29th January 2013
This confusion is one of the main reasons why the Government wants to bring in a flat rate state pension where everyone gets the same amount. The Government’s aim is to pay everyone £144 a week from 2017. It will take a generation of unravelling what has gone before to get to that point, with the switchover creating winners and losers along the way.
For decades we have been able to partially opt out of the state pension system by funnelling some of our National Insurance contributions into our own scheme. If you are in a defined benefit or contracted-out defined contribution scheme, this means some of your NI goes towards paying for the pension you will get from your employer. And since 1988, people in personal pensions have been able to contract out of the state system too, diverting some of their NI contributions into their own pot to fund their income privately in future.
Of course you don’t get something for nothing and the deal has always been that people who were paying less into the state system would get a lower state pension as a result.
Under the current system, thirty years’ contributions will earn you basic state pension of £107.45, whether you were contracted out or not. But people who stayed contracted in are also able to build up secondary pension, also known as state second pension and formerly known as Serps, of up to £160 a week extra, giving combined state pension of £267.45.
Moving from a system where some people get a maximum £267.45 and other people get a maximum £107.45 to one where everyone gets £144 will create winners and losers. So how is it going to work out who gets what?
Under the new system you will need 35 years NI contributions or credits to qualify for the full payment, rather than 30, and you won’t get anything at all if you have less than 10 years’ contributions.
The Government will calculate what your total state pension is worth in 2017 when it introduces the new system. This amount will be called the ‘foundation pension’. If that amount is higher than £144 a week, then you will be capped at that level. If it is lower, then you will be able to continue building entitlement until you receive state pension age.
So if by 2017 you have already built up, say £170 a week, because you are a high earner in your 50s who has remained contracted into the state scheme, you will keep that entitlement. While you will receive more than the £144 flat rate pension, you will lose out under the new system because you will be stopped from accruing more pension. A high earner reaching state pension age in 2035 would have built combined pension of around £200 a week, but will now be capped at £144 or whatever they have built up by 2017, whichever is the higher.
For those in defined benefit schemes that have been contracted out of the state system, the changes are rather more generous, although there could be a sting in the tail for private sector DB members. Under the current system this group can get no more than the basic state pension of £107.45, which will be their maximum foundation pension amount in 2017. The ending of contracting out for these schemes will have two effects. Firstly, this group will no longer pay NI contributions at a reduced rate, and secondly, they will be able to start accruing more than basic state pension.
This NI hike will mean someone on £40,400 will see their NI bill go up by £481.27 a year. This may seem like a lot, but anyone in this group will also benefit from being back in the state pension. And they will be able to build on their £107.45 basic state pension by earning an extra £4.11 a week for every year they contribute.
And if you think paying £481.27 a year extra tax for an extra £4.11 a week, or £213 a year income sounds not worth it, bear in mind that it would cost you over £6,000 to buy an annuity that paid the same amount.
But crucially for our DB member on £40,400 a year, their employer’s NI contribution will also go up, by a massive £1,168.65. There is a real fear this extra cost will lead to a new round of closures of defined benefit schemes in the private sector.
Or rather than see their scheme closed altogether, the Government is bringing in rules that will allow employers that do keep these schemes open to reduce the amount of final salary or other defined benefit pension you get in direct proportion to the amount of extra state pension you get.
Public sector schemes will be unaffected however.
Big winners are those who contracted out into a personal pension, even though we have been told for the last decade that this was the wrong thing to do. They get to keep their pots – which could be worth as much as £100,000 – and can still build up their state pension from £107.45 to £144 at the rate of £4.11 a year. Anyone in this group with at least 10 years to state pension age when the new rules take effect in 2017 will be able to get the same state pension as someone who remained contracted in, and will get to keep their contracted-out pot as well.
It’s maybe not what ministers wanted, but it’s just one of the many consequences of unravelling 35 years of complexity in the state pension system.