Last week This Is Money ran an article titled: “Officials admit they can’t say if your state pension top-up will work and tell savers to seek expensive financial advice” (link)
This follows several earlier articles on the “State Pension Fiasco”:
- Couple who lost £7k topping up their state pensions finally win a ‘goodwill’ refund as HMRC stands by its baffling system (link)
- The state pension top-up fiasco: Savers are paying to boost their incomes only to find payouts don’t rise and they can’t get a refund (link)
- I’m being deprived of £155 full state pension despite paying NI for 45 years because I was ‘contracted out’ behind my back! Steve Webb replies (link)
The articles are all high on anger but less clear on what the problem is. In part though, that’s because the problem is quite complicated and not easy to explain. The thread that runs through each of these pieces is that the Government has done a very poor job of communicating the 2016 changes to the state pension (the “single-tier” or “new” state pension).
In this piece I’m going to try my best to explain what’s going on with the new state pension, why things are going and what you can do about it. Before all that, let’s take a potted history of the UK State Pension.
6 April 2016: the day the earth stood still…
On 6 April 2016 the Government brought in the New State Pension (NSP). The key distinguishing element of the NSP is that it is single-tier – it has only one element – for 2018/19 it pays £164.35 per week. There are no other payments or anything like that – just one amount. The concept behind it was two-fold: (i) the old pension system was convoluted, a single-tier pension is much simpler; and (ii) the new system paid the same to everyone, the state wasn’t going to pay out extra cash to “rich pensioners”. But to understand the NSP, we need to look at what it replaced.
The Old State Pension (pre-6 April 2016)
If you reached State Pension Age (SPA) before 6 April 2016 (men over 65, women over 63), you get the Old State Pension (OSP). There were two elements to it: (i) the Basic State Pension (BSP); and (ii) the Additional State Pension (ASP). To get the full BSP you needed 30 years of National Insurance Contributions (NICs) or credits. For 2018/19 the full BSP is £125.95. If you had less than 30 years then the amount was scaled down commensurate with the number of years you had accrued. So far so easy. The ASP was where things started to get complicated. First, we need to go back to 1961…
State Graduated Pension Scheme
In 1961 the government introduced the State Graduated Pension Scheme (SGPS). Designed, to reflect that some people had paid additional NICs compared to the self-employed (through the fixed rate Class 2 contribution, note Class 4 doesn’t provide entitlement to any benefits, it’s only Class 2 that counts). However, most occupational schemes contracted out of this – by paying the value of the ‘additional’ NICs out of the occupational scheme instead of paying it to the Government. In effect, very few people accrued under the SGPS.
In 1978 something that might be a bit more familiar came along, the State Earnings Related Pension Scheme (SERPS). To cut it short, if you earned above certain limits you accrued an extra pensions entitlement to reflect that you were making more NICs. You would accrue the entitlement at a 25% rate, what’s more only your best (i.e. highest paying) 20 years counted. It sounds too good to be true, and it was. The accrual rate was too generous and in 1988 the accrual rate for those retiring post-2000 was cut to 20% and career average earnings used. Again, many people were contracted out of SERPS.
As you may have guessed, the Government again changed its mind. In 2002 they replaced SERPS with the State Second Pension (S2P). The aim of the S2P was to widen the scope of people who could get an additional entitlement and to skew benefits away from high-earners to low and medium-earners. In short, the Government created a “three-band system”: increasing accrual rates for lower earners to 40% (between certain limits) and lowering them to 10% for “middle-earners”, with the rate for higher earners, 20%, the same. The Government made a commitment that nobody reaching SPA before 6 April 2009 would be worse-off under the new system compared to SERPS. So those people received an additional accrual top-up (this principle pops up again later and is one of the causes of the current New State Pension issues).
It wasn’t long before the Government realised they once again set accrual rates too high. In 2010, the Government scraped the “three-band” system for a less generous “two-band system”. The middle and upper bands were combined and both accrued at 10%.
This lasted only 2 years until April 2012 when the Government changed the lower band to a fixed rate, and generally speaking, less generous accrual. The Government also stopped contracting out for those with a DC scheme, so only DB members could keep contracting out.
As you can probably surmise, working out your S2P requires a brain the size of two watermelons. Firstly, you split your earnings across the bands and revalue them to the tax year prior to reaching State Pension Age (SPA). You then multiply the earnings by the relevant accrual rate (including any adjustments required for SERPS). You then divide by the number of years in your working life (from age 16 to SPA).
There was one final element of the Old State Pension. Under the OSP there were also State Pension Credits. In short, these were designed so that people would have a minimum floor for their State Pension (i.e. wouldn’t have a below-poverty level pension). There were two types of credit:
- Guarantee Credit – If you have income below £163 (single) or £248.80 (couples) and savings under £10,000 (with a few other conditions) the Government tops you up to £163/£248.80 (2018/19 figures).
