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Can I rely on the State Pension?

24 Jun 2019, 9:01 a.m.   Team Rebo  


How do you plan to fund your retirement?

For many people in the UK, the answer to this question will include the State Pension. If you're one of these people, it might be a good idea to have a think about just how much faith you should put in the system and how much you should save privately just in case the State Pension doesn't live up to your expectations.

Note that this piece is not intended as a partisan political statement about whether or not the State Pension should exist/be changed. Rather it has been written to highlight some risks that you may have overlooked in your retirement planning.

What is it?

The State Pension is a benefit payment made to older people who have worked in the UK during their lifetime. It is a non-means-tested, contributory benefit payable to people when they reach the official retirement age. That is, everybody who has paid enough into the system via National Insurance (NI) contributions is theoretically entitled to receive State Pension payments when they are old enough.

How do I get it?

As a contributory benefit, in order to receive the State Pension you will need to make NI contributions. Most people are employees (i.e. they have a job with an employer) and so don't need to worry about doing this manually as NI contributions are deducted from employees' wages under the Pay As You Earn (PAYE) scheme.

If you're a business owner or self-employed, it's slightly more complicated and it might be worth having a chat with your accountant to make sure that you're doing all that you need to given your circumstances.

It's also worth noting that you can't choose not to receive a State Pension in order to avoid paying NI contributions. If you're earning money then paying NI contributions is usually mandatory.

How much and when?

Under current rules, a person reaching the official retirement age who has accrued 35 or more 'qualifying' years of NI contribution will receive the 'full' amount (£168.60 per week at the time of writing). If our retiree had accumulated fewer years of NI contributions, the pension received would be reduced pro-rata. For example, if you've only accrued half of the contributions, you'll only get half of the payments.

The official retirement age is not the same for everybody. The date on which you'll start to receive State Pension payments will depend upon your age and whether you are male or female. In recent years, the government has started to push back the State Pension age for future cohorts of pensioners as well as making the State Pension age equal for men and women.

The current plan is to push back the official retirement age to 68 by 2044. You might find it helpful to refer to the government's timetable for the changes to the official retirement age.

Funding

Money paid to State Pension recipients comes from National Insurance payments collected from current workers. That is, money deducted from the wages of people who are currently working is spent directly upon paying for the pensions of those who are now retired. In this way, the current working generation is always paying for the pension benefits of the previous generation.

Although there exists a National Insurance Fund (NIF) into which NI contributions are received and from which State Pension payments (amongst those for other benefits) are made, the government only maintains a very low balance on this account. Whenever a surplus exists in the NIF, it is lent to the government to fund other expenditures.

In summary, the UK State Pension is 'Pay As You Go'. Current pension expenditure always comes directly from current NI income. When you make NI contributions (which you don't have any choice about anyway!) you are not 'setting aside' money for your retirement. Instead you're swapping spendable money now for a government promise that you will receive State Pension payments at some point in the future.

Of course, to make this arrangement work, the future government must have the ability to collect statutory NI payments from the generation of people that will be working at the time.

The question is: will they be able to?

Demographics

As the State Pension payments made to a particular cohort of recipients are funded by the NI contributions of other, working age people, the ability of the government to perpetuate the system depends upon the ability to raise more NI than they have promised to pay out in pension contributions.

A particular problem introduced by this structure is the so-called dependency ratio. If the number of pensioners goes up or the number of NI payers goes down, the system may fall in to deficit. This situation could not possibly be maintained indefinitely as there simply would not be enough money to pay for the pension promises made by earlier governments.

Of course, there is significant political risk here. For example, there is a widespread belief that the current working generations (particularly the so-called 'Millenials') are significantly worse off than their parents' generations. Add to this the fact that the older generation were born mostly during the post-war 'baby boom' and so there are a lot of them! Modern medicine is successfully keeping older people alive, although often in poor health, for much longer than previous generations could have hoped for. So a person already receiving the State Pension today stands a very good chance of being around to collect it for many years to come. All the while, new pensioners are retiring, increasing the number of State Pensions which must be paid. In short, the population is ageing and the dependency ratio is rising.

Will the poorer younger generations continue to vote in governments who force them to pay for the pensions (and health care/social costs) of their much richer forebears even after they've had to pay 10x their annual salary for a house? It might not be sensible to treat this as a certainty. Although the generation currently in receipt of the State Pension have been promised by successive governments that they will be cared for 'from the cradle to the grave', they might find that the governments of the future are simply unable to deliver upon these promises.

You might find it interesting to have a look at some government projections of the possible impact of an ageing population upon public finances in the UK thoroughout the 21st century.

So what's the takeaway? Just because you've been promised a pension by the current government doesn't mean that the government of the day will be able to pay it.

Despite making NI contributions throughout your working life, you may not receive the pension you have been promised. Of course, it may not be the case that you receive no pension at all, rather that you might get less than you had anticipated and planned for. Alternatively, the government of the day may decide to push back the State Pension age even further than current plans have already projected, meaning you'll have to work for longer.

How far away for you?

But what should you do about it? Should you factor the State Pension into your retirement plan at all? Should you aim to put in place enough private provision that you don't need the State Pension even if it still exists in its current form when you reach the official retirement age?

Well, there's a good argument that your current age should determine how much weight you give to the government's promise to pay you a State Pension.

It's probably reasonable to assume that people who are close to State Pension age will experience the system roughly in it's current form. That is, if you've factored the State Pension into your retirement plans and you're due to retire soon, you're likely to get what the government is currently promising (hopefully for the rest of your life). After all, it would be politically difficult for any government to change the rules drastically and quickly without causing a revolution!

However, if you are significantly younger than the State Pension age, it may be worth considering that your expectation of receiving State Pension benefits similar to those paid to the current generation of recipients is based upon the ability of a future government to collect enough NI payments from the workers of the day and the sums might not add up! If the dependency ratio is too high or there are any other difficulties with collecting NI payments (e.g. automation leading to fewer workers) then you'll probably be glad of having some private provision in place.

Summary

  • The State Pension system is built around promises made by the government to make pension payments to you in the future if you pay NI contributions now.

  • It's not set in stone that a future government will be able to honour the promises that have been made due to changing demographics, economic and political risks.

  • If you are some years away from the official retirement age, it would be prudent to ensure that you have some private retirement provision to compensate for the possibility that you won't receive the State Pension payments you were expecting.

Please note that this is an opinion piece. It must not be considered to be financial advice. Please do your own research and, if necessary, consult a suitably-qualified financial adviser.


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