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A step in the right direction

A step in the right direction

Category: Annuities

Updated: 27/10/2011
First Published: 27/06/2006

This article was correct at the time of publication. It is now over 6 months old so the content may be out of date.

Finally, after three reports from Lord Turner's Pension Commission, countless newspaper column inches and immeasurable amounts of discussion, Work and Pensions Secretary John Hutton has delivered the Government's White Paper for pension reform. Echoing the search for the Holy Grail in The Da Vinci Code, the journey has been long and arduous and nobody really knows whether the answers that have been provided will prove to be correct or not.

The White Paper aims to update the state pension system that, by the Government's own admission, is rooted in the society of the 1940s. With people living longer than ever before, reform has become a necessity. Another priority was the need to make the system fairer to women who take time out of their working life to raise families and care for elderly relatives, and it is probably true to say they will be most affected by the proposals, both positively and negatively.

Longer working life

Prior to the White Paper, the state retirement age for women was already being increased from 60 to 65 by 2020 in order to equalise it with the state retirement age for men. The reforms will now see a subsequent rise for both men and women to 66 by 2024, 67 by 2034 and 68 by 2044, with each rise being phased in over two years. Anyone aged under 47 now faces a longer working life, while women aged 27 or younger will have seen their prospective retirement age rise by eight years taking into account the equalisation legislation.

Ultimately, the change in the state retirement age is necessary to help meet the cost of implementing further reforms that the White Paper proposes. The number of years of contributions required to qualify for the basic state pension (BSP) is to be reduced from 39 for women and from 44 for men to 30 years for both, in an attempt to ensure that women and others with a non-continuous work record will be more likely to attain the full entitlement. When combined with the extended working life, the Government expects this change to mean that, in 2010, 70% of women will be eligible for a full BSP (compared with 30% now), and by 2025, over 90% of men and women will be entitled to the whole benefit. Carers will be able to build up an entitlement to a state pension without having to make a minimum level of national insurance contributions.

The largest cost of reform is likely to be due to the restoration of the link between the BSP and earnings. With the state pension being linked to salaries rather than prices, the pension will become more generous and annual rises in the pension will be larger. The White Paper estimates that, by 2050, the BSP could be worth twice as much than if it had been linked to prices. The high cost to the Treasury of carrying this proposal is endorsed by the condition that this will take place in 2012, "subject to affordability and the fiscal position".

At the same time as the link between pensions and earnings is re-established, the State Second Pension (S2P) will gradually start to become a flat rate system, with the process expected to be complete by 2030. The option to contract out of S2P will also be abolished for members of defined contribution pension schemes in an attempt to simplify the system further. Contracting out to defined benefits schemes will remain to prevent further exacerbation of funding problems. In a similar vein, the Financial Assistance Scheme will be extended to ensure that people within 15 years of their schemes normal pension age on 14 May 2004 will qualify for help if the scheme collapses (extended from three years).

Personal accounts

The final major strand of reform is the introduction of a new system of low cost personal accounts to encourage people to save for their own retirement, similar to the National Pensions Savings Scheme (NPSS) proposed by the Pensions Commission. From 2012, employees will be automatically enrolled into the scheme by their employer unless there is a more generous occupational pension scheme which already offers automatic enrolment. Employees will contribute 4% of a band of earnings between approximately £5,000 a year and £33,000 a year, with employers making a minimum contribution of 3% on the same band of earnings, and a further 1% coming in the form of tax relief. Employees will be able to opt out of the scheme, in which case employers do not have to contribute, but it is hoped that up to 10 million people will utilise the account and benefit from pension funds worth up to around 25% more because of lower charges. Those without a job and the self employed will also be able to opt into the scheme.

Key members and associations of the financial services industry have already presented their opinions on the running and management of such a scheme, but further analysis and consultation will take place before the make up of the final model is decided upon. It is hoped increased cost burdens on companies will be kept to a minimum by phasing the compulsory employer contributions in over three years, and possibly over a longer period for the smallest companies. The importance and effectiveness of this proposal cannot be overstated, as a survey by the Association of Consulting Actuaries found that a quarter of small firms intend to revise their existing benefits downwards or close their scheme and rely on the Government proposition in order to manage increased costs.

Time will tell

Lord Turner has declared that the White Paper carries forward 90-95% of his proposals, but whether this will prove to be enough to avert the pension crisis, only time will tell. One recommendation that has been overlooked is that the state system become "as non-means tested as possible" in order to avoid disincentivising people from making their own private pension saving. Jeremy Ward, Head of Pensions Marketing at Friends Provident, believes that automatic enrolment into either existing employer pensions or the new personal accounts will increase the uptake of pension savings, but because means testing has not been fully tackled, there is a significant risk that it will not be in the interests of all employees to enrol in these schemes.

Concerns have also been expressed that not enough has been done to help the pensioners of today, and with many of the reforms not coming into effect until 2012 at the earliest, it is important that people do not view the reforms as an immediate and perfect solution. Ian Naismith, Head of Pensions Market Development at Scottish Widows, concludes: "What is important for all private investors is that they don't fall into the trap of believing that an improved State Pension and a national savings scheme such as the NPSS will be enough for a comfortable retirement. The only way to secure a comfortable retirement is to take matters into your own hands and start saving for yourself today, not tomorrow."

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