Will I see some kind of penalty when I take my state pension at age 67, having 'contracted out' for over 25 years?

I contracted out of the State Earnings Related Pension Scheme (Serps) at age 18, not long after starting work in 1990.

I did not contract back in until 2016 when the new state pension was announced.

I have now made 37 years of National Insurance contributions, which according to my forecast should give me a full state pension at age 67 in 2036.

My contracted out private pension will have around £106,000 in it when I am 55 next year. So, did 18 year old me make a wise choice to 'contract out'? 

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Steve Webb replies: The way that the new state pension treats the millions of people who were once members of a 'contracted out' pension scheme continues to cause confusion.

I will start by explaining how the new system works and what went on inside Government when the system was being designed. 

I'll then explain why in your case you don't need to worry, and you will indeed be getting the full flat rate, currently worth nearly £12,000 a year.

How the state pension was reformed in 2016

One of the big problems with the old state pension system - which the 2016 reforms were designed to address - is that it was incredibly difficult to know what you were going to get.

The old system had a 'basic' pension payable at different rates, and an earnings-related 'additional' state pension (often called Serps) where the amount paid was different for each individual.

As a result, it was pretty much impossible to be sure how much state pension you would get.

The idea of the new system was that everyone who had a pretty full work history in the UK should get the same figure. Most people would be on this figure and would know where they stood when planning their private pension provision.

But the challenge in moving to the new system was that two people on the same lifetime earnings with the same number of years of contributions could have paid in very different amounts.

Specifically, those who were members of traditional salary-related workplace pensions or 'contracted out' pot of money style pensions benefited from generous rebates on their NI contributions. How should the new system treat these people?

One option the Government considered was to 'forget' that contracting out had ever happened and simply pay people full pensions if they had paid in for 35 years, regardless of the rate.

But this would have been very unfair to people who had paid full contributions throughout.

At the other extreme, the Government could have said that *any* period of reduced contributions would result in a permanent stain on your NI record and you could never get a full new flat pension.

The problem with the latter approach is that it would have massively slowed down the move to the new simpler system.

To give an extreme example, someone who had just one year of contracting out on starting work in 2015-16 could have seen a deduction from their flat rate pension when they retired in the 2060s. This approach would have undermined the drive to move to a simpler, clearer system.

In the end, the Government went for something in-between.

Past contracting out would be taken into consideration when people's rights up to 2016 were worked out, but then years of work or contributions post 2016 would gradually wipe out any deduction.

As a result, with every passing year since 2016, the proportion of people retiring on the standard flat rate has been steadily increasing.

How is the state pension calculated if you were contracted out?

Turning now to your situation, the good news is that Department for Work and Pensions have already made any adjustments for past contracting out, so you should not get any nasty surprises.

Based on what you have told me, here is how your state pension would be worked out.

The first stage is to give you a 2016 'foundation amount'.

In simple terms, this is the better of the amount you would have built up by 2016 under the old rules, and the amount had the new rules been in force all the time.

For those, such as yourself, who have been extensively contracted out, it will generally be the 'old rules' calculation which determines your foundation amount.

You have sent me your NI record which shows credits in 1987/88 and 1988/89 and then a mix of contributions and credits thereafter.

As you have 29 years up to 2015/16 inclusive, your 2016 foundation amount would be based on 29/30 of the old basic pension. In today's money that would be a full basic pension of £176.45, minus one year, so £170.57.

In addition, you may have had a few pounds of 'state second pension top-up' for your work post-2002. I estimate that this would give you a foundation amount of at least £172.

Regardless of how the foundation amount was worked out, the second stage of the calculation is the same for everyone.

For every full year of contributions from 2016/17 onwards, 1/35 of the new flat rate is added to your foundation amount.

In your case you have nine years post 2016. We therefore need to add 9/35 of the standard flat rate figure – currently £230.25 – which is £59.20.

In total therefore, you will get your starting amount of around (roughly) £172 plus £59.20. this would be £231.20, but the figure is then capped at the standard flat rate of £230.25.

In many ways, therefore, you are one of the winners from the reform.

You benefited from a period of contracting out, when you paid less in to the system. But because of your work since 2016, any negative impact of contracting out will have been wiped out.

So, at retirement, you can get a full new state pension despite having paid in at a reduced rate for several decades. You can give your 18 year-old self a pat on the back for being so far-sighted.