Married couples (and civil partnership)

Where a spouse does not have sufficient qualifying years for a full BSP in their own right they can apply, on reaching SPA, for a BSP based on their spouse’s National Insurance record. The spouse with insufficient National Insurance will obtain 60% of the contributing spouse’s BSP (if the contributing spouse has a reduced BSP then it is 60% of the reduced rate). Since 6 April 2010 it has no longer been a requirement that the contributing spouse has claimed their BSP; they must just be eligible to do so for the spouse with insufficient qualifying years to claim theirs (e.g. a wife reaching SPA at 62 can make a claim based on her husband’s National Insurance record provided that he has also reached SPA, regardless of whether he is claiming or has deferred claiming BSP). Where a married woman has some qualifying years in her own right she can use her husband’s National Insurance record to increase her own BSP by the lesser of:

• the shortfall between her reduced-rate BSP and the full-rate BSP, and
• the amount of BSP her spouse’s record will provide.

This also applies to married men and civil partners, but only where their wife/civil partner was born after 6 April 1950.

State pension age (SPA)

The state pension is not paid automatically at SPA, but must be claimed on or after reaching SPA. The SPA is currently 65 for men and is being raised gradually to 65 for women by December 2018. The SPA for both men and women will then be raised gradually until it is 66 by October 2020. At the time of writing (May 2014) it was announced that the SPA will be raised to 67 for men and women between 6 April 2026 and 2028. Figure 17.1 shows these changes graphically. If you have not reached SPA already you can check your SPA by visiting www.gov.uk/calculate-state-pension

It is interesting to note that in 1981 individuals received the state pension for 25% of their adult life but by 2000 this had increased to 30% and by 2010 it had risen to 33%. To keep the proportion of adult life in receipt of the state pension constant at the 2010 level (33%), the SPA would need to be 66.5 by 2030; at the 2000 level (30%) it would need to rise to 68 by 2030; and to get back to the 1981 level (25%) it would need to rise to 72 by 2030.¹ This suggests that the current intention to raise the SPA to 68 between 2044 and 2046 is highly likely to be brought forward.

Annual increases

For those living in the European Economic Area, the BSP is increased every year by whichever is the highest of:

• the growth in average earnings
• the growth in prices
• or 2.5%.

Figure 17.1 The changing state pension age

For those living elsewhere, the BSP remains level and so will lose its purchasing value over time.

Deferring state pension

It is possible to defer taking your state pension, in which case it will be increased by a factor of 0.20% for each week of deferral, equivalent to 10.4% a year (with no compounding, unfortunately). This factor was last reviewed in April 2005 when the banks’ base rate was 4.75%, a figure closely matched by the yield on short-dated gilts, meaning that the deferral offer was attractive but not a great deal.

Since 2006 there has also been the option to defer the state pension in return for a lump sum and this is calculated on the basis of accumulating the pension payments not made (subject to this being at least 12 months of continuous deferment) at a gross interest rate of bank base rate + 2% (i.e. 2.5% at present). The lump sum is fully taxable but taxed at your marginal rate, not simply added to your income. This treatment means that basic-rate taxpayers can avoid a possible one-year trip into the higher-rate income tax band when they draw their state pension lump sum. It also protects against the loss of age allowance.

There are several factors that you need to take into account when considering whether to defer taking your state pension. Before I explain these, consider what the government minister in charge of pensions had to say about state pension deferment choices:

‘The way in which the deferral increments are worked out means that there is an extra percentage on the pension when it is drawn, while the way in which the lump sum is worked out is different and, bizarrely, relates to the Bank of England base rate. There are times when, if an actuary were making such a decision, the person should choose increments and there are other times, depending on interest rates, when the person should choose the lump sum.’

Steve Webb MP²

Deferral for an increased pension

This option now looks very appealing, particularly for shorter terms where the lack of compounding is of less import. For example, using figures from the DWP’s guide, deferring a £100 per week state pension for a year currently provides either:

• a taxable lump sum of £5,270, or
• an increase in taxable pension of £10.40 per week (£540.80 a year), possibly with a corresponding increase to any dependant’s pension.

For a person aged 66, that extra pension (on a single life basis) would cost about £15,000³ to buy on the open market. It is worth noting, too, that for the basic state pension, a ‘triple lock’ now applies to increases, i.e. the greater of 2.5%, CPI and average earnings increases. In theory this should have prompted the DWP to worsen the deferral terms. For other state pensions, CPI sets the increase basis, which arguably would require an adjustment in the opposite direction. Deferment will not suit everyone and if you are single you need to be aware that if you die while deferring state pension, your estate can benefit from only a maximum of three months’ unpaid pension.

