Preparations for the single-tier pension (STP) go into their final phase this month as laws are put into place to create the new flat-rate benefit predicted to be worth about £152 a week in today's money.
But the new system, starting in April 2016, will lead us all into unexplored territory and some potential shocks and surprises. For instance, many people will find that, instead of getting this sum, they will receive about £25 less.
In fact, the Institute for Fiscal Studies (IFS) predicts that 69 per cent of new claimants in the first four years will receive less than the £152 figure.
The IFS calculations – contained in its paper "A single-tier pension: what does it really mean?" – suggest that 40 per cent of people reaching state-pension age between 2016 and 2020 will get under £135. About 60 per cent are on track to get less than £145.50.
"There is a risk that they have been misled into expecting the full amount when that's not the case," said Rowena Crawford, co-author of the IFS report.
The main reasons for a shortfall are that the person has not accumulated the minimum 35 years of National Insurance contributions generally needed to qualify for the full sum or that they have been "contracted out" most of their working life.
"Contracting out" happens when someone has their own, extra pension – either a personal pension or a collective scheme run through their employer. In a large proportion of these cases the person will suffer no immediate disadvantage when their pension income is totted up as a whole. In fact, Laith Khalaf of the Hargreaves Lansdown pensions research team, says that people who were contracted out are "among the winners" in the switch to the new system.
Contracting out means they were opted out of contributing to the state second-tier pension, were given incentives to do so (in the form of National Insurance rebates) and were invested instead in a private pension scheme. And that private pension should yield a bigger pension income than what they could have expected from the state second pension.
Over the next two years the Government and the pension providers will begin explaining some of these issues in far more detail than they have done until now. But the complexity of pensions may mean that many people do not know what will happen to their pension in future. For instance, many people who were contracted out could find that they get no increases on a part of their private pension (the portion known as the GMP, or guaranteed minimum pension). This is because the Government promised to pay some of the annual increases due on the contracted-out part of a pension – but this promise is being swept away for people retiring under the new system. A big problem here is that most people have not been warned that they will not get the increases.
Another side-effect of the new system will be that "final salary" (or other so-called "defined benefit") employer pension schemes will be under pressure either to reduce benefits to employees or ask them to pay another 3 per cent of their salary as pension contributions. These are the main options facing these employers, according to actuary Mercer. Most of them have chosen to accept government incentives (3.4 per cent National Insurance rebates) to contract out. However, when this system ends in April 2016 such pension schemes will find the costs increasing by "around 10 per cent to 15 per cent", according to Mercer. Public-sector schemes are expected to absorb this extra cost themselves, but private-sector schemes will struggle.
Some employees "will see a cut in their take-home pay," warns Chris Thompson, a pensioner who used to work in the financial-services sector and who has become one of the country's leading experts on state pensions.
This is because people who are currently contracted out get a 1.4 per cent National Insurance rebate from the Government in order to incentivise them to stay out of the state second-pension scheme. When this ends in April 2016 that 1.4 per cent rebate will also end.
Unless their income rises or other tax deductions fall, those employees will see their net earnings decline. Individuals who are concerned about their position can start by finding out how much of a pension they are likely to get. (See links below.) People who reach state retirement age sometime after April 2016 will be able to increase their entitlement by continuing to build up National Insurance contributions – either by working or getting NI credits through, for example, claiming Jobseeker's Allowance.
Although the new system has been widely welcomed by experts, those same experts can point to dangers and pitfalls.
"Most people with a steady work history will do less well under the single-tier pension," says Mercer actuary Deborah Cooper.
IFS calculations suggest that someone who is 28 today could end up with a STP which is 11 per cent lower than a similar pension would be under the current system (see case study).
The lowering of the state-pension safety net in this way will propel people to make their own pension investments through the financial markets, leading Ms Cooper to conclude that this "potentially result in some very poor outcomes".
In a similar vein, Robin Ellison, head of strategic development for pensions at solicitor Pinsent Masons, is concerned about some aspects of the current package of pension reforms. While he greatly welcomes the STP, he is worried that other proposals – to abandon the requirement to buy an annuity – will backfire.
"There will be some horror stories in the press in five or 10 years' time about people not buying annuities."
Individuals are likely to become much more knowledgeable about pensions after both reforms – the STP and the end of annuities – are introduced, says Mr Khalaf.
He believes far more people in so-called "defined contribution" pension schemes will start taking an interest in how their funds are invested.
Under these schemes – the increasingly widespread alternative to defined-benefit pensions – people have some latitude on how their funds are invested. At the moment, some 90 per cent are in the default option proposed by the employer, says Mr Khalaf. He expects that to drop sharply. Employees are "hugely" receptive to the pension education schemes which more employers are starting to put on.
Most experts think the new proposals will be given time to bed down, without further changes, after they are introduced over the next two years. But there are some signs that the next set of changes could come sooner and be more dramatic than has generally been expected.
"Indexation of the STP and extending the state-retirement age are the biggest parameters open to change," says Rowena Crawford of the IFS.
What she means is that the main levers that the Government can use to cut state-pension costs will be the age at which it is received and the rate at which it is increased each year.
Robin Ellison, a former chair of the National Association of Pension Funds, makes another suggestion.
"The [Inland] Revenue is thinking really, really hard about whether they want to get rid of tax relief on pensions."
This would tie in with a move which Chancellor George Osborne made in the Budget in March when he extended the Isa (Individual Savings Allowance) by 26 per cent to £15,000. This surprisingly generous measure took most experts by surprise.
Mr Ellison, however, can see an explanation for the move – viewing it as a possible prelude to a far-simpler system where pension relief is abandoned and we all use Isas for our overall savings, including pensions.
Case study: Most will get less
The IFS gives an example of someone who is now 28 and whose entitlements would be markedly affected for the worse by the change. Let's call him John. He earns £111 a week, equal to £5,772 a year. If he built up 35 years of National Insurance contributions, John would be on course for state-pension income of £8,618 a year when he reaches retirement age. Under the new system, his state-pension would be 11 per cent less – £7,629.
"In the long run, the effect of the proposed reforms will be to reduce state-pension income for most people," comments the IFS. "Exactly how current younger people will respond to this policy remains to be seen. The lower state-pension income increases the need to save privately, and the reduced complexity may also make it easier for people to engage with decisions about their retirement saving and may help them to make more-appropriate decisions."
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