- Savings Credit – This is a credit for those that built up savings for retirement. In effect if your income is higher than a certain level, the Government tops you up. Because the full-rate New State Pension was set above the maximum Pension + Savings Credit, the Savings Credit became no longer relevant for people reaching SPA after 6 April 2016.
To take-away, there were things in place to make sure you got a certain level of pension income in retirement.
If there are two important themes to take away from the OSP it is this:
- It was very complicated; and
- Continually chopped and changed, but with a commitment that those under the SERP/old system wouldn’t lose out under the new/S2P system.
Back to the NSP
It wasn’t just the amounts and the simplification that changed on 6 April 2016. Several other rules changed, many of which caused problems:
- You need to have at least 10 years NICs to get anything (up from 1 year)
- To get the full £164.35 you now need 35 years NICs (up from 30)
- From 6 April 2016 you can’t claim a SP based on a spouse’s NIC record.
- All NIC classes (employed vs self-employed) accrue at the same rate.
- The Government set the principle that you couldn’t have a lower pension than your accrued entitlement to the ASP/SERPS/S2P as at April 2016.
- Contracting out for DB schemes ended (it had already ended for DC schemes)
Problem 1: Not all NICs are equal
Numbers 1, 2 and 3 meant that some people suddenly found themselves “short” of the NICs needed to get the new full pension. To help with that, you could make voluntary contributions. However, there are two types of voluntary NICs. Class 3 – which allows you to buy a higher level of the old BSP (and now New State Pension) and Class 3A – which bought old Additional State Pension (until 5 April 2017). These bought different things and it is entirely dependent on your contribution record whether you needed to buy Class 3 or Class 3A or both.
Secondly, and most importantly, Class 3 NICs for years after 6 April 2016 contribute to the NSP, increasing the rate by 1/35th. If you made Class 3 NICs for years before 6 April 2016 these could count towards your old BSP and not towards the NSP, and could therefore be pointless.
Problem 2: You can’t be worse off in the new system than you were under the old system
In a way this is a nice problem to have, but it means that to calculate your entitlement you need to calculate a hypothetical entitlement under the old system. I’m not being facetious here but: THIS CALCULATION IS INCREDIBLY COMPLICATED.
For those under State Pension Age at 6 April 2016, you first calculate what’s called the Starting Amount, a hypothetical based pension which is the higher of:
- What you would get under the old State Pension (BSP plus ASP); and
- What you would get if the NSP existed from when you started work (age 16).
If this amount is lower than the full NSP you can contribute Class 3 NICs from between 6 April 2016 and SPA to get the full NSP. Voluntary contributions for years pre April 2016 may or may not increase your pension depending on whether the Starting Amount is based on the Old System (1) or the New System (2). If your Starting Amount is based on the Old System and you have 30 NIC years then contributions for years before 6 April 2016 will not increase your pension.
If the amount is higher than the NSP then the difference between this figure and the NSP is called the Protected Payment. The Protected Payment is paid on top of the NSP, it increases by CPI every year and most importantly any further NIC years post 6 April 2016 will not add any more to your State Pension.
If you’ve followed all that, then you’re doing better than the first time I read about all this!
Why things have gone wrong
With all the background out of the way, we can look more carefully at what’s gone wrong. It’s generally a combination of two things:
- The calculations are very difficult; and
- The Government (DWP) have done a terrible job at communicating what the changes mean for you.
Maybe (a) or (b) on their own would be manageable, but together its caused huge problems for a lot of people. Let’s look at some common questions.
“I was contracted out for most of my working life, I’ve now lost my pension!”
Nobody has “lost their pension”. How to think of this is to imagine two big jars. One labelled private pension, one state pension. If you were not contracted out when you earned money you filled up the private pension jar through your occupational scheme and you filled up the state pension jar via NICs. If you contracted out, you didn’t pay some of the NICs that you would have put into the state pension jar and but instead your employer would give you the value of that extra state pension “you were giving up” when it came to taking your private pension (i.e. by topping your pension up). By contracting out you traded some, or all, of the state pension for a more generous private pension.
“Nobody told me this at the time!”
The contracting out decision was usually done at the workplace, not individual level. That’s because if there were mix-and-match of people with different contributions it would have been a ballache for HR to calculate. So usually all employees at a company contracted out or they all didn’t. As Sir Steve Webb (ex-Pension Minister) says: “you were probably not aware of this at the time – the National Insurance figure was simply deducted at the reduced rate from your paypacket without you realising that it was a lower rate.”
“I made voluntary class 3 contributions and it didn’t increase the state pension I’m due to get”
This can happen for two reasons, both reflect poorly on DWP/HMRC.