The increase rate for deferring the state pension will be reduced from April 2016 to about half the current rate, which is still not a bad deal. Using a similar calculation to the earlier example, the new increment basis implies an extra £5.20 a week for each year’s deferral of £100 a week state pension. That extra £5.20 a week for a single person aged 66 (i.e. 65 + 1 year’s deferral) would cost about £7,600⁴ to buy on the open annuity market, assuming RPI linking, against a year’s pension forgone of £5,200.

Deferral for a lump sum

When the lump sum option was introduced in 2006, the Government Actuary’s Department calculated that deferral would be of financial benefit to the Treasury, which rather gives the game away. Finding more than a 2.5% gross return for savings is possible via cash ISAs, so the logical thing to do would be to draw the pension and use it to feed an appropriate savings account. This has the added benefit of avoiding some of the problems that deferral can create, e.g. where a wife has entitlement both in her own right and via her husband’s contributions and gains nothing from deferral.

There are two obvious situations where lump sum deferral is preferable to the draw-and-save approach:

• For someone whose total income is over £27,000, removing entitlement to the full age allowance, deferring state pension can produce a useful tax saving that more than compensates for the modest interest rate. For example, if £5,000 is taken out of the total income figure by pension deferral, this could result in an increase of up to £2,500 in allowances and thus up to a £500 tax saving – effectively a 10% net return.
• For someone whose income will fall into a lower tax band at some point after state pension age, the marginal rate tax treatment described above will normally make lump sum deferral more attractive. It might be possible to achieve this band shifting temporarily via carefully timed income withdrawals.

The lump sum deferment option is due to be abolished in April 2016.

Inheriting SERPS/S2P

The surviving spouse of a contributor to SERPS/S2P can, on the contributor’s death, inherit a percentage of their SERPS/S2P entitlement. For SERPS the maximum percentage payable is dependent on the date the contributor reaches SPA – for a contributor reaching SPA after 6 October 2010 the maximum SERPS their surviving spouse can inherit is 50%. For S2P the maximum amount is 50%.

Defined benefit schemes

Where retirement benefits are provided by an occupational pension plan, whether a private- or public-sector type, and calculated on the basis of service, salary and an accrual rate, it is the pension scheme and, by association, the sponsoring employer that bear most of the risk and costs associated with providing the pension benefits. In this sense the overall benefits are predictable, but the future costs of providing them are not. For this reason most defined benefit schemes have closed to new members and many have closed to further benefit accrual for existing members as employers seek to minimise their future funding liabilities. Most public-sector schemes are not underpinned by financial assets to fund pension benefits and are therefore known as unfunded. Most private-sector schemes are supported by financial assets (to a greater or lesser extent) and are known as funded.

If your benefits have yet to be paid out, either because you are still working and accruing service or because you have left service before the normal retirement age, you need to check the financial position of the scheme and the commitment and financial capability of the sponsoring employer to continue to fund the scheme. Every three years the scheme trustees are required to provide an assessment of the scheme’s financial position and whether there are sufficient assets to secure all members’ pension benefits through an insurance company if the scheme were wound up at that time.

While this assessment can be seen as the worst-case scenario, it can often suggest that a scheme is underfunded when, on a going-concern basis, it is not. This is because securing pensions with insurance companies is very expensive. In addition, if the assessment has been carried out when investment markets have fallen sharply, this will overstate the underfunding, when in reality members take benefits at different times, thus providing the trustees with some flexibility to ride out short-term investment volatility.

If the pension scheme fails and is unable to pay out existing or future pension benefits, a government-sponsored scheme known as the Pension Protection Fund (PPF) will step in and provide benefits. If you have reached the scheme’s retirement age or are in receipt of an ill-health pension or where a survivor’s pension is in payment, the protected amount will be 100% of the pension in payment. Otherwise the protected amount will be 90% of the pension benefit, whether or not you have reached the scheme’s normal retirement age. The maximum protected pension payable is currently about £31,400 at age 65 but is lower for younger ages and higher for older ages.

Clearly, if you have a deferred defined benefit pension that is significantly in excess of £30,000 and/or the pension benefit represents a significant amount of the income that you expect to fund your lifetime spending, you need to be more concerned about the financial health of the scheme and possibly investigate whether it makes sense to transfer the cash value of your benefits to either your personal pension or your current employer’s pension scheme.

