Next April will see the old state pension system of Basic State Pension, State Second Pension and Serps abolished, and replaced with a new ‘single-tier’ state pension where everyone, subject to qualifying years, gets the same amount. It is a shame that the current watered down contribution rates mean for many, auto enrolment will not replace the state pension they will lose under the reforms.
One of the main reasons the new simplified state pension is being introduced is to reduce pensioners’ reliance on means-tested benefits, and to provide a bedrock of income just above Pension Credit to make sure it pays to save through auto enrolment.
Untangling decades of complicated state pension rules was always going to be difficult, and it will be decades before a large proportion of pensioners get the full amount – predicted to be around £150 a week from April 2016.
The backside of the medal
Switching the entire British workforce from one system of pension accrual to another – while keeping it broadly cost-neutral at least in the early years – was always going to create winners and losers. But, it is unfortunate that the biggest losers are likely to be the millions of workers with little or no private pension savings whatsoever, who form a large part of the auto enrolment demographic.
Part of the problem is the way the government is unraveling the practice of contracting out of the secondary state pension – first from Serps and then from State Second Pension. Under the outgoing system, someone who had worked all their life and never contracted out, either into a final salary pension or occupational or personal pension, could easily have built up in excess of £200 a week by the time they retired. While they will keep existing accrued benefits when the government transfers them to the new system in 2016, they will not accrue further benefits. So someone who is 50 who has built up £150 a week by next April will see their pension frozen and get no extra credit for a further 17 years’ contributing into the system.
People who were contracted out, either because they have been members of gilt-edged final salary schemes, or contracted-out occupational defined schemes, or who have taken out personal pensions, would have only received a Basic State Pension of up to £116 at retirement. This is because a part of their National Insurance contributions have been diverted into their private arrangement meant to make up the difference.
However, this group will be able to carry on building up a state pension at £4.11 per week for each year they contribute, so will in many cases be able to catch up with those who never contracted out. But not only will they in many cases be able to get the same state pension as those who remained contracted in, they will also get to keep their contracted out benefits. For those who contracted out into personal pensions, pots built up from diverted National Insurance contributions could be worth as much as £100,000.
The irony is that these state pension reform winners are, by definition, people who already have pensions – whether final salary, occupational DC or personal pensions. The biggest losers are those who remained in the state system and have nothing else.
Figures from actuaries Hymans Robertson from 2014 show that a 48 year old who has always been contracted out of the state pension system gains pension income that would cost £50,000 to buy through an annuity. Someone of the same age earning £15,000 a year who has remained contracted into the state system loses pension payments worth around £35,000.
Many of those workers who have been contracted into the state system will never build up pots of up to £35,000 needed to replace what they will lose under these reforms.
What’s more, the situation is being made worse by the way the auto enrolment contribution structure has been watered down in recent years.
The ‘qualifying earnings’ rule – that means only earnings between £5,824 and £42,385 are considered for auto-enrolment, means someone earning £10,000 a year contributes 3.4 per cent of earnings, not 8 per cent.
And the decision to exclude millions from workplace pensions altogether because they earn less than £10,000 from a particular employer creates a whole class of workers who are doubly penalised. Under the old system anyone who earned over £5,824 accrued both Basic State Pension and State Second Pension. Those earning between £5,824 and £10,000 with any employer now not only lose out on state pension, but will not be auto enrolled into a workplace scheme to help make up what they are losing.
There are good reasons for reforming the state pension. But the new minister should reform the auto enrolment contribution structure to enable low earners who have been contracted into the state system to rebuild what they are set to lose.