State Pension
What is it?
The state pension is a weekly income paid by the Government to the vast majority of the population once they reach retirement age. It's funded via taxes paid by those still working.
The first state pension was introduced in January 1909 (The 'Lloyd George Pension'), although in those days the chances of the Government actually having to payout were slim -
the retirement age was set at 70 even though a man's life expectancy at birth was only 50!
The retirement age is currently 65 for men and 60 for women (increasing to 65 by November 2018) and life expectancy at birth is now around
89 and 92 respectively for men and women (source: ONS cohort figs). However, the fact we're all
living longer is one of the reasons the state pension retirement age is due to increase to 66 by 2020 and 68 by 2046 for both both sexes.
The state pension increases each year inline with the greater of prices, average earnings and 2.5%, a so-called 'triple guarantee'. The earnings link had been scarpped by the Thatcher Government
in favour of prices in 1980, but was restored via the triple guarantee in April 2011.
What types are there?
Although there is only one type of basic state pension, for many it could be supplemented by the second state pension (S2P) and/or the pension tax credit.
Basic State PensionState Second PensionPension Tax Credit
This is the standard pension you'll receive at retirement age provided your National Insurance (NI) contribution history meets the qualifying criteria. If your contribution history falls short you could still receive a proportion of the basic pension.
The state second pension (S2P) is a 'top-up' to the basic state pension (for employees only) based upon not only your NI contribution history but also your earnings over your working life. S2P replaced the State Earnings Related Pension Scheme (SERPS) on 6 April 2002.
Under S2P you receive a proportion of your earnings between the NI lower earnings limit and an 'Upper Accrual Point' (UAP), currently £5,564 - £40,040 per year, for each qualifying year worked.
You have the option to 'contract-out' of S2P, meaning some of your NI contributions are instead be paid either directly or indirectly into an occupational or personal pension.
This is effectively a minimum income guarantee for those age 60 and over. It mainly comprises a 'Guarantee Credit' element - if your total income is below a specified
minimum level then the Government tops it up to that minimum level.
If you're 65 or over there's also a 'Savings Credit' element which could give you a small additional top-up.
While the pension tax credit is undoubtedly a welcome safety net, it does discourage some people from savings towards retirement because it would mean them losing out on this benefit.
A justifiable objection to S2P is that there's absolutely nothing stopping the Government, current or future, from moving the goalposts and leaving you with a lower S2P in retirement than you'd expected. In fact, past changes to SERPS clearly highlight this risk.
Contracting-out of S2P avoids this risk, although it does in turn open up new risks by linking the value of this retirement income to investment performance and annuity rates (excluding final salary schemes).
The amount paid into a contracted-out S2P depends on your age, income and the type of pension it'll be paid into.
| Contracting-out of S2P - Contribution Levels |
| Pension Type |
Employee NI Rebate |
Employer NI Rebate |
Note |
| Final Salary Occupational |
1.6% |
3.7% |
Pension paid must meet 'Reference Scheme' criteria, i.e. broadly inline with S2P. |
| Money Purchase Occupational |
1.6% |
1.4% |
Additional rebate based on age, see table. |
| Personal / Stakeholder |
There are no rebates, but the Government makes a direct payment each year based on income and age:
- Band 1: Earnings between £5,564 - £13,900
- Band 2: Earnings between £13,901 - £31,800
- Band 3: Earnings between £31,801- £40,040
|
The direct payment for each band is based on age, see table. |
Should you contract out?
If you distrust Governments over future S2P provision and don't mind investment risk then it might be worth considering. Unfortunately, it's nigh on impossible to make a sensible
comparison between staying in the S2P and contracting out because no-one knows if/how the Government will meddle with S2P in future. Unless you're close to retirement it's like having to make the decision blindfolded.
Note, if you're a member of a final salary scheme you have no say in the matter, the scheme (i.e. your employer) decides and they normally contract out. However, the scheme must provide you with a pension that's broadly comparable to S2P, so they shoulder the investment risk and not you.
Do I qualify?
Basic State PensionState Second PensionPension Tax Credit
You must work 30 qualifying years to enjoy a basic State Pension. A qualifying year is a tax year where your income was sufficient that you paid National Insurance contributions (or you were treated /credited as having paid them).
If you have at least a quarter of the required qualifying years you could receive a pro-rata proportion of the basic state pension. You also normally have the option to 'buy-back' weeks/years to plug gaps in your NI contribution record, via NI Class 3 contributions.
The current rate is £13.25 per week, making this a generally good deal if you fall a little short of the period needed to qualify for a full basic state pension.
