Key dos and don'ts when saving for retirement

Published by Ceri Jones on 14 June 2011.
Last updated on 22 June 2011

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The UK's pensions system is creaking. As life expectancy increases beyond even the most optimistic predictions a decade ago, the scale and generosity of pensions are being eroded on all sides.

It may be heresy to say this, but history will judge that many current pensioners, namely those in receipt of final salary scheme benefits, are in fact extraordinarily lucky. The next generation will be less fortunate.

Some women in their mid-to-late fifties will feel particularly hard done by, as the government has decided to raise the state pension age to 66 by 2020, a move which particularly hits women born between 6 April 1953 and 5 April 1960.

This is the second time the state pension age has increased for this group of women, having been told a few years ago that their pension age would increase from 60 to 63 or 64.

Half a million women will be forced to wait longer before receiving their state pension under the new timetable, and for some women this will amount to losing £10,000 of payments.

Read: The winners and losers in the UK pension reforms

Changes

In March, the House of Lords narrowly failed to push through an amendment limiting any increase in women's state pension age to a maximum of just one extra year beyond the already accepted increases of three, four or five years.

Despite support from cross bench peers, the amendment was defeated by just 226 votes to 214, although it would still have saved the Treasury around £20 billion. The Bill will now go back to the Commons for its final reading before becoming law, expected in July.

The issue has since gained plenty of publicity, however, and the proposal could yet be voted down. Saga, for instance, has received more than 15,000 letters and emails. Critics argue that the government has reneged on its explicit coalition agreement promise not to start increasing the pension age for women before 2020.

This age group of women had little chance to build up private pensions because in the 1970s women working part-time were banned from company pensions for decades.

Ros Altmann, director-general of Saga, also argues it is particularly unfair because 35 to 40% of the cohort affected are single, and 40% have no private pension.

Read Ros Altmann's piece: Women hit hardest by state pension changes

Public sector workers to pay more for pensions

At the same time, the government is working up plans to make public sector workers pay increased contributions into their pensions - by an average of 3.2% and rising to as much as 13% for those on salaries between £42,000 and £75,000.

This is being opposed by unions and other parties, such as the Local Government Association, which says that increasing contributions by so much will lead to large numbers of their members leaving pension schemes altogether, undermining their existence.

Separately, George Osborne announced in the March Budget that the government will largely adopt the recommendations of Lord Hutton's independent commission into public sector pensions, and has said the government will set out further proposals in the autumn.

These are likely to include switching from final salary to career average provision before the end of this parliament, so that the benefits public sector workers receive in retirement are linked to the average salary they achieve throughout their working life, instead of being linked to the high point just before retirement.

This will have most impact on the big earners in sectors such as the civil service where top management earn proportionately more than their colleagues.

Since the salary figures used in the calculation will be revalued in line with inflation, the measure will have much less impact on those working within an environment where there is a flattish salary structure, such as nursing.

Other key recommendations include linking the normal pension age in most public sector schemes to the state pension age. The pension age for uniformed services employees - the armed forces, police and firefighters - will be 60. Any accrued rights will be protected, meaning the final salary link for past service for current members will be maintained.

However, final salary pensions for MPs have so far escaped the net. Politicians can build up a £24,000 annual pension in just 15 years, based on their £65,738 salary - something that the man in the street would have to save £700,000 in order to fund.

The new Nest scheme

Whatever way you look at it, the onus is increasingly on the individual to put aside savings for retirement.

The government's biggest initiative to breach the savings gap is its National Employment Savings Trust (NEST) scheme, which is being rolled out next year.

Every employer will be obliged to have a pension scheme in place - either NEST or a comparable arrangement - and all employees from age 22 will automatically join their employer's scheme unless they actively opt out. This opt-out must then be renewed every three years.

What is attractive about this scheme is that while individuals will contribute 4% of their pay, the government will pay 1% via a tax rebate, and the company will pay 3% - so for many people this will be the first time they receive pension contributions from their employer.

The scheme is being introduced gradually, however, so unfortunately not all employees will offer entry to the scheme immediately, and it won't be until 2016 that all employers will be in the system.

There is a sliding scale regarding minimum contribution levels for both the employer and the employee, which depends on the date you auto-enrol and is phased over a period of up to three years.

