16th January 2013
To be fair to the Department for Work and Pensions, sorting out the UK’s pension system was never going to be easy. Virtually nobody knows how much they are going to get when they retire under today’s rules, potentially benefiting from a mix of basic state pension, state second pension and means-tested Pension Credit, as well as whatever private pensions you might have.
So the Government’s plan to create a flat rate state pension for all will bring much-needed simplicity to individuals looking to plan for their own retirement.
But you can’t unravel 50 years of Band Aid solutions without causing some pain, and while there are many winners from the landmark state pension reforms unveiled on Monday, lots of people are worse off.
The centerpiece of the reform is a flat rate state pension of £144 a week in today’s money, payable from 2017, that will increase in line with the highest of either price inflation, wage inflation or 2.5 per cent. This new flat rate pension, payable to everyone with 35 qualifying years – an increase from the 30 years required previously – is higher than the current basic level of means-tested Pensions Credit of £142.70, meaning in future people will have less worries about whether it pays to save.
Pension minister Steve Webb’s reforms are particularly good news for the self-employed and women. The self-employed have never been entitled to state second pension, which means they have only ever being able to build up a maximum £107.45 a week from the basic state pension. Self employed people will therefore see their income rise by over £36 a week, although their currently lower rate of National Insurance contributions may in future be increased to make up for the improved pension they will receive. Even so, the high cost of providing £36 a week for life from state pension age means it is likely to be a price worth paying.
People with combined basic and state second pension of less than £144 a week will also be better off. This includes people who have been out of the labour market for long periods, mainly women. Under the current regime those with less than £142.70 have had their income topped up to this level by Pensions Credit, but in the past about a third of pensioners have not claimed this means-tested benefit, whether because they have felt too proud to ask for it or because they simply didn’t know it was available to them. People with low state pension whose partner’s wealth means they would not have got Pension Credit will also be better off.
Anyone in a defined pension scheme or a contracted-out occupational money purchase scheme is also potentially better off as a result of these changes. As their name suggests, people in contracted-out money purchase schemes see part of their National Insurance contributions diverted into their workplace pension scheme. The same happens for defined benefit schemes, with that National Insurance contribution going towards paying for the considerably more generous benefits these schemes offer. As a result, it has always been understood that people in these schemes would get less state pension as a result. But under the Government’s proposals people in these schemes will be able to build up their state pension to the same level as those who have been contracted into the state second pension throughout their lives as well as still getting their more generous workplace scheme.
The Government has said companies are allowed to reduce the defined benefit income they pay their employees by the same amount as the increased state pension they receive. But it has said that it will not be reducing the benefits of 5m public sector workers. Civil servants will therefore do very well out of the deal as they will be able to benefit from an extra £1,924 a year more for a tiny 1.4 per cent increase in their National Insurance contributions.
The effect of contracting out may sound complicated, but it can be more easily understood when you look at the way people who contracted out of the state second pension into a personal pension will also benefit from the restructuring of the system.
Let’s imagine the cases of Peter and Paul, two employees aged anywhere between 45 and 55 with identical work records and salaries. The only difference between them is that in 1988 Peter decided to contract out of the state pension scheme and divert some of his National Insurance into a personal pension. For the sake of simplicity lets say that by 2017, when the reforms come in, Paul has built up combined basic and state second pension of exactly £144.
In the 20 years or so until his retirement under the old system Paul would have carried on building up state pension in excess of the new flat rate pension. If he is earning £25,800 and retiring in 2025 he could have expected £180 a week, or £9,400 a year. But he will now be capped at £144, or £5,587.40, so loses out considerably. Peter has only built up state pension of £110, but is allowed to carry on accruing extra state pension at the rate of £4.11 a year until he hits the £144 cap.
But he also gets to keep his contracted out pension pot, which could be worth anywhere between £40,000 and £70,000 depending on charges and performance. What’s more, he can take a quarter of this as a tax-free lump sum on his 55th birthday if he wishes. Paul meanwhile is left fuming that he listened to the experts who told him that you were better off staying in the state scheme.
The Institute of Fiscal Studies says younger people will also be worse off as a result of the reforms and in the long run everyone may be worse off. And probably the most likely to be upset are existing pensioners, who will miss out on the new system altogether. This cliff-edge spells hard luck for the self-employed pensioner who retires the day before the new rules come in.