 By Glyn Bradley, Associate, Mercer
Much has been said in the press about who will “gain” or “lose out” under the forthcoming state pension reform, but what exactly is going to happen and what does it mean for you? The position prior to reform is complex - even actuaries retiring in the near future would be hard-pressed to estimate their state pension. They might be fairly confident they qualify for the basic state pension (£110.15 per week in 2013/14 terms).
However, on top of that sit at least 7 different components of earnings-related pension including Graduated Retirement Benefit Pensions, the State Earnings-Related Pension Scheme (“SERPS”), and the State Second Pension (“S2P”), which might add up to another £163 a week for high earners on top of the £110.15.
To calculate the various components of state pension requires salary details over your working life, details of when you have been “contracted-out” of the earnings-related part of the state pension scheme through occupational or appropriate personal pension schemes, and information on any entitlements you might have accrued under various crediting arrangements including those for the self-employed, unemployed, married, carers, and people in receipt of benefits. Then, if the total falls below a minimum level, you may be eligible for a means tested Pension Credit top-up. The last aspect makes it particularly hard for people to establish if pension saving would leave them better off in retirement – a particular concern under auto-enrolment.
All in all, most would need a spreadsheet of considerable complexity and every P60 since age 16 to get the outcome right.
In the Pensions Bill, the Government has proposed to sweep away this complexity: anyone with 35 years’ credits (from whatever source, though under the new system you won’t usually qualify for a state pension on your spouse’s record) will have a single-tier state pension of about £144 per week (in 2012/13 earnings terms); those with less will have a proportionally reduced amount (subject to having at least a minimum number of years’ credits).
Anyone attaining State Pension Age on or before 6 April 2016 is not affected by the new system, but there will be transitional measures for anyone else with entitlements under the current regime. As at 6 April 2016, a “foundation amount” will be calculated, being the higher of
1. The state pension an individual would qualify for under the existing system, assuming they were given no further credits from that date; and
2. “n/35ths" of the new single-tier pension, for each credited year, less an amount broadly equal to any additional state pension foregone by any contracting-out in the past.
People whose foundation amount is greater than the full single-tier will be able to keep that extra amount, but they won’t be able to accrue any new entitlement. Any excess over the single tier pension will be indexed before and after state pension age in line with CPI inflation, which is not as generously as the single tier rate (proposed but not yet confirmed to be increased in line with the “triple lock” – the maximum of CPI inflation, average earnings and 2.5% p.a.). Interestingly, if you’ve been on high earnings and contracted-in since 21 you might have already achieved this by your early-40s.
If the foundation amount is less than the single tier amount, then individuals can accrue single tier pension at the rate of about £4.11 per week (£144 ÷ 35) for each further “qualifying” year, up to a maximum of the full single tier amount.
Finally, the “simplification” emerges over the horizon: with the exception of those who have already built up a bigger state pension or are too close to it to build up sufficient credits in time, most people will be expected to build up the single tier amount. Their income should be above the level where, for a single person, Pension Credit might be payable, which should make it easier for them to understand what they can expect from the state, and therefore what private retirement saving they want to aim for.
There is a price though for this (relative) simplicity:
• Contracting-out will end in 2016. National Insurance rates will rise for those contracted-out until that date, and for their employers.
• Those that expected to remain in employment or caring for most of their working lives will get less than they would have done under the existing system even if they are on relatively low earnings.
• State Pension Age will be regularly reviewed to target a specified proportion of adult life in retirement.
• The overall amount paid on state benefits is expected to go down in the long term compared to the position if no changes were made (although this could be viewed as a benefit for those in employment then, whose taxes support the state benefit system).
The challenge now is to take the simplified system and see whether people can better engage with pensions now that the state pension – the foundation on which private provision is built – can be understood.
Estimated pension under the new system for men in contracted-in employment throughout their working lifetime (2012/13 terms)
Other key assumptions for chart:
• Earnings progression has followed national average earnings.
• Price inflation from 2013/14 onwards assumed to equal 2.5% p.a.
• Future individual and national average earnings inflation assumed to be 4% p.a.
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