What pension will you get from the state?
We all hope that when we retire we'll have the time and opportunity to pursue our hobbies, go travelling or even start that best-selling novel we've always planned to write. But, the question is, will we be able to afford it?
According to research by Baring Asset Management, more than a third of Brits are counting on the state pension to fund their retirement. Unfortunately, what you get from the state will be much less than many people assume.
The government provides various forms of state pensions. The first, and most common one, is the basic state pension. At the moment, the full basic state pension is £97.65 a week for a single person, and £156.15 a week for a couple, unless both of them qualify for a full state pension.
In order to qualify for a full basic state pension you must have built up enough qualifying years. These are tax years in which you have earned enough income to pay national insurance. At the moment, women need 39 qualifying years to be eligible for the full state pension, while men need 44, but from April 2010 this will fall to 30 years for both sexes.
If you find you haven't built up enough years to qualify for a full state pension, you have the option of buying back the missing years. An amendment made to the Pensions Bill in October 2008 means you can now buy up to six additional years of contributions on top of your current allowance.
However, Laith Khalaf, a pensions expert at IFA Hargreaves Lansdown, warns that only a few people will be able to take advantage of this. "It applies to a limited number of people, as you'll only be able to do this if you hit state pension age by 2015," he explains.
"And I wouldn't recommend that people buy back years unless they're approaching retirement and know they will not get the full basic state pension."
If you're 20 years away from retirement, for example, there's little point in topping up this way because the number of qualifying years you will need is about to fall dramatically.
State second pension
The basic state pension is topped up to a minimum of £132.60 a week by either pension credit or the state second pension. Pension credit is means-tested, so if you have any savings you might not qualify. But most employed people will qualify for the state second pension.
Up to 2002, the state second pension was known as the state earnings-related pension scheme (SERPs). This was based on your record of NI contributions and your level of earnings as an employee.
While these principles still apply, in April 2002 SERPs was reformed to provide a more generous additional state pension for low and moderate earners, and extend access to certain carers and people suffering from long-term illness or disability.
The state second pension gives employees earning up to £31,800 (in 2009/10) a better pension than SERPs, whether or not you are contracted out into a private pension, with most help going to those on the lowest earnings - up to £13,900 in 2009/10.
"The state second pension could add several thousand pounds a year to your basic state pension," says Khalaf. "But if you've been self-employed all your life, you may not receive this extra income at all."
Pension credit kicks in if your total retirement income, including the state pension, falls below £132.60 a week. There are two aspects to pension credit.
The guarantee credit is available from age 60 and is meant to guarantee that everyone has a minimum level of income - currently £132.60 a week. However, you won't be eligible if you're deemed to have sufficient income or savings.
The savings credit, which you can claim from the age of 65, rewards you for any savings you've put aside yourself. For each £1 of weekly income you have above £98.40 and below £132.60, the savings credit pays you 60p. But you'll also be losing £1 of guarantee credit.
It's a fiendishly complicated system, but pensioners are expected to get to grips with it or run the risk of being labelled a 'benefit cheat' if they get it wrong. So it's not surprising that, according to Help the Aged, 40% of people who qualify for pension credit fail to take it up.
"While it's obviously necessary to protect those people who retire without a great deal of income, it would be preferable to have a simpler system," says Khalaf.
How much will you get?
When you come to tot up your state pension benefits, however, you'll find they won't amount to much. "The maximum you can get is set at around £13,000 a year, and this includes the state second pension and any state pension you might receive from a deceased spouse," says Khalaf.
"Very few people will reach that level, and are more likely to get the average of around £7,000 to £8,000."
So how can you find out exactly how much you can expect to receive when you retire? First of all, you can request a forecast by calling Directgov on 0845 300 0168 or you can download an application form at directgov.uk/pensions.
It's a simple process and gives you a starting block from which to work out how much you should be saving into your pension - you can do this by using online pension calculators. Hargreaves Lansdown has a good one at h-l.co.uk/pensions.
As a rule of thumb, you will need two-thirds of your salary to fund your retirement, assuming that your expenses fall when you retire. Many families will have finished paying off their mortgages by this point, which can reduce regular expenses by as much as 20% to 30%.
Plus, more generous tax relief for older people, such as increases in the personal allowance, and a decline in work-related expenses (such as the cost of commuting) may mean you can live comfortably on this sum.
How much you'll get will also depend on when you retire. The state pension age is currently 65 for men and 60 for women, but from April 2010, women's pensionable age will gradually increase, hitting 65 by 2020. This will apply to any woman born on or after 6 April 1950.
So, from 6 April 2020, both men and women will have to wait until they are 65 to claim the state pension. And from 2024, the state pension age will start to increase again, until it reaches 68 by 2046.
You can, however, decide to defer your pension if you wish, which could increase your weekly income.
The present government has said it is reviewing state pension, so the age structure may change in the near future. But whatever the potential changes, it is vital that you understand what you are entitled to so you can plan for your retirement.
One consideration is how your retirement income will be taxed. As your state pension is paid to you without tax deducted, you need to work out whether any tax is due - and ensure you pay it.
To find out whether you will need to pay tax, add up all your taxable income. This will include your state pension, any company pension and income from investments, but won't include pension credit or interest from an individual savings account.
If this exceeds your personal allowance, you'll need to pay tax. This is currently £9,490 for single people aged over 65 and £9,640 for those over 75.
Is it worth deferring your pension?
If you decide to work beyond the age of 60 or 65, or you don't need the money urgently, then you have the option of deferring your state pension. This allows you to build up extra income or a taxable lump-sum payment. It's worth considering if you can afford to postpone your retirement, as the benefits could be attractive.
For every five weeks you defer drawing your state pension after you reach state pension age, the government will increase your pension entitlement by 1%. This is equivalent to an annual return of 10.4%.
The downside is you lose the benefit of that income while putting off retirement. So to decide whether it's worth deferring you have to balance how long you plan to defer and how much income you'll lose against a higher level of income when you start to draw your state pension.
For example, if you were due to retire in April 2009 but chose to give up this year's state pension of £97.65 a week, then you would lose £5,077.80 of income over the year.
If you choose the lump sum, you must defer taking your state pension for at least a year. This option will pay you the pension you have missed out on, plus an interest rate of 2% above the Bank of England base rate.
The extra pension income is the better deal in terms of the return you get, unless interest rates are very high - at present base rate is just 0.5%. But it avoids the risk that you die before you have received all the income you deferred.
A scheme originally established in 1944 to provide protection against sickness and unemployment as well as helping fund the National Health Service (NHS) and state benefits. NI contributions are compulsory and based on a person’s earnings above a certain threshold. There are several classes of NI, but which one an individual pays depends on whether they are employed, self-employed, unemployed or an employer. Payment of Class 1 contributions by employees gives them entitlement to the basic state pension, the additional state pension, jobseeker’s allowance, employment and support allowance, maternity allowance and bereavement benefits. From April 2016, to qualify for the full state pension, individuals will need 35 years’ of NI contributions.
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Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.