Here is an investment I promoted on my radio show recently. You pay £733 and in return you get a guaranteed annual income of £231 for life, index-linked by prices, earnings or 2.5 per cent, whichever is the highest.
Isabel wrote in: “I asked my financial adviser but he didn’t know anything about it”. I am not surprised. Nor do I blame the adviser. He was in the heady stratosphere (or perhaps the murky depths) of the new state pension. You know, the flat-rate pension that is paid at more than 20,000 different rates?
The pension that requires 35 years’ worth of National Insurance contributions to get the full amount but of which more than a million with at least 35 years’ contributions will not get the full amount? That one.
Yes, it is paradox time. Let me deal with that last one: you need 35 years’ worth of NICs to get the full flat-rate new state pension of £155.65, but even if you have paid that much you may get less than the full state pension. More than 1.7 million people reaching state pension age in the next 10 years – about one in three – will be affected.
These are people who have paid into a good workplace pension and were contracted out of Serps. To get the full amount of the new state pension – or at least approach it – they will now have to pay yet more NICs on top of whatever they contributed before 2016/17.
The biggest group affected worked in the public sector: nurses, teachers, civil servants, police and so on. Also caught are the millions who paid into one of the thousands of private sector final salary or defined benefit schemes.
“The pension that requires 35 years’ worth of National Insurance contributions to get the full amount but of which more than a million with at least 35 years’ contributions will not get the full amount? That one.”
There is another group affected by the paradox that many Money Marketing readers will recall. They were sold a personal pension and persuaded by an alliance of advisers and government incentives to contract out of Serps and pay lower NICs.
Sometimes they only paid into their personal pension the equivalent of the NICs saving they made – so-called rebate-only contracted-out pensions. They believed it was a good idea to replace an earnings-related, index-linked pension guaranteed for life by the government with a small defined contribution pension not earnings-related, not index-linked and not guaranteed by anyone.
That decision has come back to bite them, because they now face a hefty deduction from their state pension just for being contracted out. This deduction can be huge, even if they were only contracted out for a few years.
One listener, David, told me he had paid in for 47 years and was contracted out for 11. His contracted out deduction was about £32. Instead of £155.65 he was going to get £123. He asked, not unreasonably: “I paid in for 36 years without being contracted out, so surely that should entitle me to the full flat-rate pension?”
Sadly not. In this “looking glass” world step one gives him a full pension and step two deducts a large amount from it, leaving him with no more than the old state pension.
Many of those subject to a large contracted out deduction (called contracted out pension equivalent) could reduce or even eliminate it using a new and little known scheme. Every year of NICs they pay from 2016/17 onwards earns them extra pension at the rate of 1/35th of the £155.65 flat-rate amount: an extra £4.45 a week.
As the voluntary Class 3 contributions are just £14.10 a week, the payback time, even after tax on the pension, is just three or four years. Annually, the figures are £733 for a year’s Class 3 contributions and £231 a year added to the current state pension. That amount will rise each year with the triple lock, meaning an increase of 2.5 per cent or more guaranteed until at least 2020.
It is only NICs paid from 2016/17 that count in this way, so people reaching state pension age this tax year will not be helped by it, as they are too old to pay extra contributions. You can only pay them up to the tax year before you reach state pension age.
The scheme will help women born from 6 July 1953 and men born from 6 April 1952 who reach state pension age in 2017/18 or later. If they have a contracted out deduction, they will earn more pension even if they have already paid 35 years’ worth of contributions.
The more years left before they reach pension age, the more they can boost their pension. For example, men and women born 6 July 1954 to 5 April 1955 who will reach state pension age in 2020/21 can pay four years’ contributions and boost their pension by £17.80 a week at current rates.
Many people will not need to pay the extra contributions directly. Anyone who is working and earning over £112 a week in at least one job will get NICs through their earnings.
A parent entitled to child benefit for under-12s will get credits, as will anyone registered as unemployed or on other work-related benefits. Men born before 6 October 1953 may get “man credits” (don’t ask!) to cover one tax year. Carers may be able to get credits but some will have to ask for them.
If all that fails, then people can pay the £733 a year Class 3 voluntary contributions. Self-employed people with profits below £5,965 can pay voluntary Class 2 contributions for a mere £2.80 a week.
I hope Isabel’s financial adviser is reading this. It will probably be the best investment she can make.
Paul Lewis is a freelance journalist and presenter of BBC Radio 4’s ‘Money Box’ programme. You can follow him on Twitter @paullewismoney