Are voluntary national insurance contributions for you?

The UK Government introduced a new state pension for people reaching state pension age from 6 April 2016. But its attempts to “improve people’s understanding of their state pension have had limited success so far” according to a recent report from the National Audit Office.

That could well be because the Government’s own impact assessment showed millions of winners and millions of losers from the new system.

Unfortunately, the accompanying press release focused on the former and ignored the latter!

One of the biggest misconceptions about the new system is that everyone will be entitled to receive a new state pension at the full rate – £155.65pw for 2016/17.

In fact hundreds of thousands of people who were members of generous occupational pension schemes and who will reach state pension age over the next few years will get less than this.

This category includes many thousands of Prospect members who contributed to public sector pension schemes (eg the civil service pension scheme, research council pension schemes, local government pension schemes etc.), nuclear industry pension schemes (ie the UKAEA’s schemes and / or the defined benefit section of the CNPP), final salary sections of different groups of the Electricity Supply Pension Scheme (and its equivalents in Scotland and Northern Ireland), final salary sections of the British Telecom Pension Scheme and basically any other generous defined benefit pension scheme in the public or private sector that was “contracted out” of what was called SERPS or, later on, the State Second Pension.

So a large majority of Prospect members reaching State Pension Age over the next few years will receive less than the advertised full rate of the new state pension – £155.65pw (2016-17).

However this is not as bad as it seems for two reasons: (1) this group will get no less than they would have from the previous system and, in fact, the vast majority of them will benefit from the change to the new state pension and (2) there are mechanisms in place for many people in this group to boost the amount of new state pension they receive.

This blog is largely about how people in this category can boost their new state pension entitlement and whether doing so is a good idea.

It does not cover particularly new ground. Royal London recently produced a comprehensive guide to topping up the new state pension in general. Paul Lewis from BBC Radio 4’s Moneybox wrote an informative blog focused particularly on this group.

This blog explains why this affects so many Prospect members in particular and covers many of the questions they have been asking.

– Why do people who have contributed to “contracted out” pension schemes throughout their careers and who reach state pension age in the years after the new state pension comes in get less than the full rate?

When the new system came in, a “starting amount” was calculated for everyone as at April 2016. This is the greater of the amount they would have been entitled to under the old system and if the new system had applied throughout (but making an allowance for the fact that this group paid lower National Insurance contributions in the years they were “contracted out”). Due to being in contracted out pension schemes, people with enough National Insurance contributions (or credits) were generally entitled to a “starting amount” of the level of the full basic state pension (£119.30pw in 2016-17) only. Thirty years of National Insurance contributions (or credits – eg covering years where you were looking after young children) were sufficient for a full basic state pension.

– So everyone who contributed to a “contracted out” pension scheme will get less than the full rate of the new state pension?

No. The “starting amount” is just that – a starting amount. Every year of contributions (or credits) after the “starting amount” was calculated in April 2016 adds to the amount of new state pension this group is entitled to. Every additional year is worth 1/35th of the rate of the new state pension (because 35 qualifying years are required for the full rate of this pension). That’s approximately £4.45 per week for every additional year.

– So, if I have a lot of years to go before I reach state pension age after the new system came in, I will probably get the full rate of the new state pension?

Probably, yes! Someone who makes nine additional years of contributions (or more) after April 2016 probably builds up £40 per week (or more) in new state pension entitlement. This, on top of a “starting amount” of the full basic state pension of £119.30pw, will bring them to the level of the full new state pension (the full rate of the new state pension will be the maximum someone in this situation can be entitled to).

– What if I have fewer than nine years to go until state pension age after 6 April 2016?

If you were in a contracted out pension scheme throughout your career, your maximum level of new state pension will probably be less than the full amount.

– What if I have more than nine years to go before state pension age or I have less than nine years to go but I intend to retire before state pension age?

You must work or get credits to qualify for an additional £4.45 per week on top of your “starting amount”. If you retire before state pension age and are not in a position to qualify for credits, you could consider making voluntary contributions to increase your entitlement by £4.45 for the year in question.

– What are voluntary contributions? How much are they? How can I pay them?

Voluntary National Insurance contributions are called Class 3 contributions. They can be paid monthly or in a lump sum by direct debit, bank transfer or by cheque. The rate of Class 3 contributions is £14.10 per week (for 2016-17). You can find out more on HMRC’s website.

– Is it a good idea to make voluntary contributions?

If your circumstances mean that making voluntary contributions for a certain year would increase your new state pension entitlement then the relative price of the contributions and additional pension they purchase certainly appear attractive. It is important to note that contributions are paid out of taxed income and the new state pension is subject to income tax (so the final return may not be as attractive as it first appears). Whether voluntary contributions turn a “profit” in the end depends on how long people live. But someone with average life expectancy should see more in additional new state pension than they paid in voluntary contributions. The option to make voluntary contributions also has to be assessed in relation to other opportunities available and Prospect cannot provide financial advice on this.

– When should voluntary contributions be made?

Voluntary contributions can only be made for specific years. There is no need to make them in the year in question and they can be paid in arrears. As long as you make the contributions before you reach state pension age it can be worthwhile to wait a number of years before making them (eg put a slightly lower amount of money aside now and use that plus any returns on it to pay the voluntary contributions as a lump sum later).

Further information on the new state pension is available from Prospect’s website.

I expect there will be a lot of interest in voluntary contributions from Prospect members in the circumstances described above.

I hope most of the questions have been covered already, but please feel free to put any more in the comments section below and I will respond as soon as I can.