Other reasons why you might wish to transfer benefits, regardless of whether or not the scheme is in good financial health, include the following:

• You do not need the guarantees that the scheme provides and/or the benefits are insignificant in relation to your overall wealth and you are comfortable with taking on the investment and longevity (living too long) risks yourself.
• You envisage living abroad when you take benefits and wish to mitigate the currency risks by investing and eventually taking benefits in the currency of your new country of residence.
• You do not need some of the benefits that the scheme provides, such as spouse’s and dependants’ pensions, and would prefer to have a higher pension instead.
• You would like flexibility as to the level of benefits that you take from year to year, with the ability to vary these to suit your spending needs.
• You have little confidence in the scheme trustees and/or the employer to pay the expected benefits.
• You believe that you (or an investment manager) can obtain a better return on your share of the value of the pension fund than the scheme trustees.
• You wish to use your pension benefits to invest in a commercial property, possibly to be used by your business.
• You wish to access the capital value by way of regular or lump sum drawdown (see Chapter 18).

A defined benefit pension is potentially a very valuable benefit and can provide a good foundation to your wealth plan. However, if benefits have yet to come into payment, it will certainly be advisable to review regularly both how the scheme fits into your overall planning and the financial strength of the scheme and the sponsoring employer. Because assessing the merits of transferring a defined pension benefit can be complex, you will almost certainly need to consult an independent financial adviser who is qualified and authorised to give such advice. The fees for this type of advice can be quite high, particularly where the deferred benefits are significant, as this reflects the complexity of the work and additional risks to the advice firm.

Defined contribution schemes

In contrast to a defined benefit scheme, with a defined contribution (DC) scheme the contribution levels are known (if continuing), whereas the eventual benefits are not. The benefits that the scheme can provide will depend directly on the size of the fund (influenced by both contributions made and investment returns achieved) as well as mortality and long-term interest rates. Interest rates affect annuity rates, particularly at younger ages, which in turn will dictate the level of guaranteed income that can be secured with the fund or, alternatively until 6 April 2015, the maximum level of income that can be withdrawn directly from the fund. The member of a DC pension scheme, therefore, takes on all the investment and longevity risks themselves.

A registered pension scheme may invest up to 5% of its funds in the ordinary share capital of a sponsoring employer, up to four, as long as the total holdings in them are less than 20% of the fund value in total. The value is tested only at the time the investment is made and not subsequently. There is no restriction on how much of the sponsoring company’s shares may be owned by a pension plan and this could, in theory, be 100%.

There are two types of DC pension scheme: occupational and personal.

The lifetime limit

The total amount of benefit that you may accrue within all registered pension schemes is limited to an upper limit known as the lifetime allowance (LTA). There are several types of lifetime allowance:

1. Standard – £1.25 million (from 6 April 2014).
2. Individual protection 2014 – between £1.25 million and £1.5 million (must be applied for between 6 April 2014 and 5 April 2017).
3. Fixed protection 2014 – up to £1.5 million (from 6 April 2014).
4. Fixed protection 2012 – up to £1.8 million (from 6 April 2012).
5. Enhanced – no limit (if applied for between 6 April 2006 and 5 April 2009).
6. Primary – limit is the amount that the fund exceeded £1.5 million on 6 April 2006, increased by 20%.

For defined benefit pension schemes, benefits not in payment are multiplied by 20 to determine their value for LTA purposes. If your pension fund exceeds the available LTA when you take benefits, a tax charge will apply. This will be either 25% if you take the excess as an income, or 55% if you take the excess as a lump sum.

As a general rule it makes sense to avoid exceeding the LTA (although sometimes it is less of a problem) and therefore you need to monitor the effect of:

• any new proposed contributions
• the investment strategy and returns arising
• if and when to take benefits from the plan in the form of a tax-free lump sum and taxable income.

I’ll explain in more detail how best to manage your pension plan in the next chapter, but for now I just want to consider the lifetime allowance in the context of whether or not you make any new contributions. As illustrated in Table 17.5, if you have no existing pension provision, it is unlikely that you will exceed the lifetime allowance unless you contribute near to the annual allowance maximum and/or have a long time horizon before taking benefits and/or achieve quite high investment returns.

Table 17.5 Summary of growth required to reach standard lifetime allowance assuming no existing pension fund

*This is the effective income tax rate for those with taxable income of between £100,000 and £120,000 due to the loss of personal allowance (2014/15 tax year)

Figure 17.7 shows the annual investment return required to reach the lifetime allowance at different levels of existing pension benefits and terms assuming that ongoing contributions are made to a defined contribution scheme equal to the annual allowance of £40,000. Fund values in excess of about £600,000–700,000 with a term of more than five years need either low or negative returns to avoid breaching the lifetime allowance.

Figure 17.7 Annual growth required to fund £1.25 million lifetime allowance assuming £40,000 annual contributions with existing fund value