FOOL'S EYE VIEW
How The State Pension Works

By James Carlisle
October 7, 2002

Most people have an inkling that that the State coughs up about £75 per week to pensioners, but if you're making plans for your evenutal retirement, you need to understand things in a little bit more detail than that. The trouble is that the detail is a complete mess after years of legislative mucking about. Not only that, but there's bound to be plenty more mucking to come, if only because the current regime will eventually become too expensive for the State to manage. The best you can do, though, is to start with an understanding of how the current system works.

In essence, what people think of as 'the state pension' is made up of three separate elements: the Basic State Pension (the 'BSP'), the State Second Pension ('S2P' to those in the know) and the Minimum Income Guarantee (the 'MIG'). We can look at these in order.

The Basic State Pension

Contrary to popular opinion, not everybody qualifies for the full Basic State Pension. In fact, the Government revealed earlier this year, that only 92% of men get the full BSP, while that figure reduces to just 49% for women. Overall, there are 11.1 million state pensions being paid at the moment (split roughly one third men and two thirds women) and the average payment is only £60.11 per week against the full rate of £75.50.

The problem is that your entitlement to the BSP builds up from the national insurance contributions you make during your working life. The way it builds up is through 'qualifying years', which happen if you pay (or are deemed to pay) national insurance in a given year. That means earning above £3,900 for 2002/3.

Roughly speaking, the more qualifying years you have, the more basic state pension you stand to get. To get the full whack, a man will generally need to have 44 qualifying years, while a woman will need 39 (rising to 44 as the retirement age moves from 60 to 65 for women by 2020). If you have less than a quarter of this, 11 qualifying years for a man and 10 qualifying years for a woman, then you'll most likely get no basic state pension at all.

You may, however, 'score' qualifying years, even though you don't have any earnings, if you receive certain benefits -- like the Jobseeker's Allowance or Incapacity Benefit -- or if you are looking after a child and receiving child benefit or caring for someone with long-term illness or disability (this is called Home Responsibilities Protection). It is also possible to make retrospective contributions for up to the past six years. However, you have to balance the cost of the payment with the addition it will make to any pension you stand to get. If, for example, you still won't get past the 11-year threshold, then there's no point.

In the past, it has also been possible for married women to pay a lower rate of national insurance in exchange for passing up their qualifying years (and thereby falling back on their husband's pension entitlement). Unfortunately, it seems that many women were not made aware that the lower NI payments would mean no personal state pension and there are growing calls for some form of compensation.

Anyway, assuming that you've built up enough credit with your national insurance contributions, you'll qualify to get the maximum (currently £75.50 per week) when you reach 65 if you're a man, or 60 if you're a woman. Couples stand to get £120.70, unless they qualify for more with two single pensions in which case they get those. There's a string of more complicated provisions that affect, for example, widows, widowers and divorcees.

The State Second Pension

The 'additional state pension' is currently in a state of some confusion as we move over from what used to be known as SEPRS (short for 'State Earnings Related Pension Scheme') to the new State Second Pension. Phase one of this process took place in April 2002 and phase two is pencilled in for 2006/7.

The State Second Pension does, however, operate in a very similar way to the previous regime under SERPS, in that the more you earn, up to a limit (£30,420 in 2002/3), and the more national insurance you therefore pay, the more additional pension entitlement you build up. The main difference is that now it builds up more quickly for earnings up to a lower limit (£10,800 in 2002/3) and benefits can also be accrued by carers and those suffering from long-term incapacity. There is more detail of how it works on the Government's 'pension guide' website, but the effect is to provide a more generous additional state pension for those on lower earnings.

Neither SERPS nor the State Second Pension gives any benefits to the self-employed, but if you're in employment, you have a decision to make: whether to stay in the State Second Pension or 'contract-out'. Staying in the state scheme means that you build up the rights to the State Second Pension, whereas 'contracting-out' means that you don't. But, instead, the Government will pay a 'national insurance rebate' into a pension scheme of your choice (so long as it meets certain conditions).

So you have to work out whether the national insurance rebate that the Government will pay into a separate pension for you (either a personal pension or a company pension) is worth more to you than building up your entitlement to the State Second Pension. Unfortunately, to make that assessment, you'd generally need to have a degree in mathematics and be clairvoyant, but there are some vague pointers in this article.

You can get an idea of how much State Pension you stand to receive by requesting a forecast.

The Minimum Income Guarantee

How much you get in terms of the Basic State Pension and Second State Pension depends on how much entitlement you've built up, rather than whether you need it. So they're more like forced saving than any kind of welfare for the aged. The Minimum Income Guarantee, or 'MIG', on the other hand, serves the purpose of welfare by providing a floor to people's incomes beyond the age of 60.

The idea is that, if you or your partner is aged over 60 and you have less than £12,000 in savings and don't work for more than 16 hours per week, then you may qualify to have your income topped up to the level of the MIG. Currently this is £98.15 per week for a single person and £149.80 for a couple, but it may be higher in some circumstances (for example if you're disabled and living alone). There's more about who qualifies and how to claim the MIG in the Pension Service Guide (1mb pdf).

Do It Yourself

The most important thing to recognise about the State pension is that it doesn't amount to much at the moment and the position seems set to get worse, as the population gets older and the Pension Timebomb comes home to roost. If you're aiming for a comfortable retirement, then you're unlikely to get there without some hard saving of your own -- even if you have the additional benefit of a company pension.

For more about DIY approaches to saving for retirement, have a look in the Fool School and the Fool's Pension Centre and ISA Centre.