A senior RAF officer, Malcolm Pledger, Deputy Chief of Defence Staff (Personnel) said there had been a "failure" of the original contract between Texas-based IT services supplier EDS and the Ministry of Defence's Armed Forces Personnel Administration Agency.
As a result the private finance initiative contract has undergone a "substantial reconstruction" as the two sides seek to improve the timeliness, accuracy and cost of handling the pay and pensions of hundreds of thousands of UK service personnel.
Efforts to rescue the contract - one of the Labour government's first big technology-based PFI deals - has secretly involved ministers from both the Treasury and the MoD.
Although Pledger revealed that there had been an "evident failure" of the original contract he did not seek to apportion blame. He said PFI had not been properly understood by either side. "There was particular naivety on the transfer of risk."
He added, "MoD wanted improved services within the original contract price but EDS needed further funding to deliver the improved information systems. The result - a contractual stalemate."
This made it difficult to deliver changes necessary to support initiatives and legislative requirements. He referred to the risk of "pouring in cash to keep afloat a contract which continued to leak - nay haemorrhage - just to maintain the status quo".
The agency had considered ending the 12-year deal after only two years, and bringing the staff and IT systems back in-house, but decided instead to rewrite the contract.
The problems may draw attention to the extent to which the Government is reliant on EDS. The IT consultancy, Kable, estimates that EDS controls nearly half of central government's outsourced computer systems, including those that issue driving licences, collect the nation's tax revenue and pay out social security benefits.
In January 1998, EDS took over 90% of the staff and all of the main IT systems at the Armed Forces Personnel Administration Agency. Handling up to £8bn, a third of the total defence budget, the agency is responsible for paying active service men and women, and pensioners.
EDS said the contract was reconstructed in part because the "parameters of the agreement changed". There is a "new approach to the delivery of change and joint vision which aims to enhance the relationship between MoD and EDS and lead to improved service".