The State Second Pension must be simplified to make it easier for people to decide whether to opt in or out of the scheme, an insurance trade body said yesterday.
The Association of British Insurers blamed the Government for the confusion surrounding the advantages of contracting in or out of the state earnings- related pension.
It said the Government's decision to reduce the rebate paid to people who opted out of S2P had made it very difficult for individuals to assess whether or not to stay in or out of the scheme.
It is calling for the pension to be reformed into a flat-rate scheme to provide better pensions for people who stay in it and greater incentives to save for those who opt out.
The ABI is the latest group to wade into the controversy surrounding S2P, after research by consumer group Which? and City watchdog the Financial Services Authority both found people who had contracted out of the scheme were likely to be worse off than if they had stayed in it.
Which? warned that an estimated 4.5 million people who contracted out of S2P into a personal pension were likely to be around 20 per cent worse off, while the FSA said those who had contracted out since 1988 and had not contracted back in were likely to see their pensions reduced by an average of £4 a week.
Chris Kenny, ABI director of life and pensions, said: " Used properly, the contracting-out system could have great benefits for consumers and taxpayers.
"The present situation has come about because the Government has reduced the level of contracted-out rebate that is paid into private pension schemes.
"This has made the decision over whether or not to contract-out a very difficult one for individual savers, given the risks associated both with private saving and with staying in the state pension."
S2P, and its predecessor the State Earnings Related Pension Scheme (Serps), provide an earnings-related top-up to the basic state pension.
But the ABI said the scheme did not now provide a sufficient income in retirement for many people, increasing the need for means-testing.
At the same time in 1997 the National Insurance rebates, paid to people who opted out of the scheme and invested in an occupational or personal pension, became age-related, reducing the amount younger people got.
Then in 2002 the rebates were made "financially neutral" so that they no longer reflected the increased investment risk an individual was taking on by investing the money themselves.
The ABI said the first step in reforming the system needed to be increasing the level of rebates given to people who opted out so the advantages of not being in the scheme were clearer. n More than a third of British pensioners have underestimated how much money they need to fund the sort of retirement they had hoped for, according to a Prudential survey.
It estimated 3.75 million of Britain's 11 million pensioners would like to boost their pension income by an average £7,300 per year - an extra £180,000 over the course of a 25-year retirement.