-selling of the policies used to contract out of S2P.

After a two-year investigation, the FSA, said that only 1.5 per cent of the eight million people advised to opt out of S2P and have part of their national insurance contributions paid into their private pension instead may have been mis-sold. But Teresa Fritz, principal researcher at Which?, says: “This is the tip of the iceberg. We have calculated that the total number of people affected could be 4.5 million.”

As the spat between the financial and consumer watchdogs rumbles on, pension savers who have opted out may now be wondering what to do for the best. From 2012, however, the Government will solve the problem by putting an end to the option of contracting out of S2P.

The Government plans to put everybody – apart from members of salary-related pension schemes – back into the state system. But in the meantime, can savers benefit from opting in or out?

Experts say that the Government has cut back the national insurance rebates to such an extent that there is no longer a financial advantage in being opted out. Despite this, there are still plenty of people who excercise their right not to be fully tied to the state system.

Legal & General writes to its opted-out pension policyholders every year to suggest that they may be better off going back in to S2P, but 75 per cent have chosen to remain contracted out. About 3.5 million savers remain opted out.

Adrian Boulding, Legal & General’s wealth policy director, believes that people choose the opt-out for two reasons. “One is flexibility, the other is trust,” he says. “When you have your own personal pension, you can take the benefits early (from age 55 after 2010), whereas a state pension cannot be taken until the state retirement age. You can also take 25 per cent of your personal pension as a tax-free lump sum, which you can’t do with the state scheme.”

The downside of personal pensions is the investment risk. Your pension will only be as good as the investments you have chosen. So is there any point in opting out now, with only five years left until the option is removed? A young person currently starting work for the first time and earning £25,000 a year would receive a rebate of £1,239 a year paid into a pension if opted out of S2P.

Most advisers do not recommend it. Mike Marigold, of Montgomery Charles, the independent financial adviser (IFA), says: “Ironically, we have to tell young people nowadays that they are better off relying on the state than opting out of S2P into a personal pension, which seems to be giving the wrong message.”

Tom McPhail, head of pensions research at Hargreaves Lansdown, another IFA, says that some people are still opting out. “Although we believe that the default option is to stay in S2P, there are youngsters who are interested in investment and decide that they would rather have control of the money than trust the Government,” he says.

Another part of the equation is that S2P itself is changing. The Government is planning to turn S2P from an earnings-related pension to a flat-rate scheme between 2012 and 2030. Steven Cameron, head of business regulation at Aegon, the insurer, says that higher earners will start to be affected almost immediately as the upper earnings limit for S2P will be frozen, while the earnings on which national insurance contributions are paid will not. “In effect, higher earners will be paying more for less,” Mr Cameron says.

The Government’s plan for S2P will save it about £1.6 billion in the short term, but pension experts caution that the next generation of taxpayers will be landed with the bill for the extra state pensions instead.

Factfile

The state second pension (S2P) is an extra state pension. If you are an employee, part of your national insurance contributions go towards your S2P entitlement, unless you are contracted out.

You may be contracted out if you are a member of an occupational pension scheme. If you are unsure of your position, ask your wages department.

To opt back in, ask your pension company to arrange this on your behalf. To opt out, pension companies normally insist that you take professional advice first.

The self-employed do not contribute to S2P.

The Pensions Policy Institute says that the average S2P being received by people of pension age is £13.48 a week.

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