If you are employed in the UK, you may be eligible to receive a State Second Pension in addition to the basic State Pension that almost every UK resident receives when they reach State Pension age. You'll qualify for this additional pension (known as S2P) if you have been earning above a certain amount (currently £4,940 but liable to change) on which you have paid sufficient National Insurance contributions. If you are self-employed, you are not eligible for the State Second Pension.
At the moment, the government permits S2P holders to leave the scheme and choose to hold their second pension through a private insurer instead. This is known as 'contracting out'. Contracting out is a temporary option; it's likely that all but final salary pension holders will be prevented from opting out by 2012.
If you do decide that you would prefer to have your State Second Pension managed elsewhere, the government will pay some of your National Insurance contributions and the income tax relief that you would have enjoyed through their Pension scheme into a private pension of your choice. The money that the government gives back to you when you contract out is technically a rebate, but you are only allowed to use the funds for the purposes of a pension. This is because the whole point of the State Second Pension scheme is to supplement your basic State Pension upon retirement.
Are you contracted out already? The only way in which you might already have contracted out your S2P without your full knowledge is if you were offered an occupational pension scheme through your employer. Firstly, check with your employer to find out whether you are contracted out. If this is the case, you cannot contract back in while you are a member of this scheme. If you are unsure about the current status of your State Second Pension and you are not part of a company scheme, you can apply for a Pensions forecast from HMRC by calling 0845 3000 168.
So why would you want to contract out your State Second Pension? The main reason that people choose to contract out their S2P is that they feel they are likely to get a better retirement income through a private pension scheme. If you are older and likely to be extremely reliant on your State Second Pension to sustain your lifestyle once you retire, contracting out, and accepting the financial risks that accompany this decision, may not be the right choice for you.
Consumer champion Which? advise treating websites that urge you to contract out with caution, saying that they "suggest that most people under 40 would be better off contracting out". Many of these sites carry no endorsement from the private insurers whose private pensions they recommend, and there is a danger of being worse off if you contract out without having all the information that you need to make the decision.
In order to find out what kind of S2P rebate you would receive from the government to invest in a private pension scheme, you can either apply for a Pension forecast from the government on 0845 3000 168 or talk to a private pension provider. Either way, they need to know your age and earnings (and your National Insurance number, in the case of the government). If you contract out, you should review your decision every three years, according to Which? to ensure that your pension is growing at least at the rate of the government scheme, or preferably faster.