Changes to the state second pension, or S2P, the government’s earnings-linked top-up pension, were announced in May. Under the proposals, the S2P will evolve into a flat-rate benefit.

So what is afoot with the state second pension?

The news headlines trumpeted the restored link between the basic state pension and earnings inflation. But under proposed changes, higher earners will have their S2P slashed by up to £50 per week. The principle that the more National Insurance you pay, the more pension you get, will disappear, and higher earners will effectively subsidise those on lower incomes.

Sounds like another stealth tax?

I’m afraid so, although some low earners will be better off. Changes will be gradual over many years. Only by 2030 will payouts align at the lower maximum flat rate of £60 in today’s money.

Will everyone be worse off?

No, according to Aegon, the inssurer. Although anyone earning less than £12,500 will receive pretty much the same maximum S2P entitlement of £60 a week, they will receive a more generous basic state pension linked to earnings. People earning above the upper earnings limit of £33,000 will be worse off. Aegon says the jury is out for those earning between £12,500-£33,000.

How will S2P be calculated?

The maximum level you can earn will decline slowly up to 2030, when the maximum possible S2P accrual will be a proportion of £60, depending on how long you worked. If the longest working life is deemed to be 49 years, but you work only 30 of them, your maximum accrual will be 30/49ths times £60. S2P will gradually wither away, as it becomes a smaller proportion of average earnings. This is because, while the basic state pension will rise in line with earnings, the S2P only retains a link with inflation.

When will changes be introduced?

If and when the government implements its Pension White Paper proposals, the basic state pension and S2P will be overhauled in unison. The launch date could be any time from 2012 to 2015, depending on affordability.

What is S2P anyway?

The maximum weekly S2P people now retiring can receive is more than £100, compared with the £84.25 a week basic state pension.

The second-tier scheme came into being in 1978, in the form of the State Earnings-Related Pension Scheme (Serps) – to provide everyone with a generous earnings-related top-up to the basic state pension. Funding came from National Insurance contributions. In 1988, Serps benefits were slashed and in 2002 Serps became S2P, and the scheme was weighted towards lower earners.

How is entitlement calculated?

People earning above the upper limit of £33,540 receive 20 per cent of average lifetime earnings between the upper limit of £33,540 and the lower limit of £4,368. The working life is deemed to be 49 years. Once again, if you only work 30 years, you receive 30/49ths of the total. Another system applies for people earning under the upper limit.

How can I find out my entitlement?

You can get a rough forecast at: www.thepensionservice.gov.uk/atoz/atozdetailed/rpforecast.asp. Note that plans in the Pensions White Paper aren’t yet incorporated into projections.

Can everyone get S2P?

No, the self-employed are ineligible. Carers of the disabled and children already receive some benefits, and more will qualify for S2P in future.

What is contracting out? Isn’t this related to the S2P?

At present you can “contract out” of S2P and renounce any entitlement to government S2P benefits for each year that you are contracted out. Instead, the government pays a rebate into a company or personal pension scheme for you. The idea is that if fund performance is good, you can accrue superior benefits in your own private pension pot. Under the new regime, people who have contracted out into private pension pots will stop receiving benefits and will automatically be contracted back into S2P. Members of contracted out employer-run final salary schemes will stay contracted out, although the government is cagey about what rebates will apply.

What should I do in the meantime? Should I opt back in now?

If you’re in a money purchase, personal or stakeholder scheme you could go back in at any time until the new regime comes into force.

You should take advice now on what to do. The government recently revised rebates for 2007-2012. For those under 43 it could be advantageous remaining contracted out. But the older you are, the more sense it may be to contract back in.

There are some benefits to staying contracted out. Some advisers don’t trust future governments to water down entitlements to the S2P. At least if you’ve taken the money as a rebate, the cash is sitting in your private pension plan. Also, you can now take 25 per cent tax-free cash on retirement with pensions savings accrued as a result of contracted-out rebates. With contracted-out money, you can draw your pension income from age 50, rising to 55 after 2010. With S2P your retirement income only becomes payable from age 65.