The initial contributions start at 2% (of which half is paid by the employer) with the final minimum level of contributions currently 8% (of which 3% is paid by the employer), and contributions from both the employer and the employee are based on the employee's qualifying earnings - currently defined as earnings between £5,035 and £33,540 a year.

The employer will deduct their workers' contributions from their net pay and send these contributions to Nest Corporation, which will then claim basic-rate tax relief on the member's contribution on his or her behalf.

Kinks in the system

One weakness of the NEST scheme is that, despite the government's posturing that the charges on the scheme are competitive compared with other pension products, at 1.8% on every new contribution, this is simply not true - it will actually be rather expensive in the early years until the cost of establishing the scheme is paid down.

If you are thinking of setting up a pension plan and your employer currently does not have one, you will do well to wait to see what it decides to offer. There will certainly be hot competition for this business.

For example, ATP, the Danish national pension scheme provider, has announced it will enter the UK market and undercut the NEST scheme. ATP says it can keep administration costs below £5 per head per year, while NEST has calculated its costs at £15 per head per year.

Another problem with auto-enrolment is that thousands of people will build up pensions savings that are too small to be cost-efficiently converted into an annuity on retirement.

An employee on an average salary of £25,000, with a combined employer/member contribution of 8%, will accumulate a pension pot of £17,432 after seven years, assuming investment growth of 7% a year, charges of 1% a year and annual salary growth of 1%.

But these assumptions are fairly generous - the period required to accumulate £18,000 quickly rises to 19 years if the figures are based on minimum NEST contributions until 2017, as in the first few years of NEST's operation employers will be allowed to contribute reduced amounts.

The figure of £18,000 is a particularly significant one. As small amounts are difficult to convert into annuities, a special concession in the legislation, called trivial commutation, currently allows any pension worth £18,000 or less to be taken as a cash lump sum, of which 25% can be taken tax-free.

Experts predict that under the new scheme tens of thousands of members coming up to retirement will be eligible to take their pots as a cash lump sum in this way, and in most cases this will be the right thing to do as annuity rates are getting worse.

However, this will do nothing to further the government's aim of helping the public save for their future and be self-sufficient in retirement. Neither will NEST do much for people who move jobs frequently because transferring pension pots is cumbersome and expensive, and this work is often shunned by advisers.

The government has therefore established a cross-departmental working group to improve transfers of small pension pots ahead of automatic enrolment in 2012. NEST itself is unlikely to be able to take transfers in until 2017.

NEST and the means-testing trap

NETS's major flaw is how it dovetails with the UK's current means-testing system. As the current benefits system stands, introducing NEST would mean thousands of the less well-off could end up saving money they can ill afford, only to find their pension savings have achieved nothing more than to lift them off means-tested benefits.

To address this, and other flaws in the system, the government mooted in its March Budget the introduction of a flat-rate pension scheme of £140, index-linked, which will eventually allow it to dismantle means-testing. These reforms would also see the end of pension top-ups, as well as Pension Credit.

Until that happens, contributions to NEST will still be trapped in the current system. At present, Pension Credit kicks in if your total retirement income, including the state pension, falls below a certain level, currently £137.35 a week and £209.70 if you have a partner.

These amounts can rise if you are disabled, have caring responsibilities, or housing costs - such as mortgage interest payments.

However, you will lose a portion of Pension Credit if you have certain income or savings.

Currently, for each £1 of weekly income you have above £103.15 and below £137.35, the Savings Credit pays you 60p, but you lose £1 of guarantee credit. It's a fiendishly complicated system, and not surprisingly, 40% of people who qualify for Pension Credit fail to take it up, another fine reason for its abolition.

Consequently, those approaching retirement in the next few years without any savings should probably leave NEST well alone, while young workers thinking about setting up a pension should wait to see the details of their employer's new scheme.

Once the introduction of a single flat state pension is confirmed, it may benefit the lower paid to save with NEST as they will receive employer's contributions and tax breaks for investing in it, and they will effectively get to keep the money they have saved.

More help

■ Know your state pension benefits: obtain a forecast.

■ Pension Credit line: 0800 99 1234

■ The Pension Service has a calculator on its website into which you can input your financial details to get a Pension Credit and Savings Credit estimate.

■ Updates on legislation and advice on state pension entitlements: www.pensionsadvisoryservice.org.uk; 0845 601 2923.

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