Does increasing your state pension make sense?
New rules governing the state pension take effect from April 2016 and the will fundamentally change the attractions of deferring the pension or buying additional years.
If you were born on or after 6 April 1951 (men) or 1953 (women) you will be eligible for the new flat-rate pension from next April. Forecast to be no less than £151.25 per week, this will rise each year by the higher of inflation, average earnings or 2.5%.
Under the current system you need 30 years of national insurance contributions (nics) to qualify for the full amount; this will increase to 35 years.
Purchasing additional years
If you don’t have the full 35 years, there is an opportunity to buy additional years in the shape of Class 3 and 3A nics (only for those at retirement age). Currently it costs £733 to purchase a qualifying year (up to a maximum of six) which provides an additional inflation linked pension of up to £225 a year – a pretty attractive return as long as your health is reasonable.
Under the new scheme the cost will be dependent on the extra income required and the age of the applicant. Let’s say you’re a 65-year old female. You will hand over £22,250 for an additional £25 per week (£1,300 per annum) of pension which will be inflation linked and 50% will continue to be paid to a surviving spouse. This equates to a rate of 5.84% whereas the equivalent commercial annuity rate is 3.69%.
At first glance, this appears reasonably attractive but upon closer inspection much less impressive for several reasons:
- Income tax: You are converting capital into income and if you have £22,250 available in cash it’s likely that you are paying some Income Tax. Even at a rate of 20% it will take more than 21 years to get your money back (ignoring any inflationary increases).
- Your health: If you have reduced life expectancy, exchanging capital for lifetime income isn’t the best course of action, unless you happen to be married to someone who might live 20-odd years longer than you and benefit from the 50 per cent payout.
- Access to capital: Another consideration is the purchasing power of a lump sum compared to a relatively small uplift in your regular income. If the amount represents a significant percentage of your savings, it’s probably prudent to retain the funds on deposit (perhaps in an ISA) rather than exhausting them to purchase additional income.
Less reason to defer your pension
There’s been much talk recently of deferring the state pension and the rules will also change next April. Currently pensions increase by 1% for every 5 weeks deferral, but this will reduce to 1% for every 9 weeks – halving the annual uplift from 10% to 5%. Deferring the current state pension for a year currently increases your annual payment by £627 (inflation linked) having forfeited a year’s income (£6,032), making it profitable after 10 years. Under the new rules deferring only becomes profitable after 17.5 years – a staggering jump.
With the impending changes, if you’re approaching retirement age, request a state pension statement at: www.gov.uk/state-pension-statement.
This article first appeared in Yourmoney.com on 11 November 2015.