For your earnings to contribute towards S2P each tax year they need to exceed the National Insurance 'Low Earnings Level', currently
£5,564. This applies to employees only, the self-employed do not qualify.
You could be entitled to the 'Guarantee Credit' element if you're aged 60 or over with a weekly income below £142.70 if you're single,
or you and your partner's combined weekly income is below £217.90.
When assessing your entitlement to the Guarantee Credit income from savings & investments is ignored, but a notional weekly income of £1 per £500 of
savings/investments over £6,000 is used, e.g. if you have £10,000 of savings then £8 (£10,000 - £6,000 / £500) would be added to your weekly income for the purposes
of the calculation.
For the 'Savings Credit' element you must be 65 or over with a weekly income between £111.80 -
£188.00 if you're single, or a joint income between £178.35 -
£277.00.
How much will I get?
Basic State PensionState Second PensionPension Tax Credit
The current basic state pension is £107.45 per week. A spouse who qualifies based on their partner's NI contributions receives £64.40 per week.
It currently increases with the greater of prices, average earnings and 2.5% each year. But what happens to the level of state pension long term is anyone's guess.
The amount of S2P you'll receive is based upon your yearly earnings over your working life, but it's not the simplest of calculations!
In essence, your earnings each year are split into three income bands. Each amount is then re-valued inline with average earnings to the year before you retire, before being multiplied by an 'accrual' rate then divided by the number of years in your working life. The three figures are then added together to give a total S2P benefit for that tax year.
The Department of Work & Pensions (DWP) provides a useful online state pension forecast service, allowing you to forecast your basic state pension and S2P based on your NI contribution history to date.
It's worth bearing in mind that the Government has steered S2P towards providing more help for those with low earnings compared to predecessor SERPS. This is a trend that may well continue.
The 'Guarantee Credit' element tops up income to £142.70 per week for a single person or
£217.90 per week for couples.
The 'Savings Credit' element provides a maximum £18.54 per week for a single person and £23.73 per week for couples.
You could try using the DWP Pension Credit Calculator
to get a clearer idea of whether you might qualify.
The pension tax credit conundrum
While it's generous of the Government to offer a guaranteed minimum weekly income for those over 60, it's something of an own goal given they want us all to save more
towards retirement. The problem is this: suppose you have no pension provision (other than expecting to receive some state pension) and negligible savings/investments,
there's no incentive for you to bother saving towards your retirement. All you'll end up doing is lose out on some, or all, of your guaranteed pension credit.
Of course, if you can afford to, it would be nice to save lots towards your retirement to ensure you enjoy an income well in excess of the guaranteed pension credit.
However, if you're struggling to save and think you might qualify for the guaranteed pension credit, think twice before contributing into a pension, you might end up
effectively paying for a benefit you'd otherwise get for free!
The Government is currently considering alternatives, so watch this space...
What happens if I die?
Basic State PensionState Second PensionPension Tax Credit
Your basic state pension dies with you. However, if your spouse receives less than the full basic pension their basic pension will normally be increased to the level you were receiving.
Your spouse can inherit between 50% - 100% of this pension, depending on when you were born.
The S2P / SERPS payable to spouse on your death are as follows:
| Sex |
Date of Birth |
% Payable |
| Male |
on or before 5 October 1937 |
100% |
| Male |
between 6 October 1937 - 5 October 1945 |
60% - 90%* |
| Male |
on or after 6 October 1945 |
50% |
| Female |
on or before 5 October 1942 |
100% |
| Female |
between 6 October 1942 - 5 July 1950 |
60% - 90%* |
| Female |
on or after 6 July 1950 |
50% |
| * percentage depends on exact date of birth. |
Things can only get worse?
The outlook for the state pension is pretty grim for two main reasons:
- It's funded by those still working. While there are currently three workers to fund each pensioner, by 2050 it is expected there will be just one. You do the math...
- We're all living longer, on average, hence drawing a state pension for longer too. Life expectancy is predicted to continue increasing.
Unless these trends reverse then it's inevitable that future Governments will either have to continue increasing the retirement age and/or increase taxes if the basic state pension
is to be preserved at it's current level of around 15% of average earnings.
State Pension Jargon
Here's some of the more common state pension jargon you might come across:
| Pension Tax Credit | A state benefit that's effectively a minimum income guarantee for those age 60 and over. |
| S2P | State Second Pension, a 'top-up' to the basic state pension (for employees only) based upon NI contribution history and earnings over your working life. |
| State Pension | A weekly income paid by the Government to the vast majority of the population once they reach retirement age. |