State Pension – Elements 16

This post is part of the Elements series, a Periodic Table of all the Investing Elements that you need to take control of your financial life. You can find the rest of the posts here.

The State Pension

What is it?

The New State Pension (( Apologies to men born before 6 April 1951 and women born before April 1953 – today we’ll be looking at the recently introduced scheme only; you already have your Old State Pension and I hope that you understand how it works )) is a monthly payment from the government.

• It’s currently set at around £8K pa – this is designed to remove recipients from the welfare system, because it modestly exceeds the means-test limit for further support.
• This level is protected by a “triple-lock” – it rises each year by the highest of inflation, wage increases and 2.5%;
• £8K pa is generally regarded by the mainstream media as generous and a burden on young working people, but it compares unfavourably with the minimum wage (£15K pa) and the benefits cap (£23K in London).

More importantly, the State Pension is not a handout, and it is not automatically available to everyone.

• Qualification is by both age and by contributions from earnings – national insurance contributions (NICs).

What kind of element is it?

The State Pension is a product provided by HM Government.

Who needs it?

Everybody could benefit from “free” money, so instead let’s look at who qualifies for it.

First, the age qualification.

• For most of my life, men got the pension at age 65, and women got their pension early, at age 60 – this was the Old State Pension scheme.
  • Eventually people decided that this was unfair, and the decision was taken to equalise the age qualification. (( Some women seem not to have heard about this, hence the current WASPI campaign that they should still get the pension at 60 ))
  • This process is ongoing, and the qualification age will be the same for men and women by the end of the decade.
• The government also decided that with life expectancy constantly rising, paying out at 65 was too generous – people could easily live for 20 more years from there.
  • So the State Pension Age (SPA) will rise to 66 in 2020, and then to 67 in 2028 and 68 in 2044.
  • These arrangements are reviewed once in every parliament (so once every five years) and further and earlier rises are expected.

Next, the contribution qualification.

• You need to make 35 years of National Insurance Contributions (NICs) to qualify for the full State Pension (SP).
• Even for a graduate starting work at 22 and qualifying for the SP at age 66, paying in for 35 out of 44 years seems reasonable.

But for many people who will reach the SPA over the next thirty years, there is a snag.

• During the 1980s and 1990s, people were encouraged to “contract out” from the second state pension (SERPS), which has since been abolished.
• This allowed you to pay lower NICs, and the government would also make contributions into a personal pension designed to replace the SERPS.
• There was no intention that the base State Pension would be affected by this, but when the system was revamped recently, the government decided that these years of lower NICs wouldn’t count as full years of contributions.
• To use myself as an example, although I have more than 35 years of NICs, I only qualify for a £7K pension rather than an £8K pension.
• That’s a 12.5% reduction because of a few years of contracting out.
• This problem will resolve itself in time since contracting out disappeared in the recent revamp, but for the next couple of decades there will be some people not getting the full pension.

What comes before it?

You need to be employed to make standard NIC contributions.

• There are alternative arrangements for the self-employed
• And groups with interrupted working lives (such as carers) typically receive NIC credits to top-up their pension entitlements for years where they made no contributions.

NICs are compulsory and deducted at source by your employer, so there is no opting out or choice involved here.

What comes after it?

Nothing – the State Pension is paid until you die.

What age do you need it from?

As soon as you can get it – 65 just now, 66 in 2020, 67 in 2028, 68 in 2044.

What age do you need it until?

Until you die.

How much does it cost?

NIC contribution rates vary according to how much you earn.

• To make things more difficult to understand, the government quotes rates and thresholds with reference to weekly and monthly rather than annual earnings.
• You pay NICs by the week/month, unlike income tax, which is totted up at the end of the tax year.

Here’s the situation for the current 2016/17 tax year:

1. Over £112 per week (£5.8K pa) you pay nothing, but you get “the benefits of paying” – you are credited with having paid NICs anyway.
2. Over £155 per week (£8.1K pa) you start to pay, at a rate of 12% of earnings.
3. Over £827 per week (£43K pa) you pay a lower rate (2%) on your additional earnings.

So a person earning £43K pa (the upper threshold for the switch in rates) pays 12% on £35K of earnings, or £4K per year.

• Someone on £25K pa would pay 12% on £17K, or £2K pa.

As you can see, the State Pension is not free money.

• Someone on average earnings will have paid in a minimum of £70K, which will have been invested for up to 35 years.
• In return they receive perhaps 16 years of £8K – a total of £128K.
• Higher earners get a much worse deal than this.

You could probably do better investing the money on your own behalf.

What’s in it?

Nothing – the Government doesn’t actually run a pension fund.

• Instead, the contributions from this years workers are used to pay the pensions of this years retirees. (( This is the theory – the practice is even worse, as government revenues are not hypothecated in any way ))

What does a good one look like?

There can be only one.

• In comparison to the Old State Pension – particularly in the 1990s – the New State Pension looks pretty good (once the contracting-out problem drops out of the picture).
• In comparison to most countries in Europe, the £8K pa allowance is pretty mean.

What does a bad one look like?

As above, the old system was worse.

Any recommended brands?

There is just the one brand – HM Government.

• Since they print the pound notes, you can rely on the State Pension (despite mainstream media coverage to the contrary).

What are the main risks?

There’s not much risk at present that the State Pension will disappear entirely.

There are two main risks to do with its form:

1. that the qualification age will continue to rise
   • almost certainly true, though not as quickly as people expect
2. that the amount of the pension will fail to keep pace with inflation
   • impossible for the next few years with the triple lock, but an increasing risk as time goes by and demographics work against the government finances

How do you deal with these risks?

There’s nothing you can do about them directly, except perhaps vote for a political party whose policies on the State Pension align with your views.

Indirectly, it would be unwise to rely entirely on the State Pension for your retirement income.

• Take up your Workplace Pension offer, and pay enough in to secure the matching contributions available (this is free money).
• Pay some extra contributions into a SIPP, particularly if you are a higher rate tax payer.
• If you have any money left over, take out an ISA each year.

Until next time.