The state pension reform – were you better off contracted out after all?

16th January 2013

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As the French say, you can’t make an omelette without breaking eggs, and while the landmark reforms to state pension unveiled this week certainly create plenty of gainers, they also leave a fair number of losers too.

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. 

12 thoughts on “The state pension reform – were you better off contracted out after all?”

  1. gill says:

    why do i have to wait for 6 weeks to get pension credit and why are the staff so unhelpful and rude

    1. Maryanne says:

      Yes, the civil service is no longer civil..why are people just so bloody horrible:}

  2. Anonymous says:

    Wheale should be ignored. BoE misinformation is now the default.

    UK still going down, hard. Next external shock and it’s game over. Then all the fiddles come out the woodwork to haunt.

  3. Anonymous says:

    Shaun,
    Reduced income tax receipts a result of reduced real wages and higher basic tax allowances this year and next possibly?
    Capital capturing more of the profits vs labour – time for company’s £ sales vs UK tax paid to be published either in their accounts or by HMRC (Amazon, Google, Vodaphone & Starbucks etc. top my list!). I suggest a 20% target seems an acceptable level on a par with income tax.
    Tobin tax still on EU agenda would rein in the casino bank operations – resisted by UK but stamp duty still applied to individual share purchases!

    1. Anonymous says:

      Hi Chris

      I am sure that your initial question is an influence on the numbers but higher up the scale the higher rate (40%) threshold has not only fallen behind inflation it has fallen outright. The basic rate band was £35,000 in 2011/12 but is only £32,010 this tax year. So there is an element of swings and roundabouts at play here.

      As for corporate taxes I completely agree that the current system is in disarray and we need to find a new one.

  4. forbin says:

    Hello Shaun,

    Seems that the BBC published a story the other day about the interest rate rise in which they confirmed my view that it was wages they were targeting all along …..

    http://www.bbc.co.uk/news/business-26282194

    I consider that the HMG thinks that the bank bailouts will pay for themselves if they can get growth going and sell the banks shares off – hopefully at a tidy profit

    This has been the way used with previous bank bailouts

    They’ve always been smaller and usually local to the UK ( or other countries ) . I think they’ve been rather surprised at the lack of growth and the actual poor state of the banks even after all this cheap money they have had ( 0.5% helps banks and IMHO the HGM as well ) .

    Still I ‘m sure if they could they would have negative rates , after all if food , housing and fuel ( and transport , I’m looking at you rail fares ! ) are not falling back , add in lower wages increases ( forget one off bonuses , they’re one off and for the few ) are still happening – then who will have the money to run a consumer economy ?

    Borrow more ? oh deary me……..

    maybe the future is Dune ……

    Or Harry Harrisons Home World

    Progrock has a valid point , we’re one shock away from a very interesting time ……

    I’d posit it will be next year when KSA gets their refinery working and between 400-600K of oil disappears from the open market….
    ( oil products will be sold to China who are building it )

    Forbin

  5. SH says:

    I thought I had contracted out but Scottish Widows have just informed me that they told me that I had contracted out but forgot to do the paperwork. Apparently, their are a number of us in the same boat / They have just offered me a cheque for just under £15,000.I am a higher rate tax payer ,how do I calculate my loss .I’m 49 yrs old.

  6. Anonymous says:

    Sure they won’t do a hard default, just a soft one. But that will hurt UK living standards big time. It won’t be Mad Max, more Rita, Sue and Bob Too. :-)

  7. DaveS says:

    True, I agree it will be a soft default but again other debtors will follow in an inflationary race to the bottom.

    I wonder what sort of world we would be in if all the big debtors try to inflate their debt away together. I am in no hurry to experience that either :-)

    One puzzle has been the relative strength of the pound given all our deficits. Who is buying it ? Given that our inflationary default will likely be triggered by a collapse in the pound then maybe the clowns are out their buying it right now ?

  8. Anonymous says:

    Hi Anteos

    You make a good point about fiscal deficit can kicking to the next Parliament. You made me look to also to the preceding one which did the same in two ways. From my blog (Notayesmaneconomics then) of May 12 th 2010.

    “However this is an area where all three main political parties have similar flaws in their plans. If you look at the three published manifestoes there is a hole in each of them of a similar size, £30 billion. So in truth none of them are being transparent and honest in their spending pledges. So the answer to the question what are they not telling us? Is in economic terms £30 billion. This is just over 2% of our Gross Domestic Product (GDP). Put another way it is around a quarter of the annual cost of the National Health Service.”

    And

    “Another problem: future economic growth

    Forecasts for the UK fiscal deficit going forward do not look good. Unfortunately they were based upon unrealistic economic growth figures so in fact they are even worse than they appear. As I wrote above this year is showing signs of growth but 2011 and 2012 had official growth forecasts of 3% for each year compared with independent growth forecasts of more like 2% for each year and this is a little hand grenade in the figures that the previous administration left behind for the new Chancellor.”

    Of course we now know that economic growth undershot even that. But it would appear that the current and preceding parliament has undertaken a fair bit of can kicking. This is missing from the media debate.

    The real issue is that none of the parties who have been in power have ever really acknowledged reality or tried to deal with it. Our whole political class has a problem or rather they are making one for us.

  9. Anonymous says:

    Hi Guys

    I spotted this in a twitter conversation yesterday which adds some numbers to your thoughts of soft default of the UK over time. The £ from 1915.

    http://twitpic.com/dw76as/full

  10. Noo 2 Economics says:

    Ignore the bit about the BOE taking action to prevent spiralling wage rises. I read that elsewhere and have mistakenly attributed it to Simon – doh!.

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