The first reason is that you would have made contributions for years before 6 April 2016 and your Starting Amount is based on the Old System. As I mentioned above, if your Starting Amount is based on the Old System, contributions for years before 6 April 2016 may not increase your pension. By topping up for years before 6 April 2016 you may have been topping up an already “maxed out” old Basic State Pension.
Being frank, I think the Government should take a big bit of blame on this (as well as elements of the financial press exhorting people to make Class 3 contributions). They heavily warned people that they might need to make voluntary contributions but they made it less clear on the very important “what years count” rule. This should have been in huge flashing lights for people to make it very clear what contributions earn what entitlements. For most people, the distinction of what year means what isn’t very clear and is arbitrary.
The second reason is that your Starting Amount is higher than the New State Pension. That is, you would have been better off under the old system than the new one so in effect you get paid an amount as if you were on the old system. Making class 3 contributions is therefore irrelevant.
The Government can maybe take a little less bashing on this. But the reason people get confused on this is because it is a very confusing calculation. To do the calculation you need to work out your entitlement to the BSP and ASP and this in turn may require you to calculate your accruals under SERPS. You then also need to calculate the much simpler entitlement under the NSP. So, it’s all well and good bringing in a new, simpler system but the reality is, it’s not simpler for most people, in fact it’s a lot more complicated.
This is not to mentioned other issue, Pension Credits, which may secretly kick in which would top-up your income to a level near-commensurate with NSP and make voluntary contributions not cost-effective.
What you can do about it
If you are reading this and thinking about your pensions entitlement and whether you need to make voluntary contributions then you can get what’s called a State Pension Statement from the Government. You can do so from the following website: https://www.gov.uk/check-state-pension. Alternatively, you can complete what’s called a BR19 form and post it off. You can download the form from this website: https://www.gov.uk/government/publications/application-for-a-state-pension-statement
The statement will give you a headline figure: for a lot of people this will be £164.35 (for 2018/19). This is the full New State Pension. If your figure is more than £164.35 then that means you accrued a higher entitlement under the old system, so you’re state pension is based on that (see about the Starting Amount above). If your figure is less than £164.35 then that means you have yet to earn enough NI years to get the full NSP. This means you need to make further NICs to get the 35 years required for the full NSP. You can do this in a few ways:
If your starting amount is based on the Old State Pension:
- If you have more than 30 NIC years then you can’t top up your pension using pre April 2016 contributions. But you can make post April 2016 contributions. Either through working, voluntary Class 3 contributions, or self-employed Class 2 contributions.
- If you have less than 30 NIC years then you can top up your pension using pre April 2016 contributions to a maximum of 30 years (thereafter extra pre April 2016 contributions will not add to your pension). If at this point your starting amount is still less than £164.35 you can make post April 2016 contributions to increase your pension.
If your starting amount is based on the New State Pension:
- You can work for the additional years required, making Class 1 or Class 2 contributions.
- You can make voluntary Class 3 NICs for any incomplete contribution years over the past six years by paying for the relevant missing months.
- If you have lots of years left until SPA, it might not be worth making voluntary contributions for gaps, as you might get the required number of NIC years through future contributions.
If your statement shows an amount less than you were expecting, or don’t understand it, then you can call the Future Pension Centre on 0345 3000 168. They will be able to explain how the figures are calculated and send these calculations to you in writing. They can’t give you financial advice however, so don’t expect them to advise you whether to pay any voluntary NICs. From what I’ve read online, the vast majority of people find them very helpful to contact.
Some closing thoughts
If you’ve got this far, thank you for reading. I appreciate this is a potentially very dry and dull topic. Whilst there has been lots written on the subject, I have struggled to find resources that pulls it all together and aren’t 30 pages long! The best resource I have found is a presentation by Royal London from 2017 (link) and on the related website (note: it’s set out for “advisers only” so use at your own risk).
Below is a diagram from the presentation that pretty much puts into pictures what I’ve set out above. Even in diagrammatic-form it’s still quite a chore (note 2016/17 figures are used in the diagram).
Some further helpful resources:
Whilst I think the intention behind the move to a single-tier pension is noble, it has been poorly executed. HMRC and DWP do not have stellar reputations in being open, transparent and good communicators. Expecting them to communicate such wholesale and complicated changes was never going to be without hiccups. Another issue was trying to do too much in one go; fiddling around with NI years, contracting out changes and the extensive linking to the old State Pension. In addition, there’s stuff I haven’t even talked about, such as changes to the state pension age and bereavement allowances. In that sense it feels like the main purpose of the change, simplification has been lost in trying to achieve other (political?) motives.
Please feel free to share your thoughts. Whilst I’ve tried to ensure I’ve got everything correct, there’s a possibility (probability?) I may have made mistakes or typos in places. As always, conduct your own due diligence and if in doubt speak to an expert.
All the best,
Young FI Guy