Pension Basics and the Basic State Pension

Pensions are high on the agenda at the moment, following the recent publication of the latest report from the Pensions Commission and a raft of rule changes which came into force on 6 April 2006 (known as A-Day). However, there's a considerable amount of confusion over how pensions operate and how they'll change in future, making it very difficult for us to make financial plans for our retirement.

What is a pension?

In its simplest form, a pension is essentially an income that you receive when you retire. To build up a big enough pot of money to provide that income, someone has to do some saving. What makes one pension scheme different from another is down to how this money is saved, whom it is saved by and how the income is eventually generated.

To encourage us to save enough for our retirement, the Government provides a tax break. So, as long as a pension scheme fulfils the criteria they have set down, then the money that goes into it comes out of your pre-tax earnings. Think of it this way: you put some money in, then the Government chips in the tax that you have paid (or would pay) on that money. There is a limit, of course, on how much you can pay in. The limit will depend on what type of pension scheme you are contributing to. In the case of some schemes, the older you are, the more you can put in.

These contributions form a pension fund, which is invested over the years until your retirement. In theory all this seems fine and dandy. In practice, life is about to take a shot across your bows. Pension rules are far more complex than they need to be and the new rules due to come into effect soon are adding to the confusion as there a number of transitional issues to deal with.

It is worth bearing in mind though that a pension is only one way of saving for your retirement. You need to balance the pros and cons and compare various options. The benefits of pensions are:

• The tax break;
• The fact that you aren't able to succumb to temptation and spend the money prior to your retirement.

Offsetting this are the two main flaws:

• The charges tend to be more complex and higher than other long-term investment schemes;
• They aren't particularly flexible, particularly in respect to how you receive your pension money once you retire.

State Pensions

To start with, let's take a look at what the government provides. Currently, the State provides just over half of all the income received by pensioners. We'll concentrate on three sources - the Basic State Pension, Pension Credit and the State Second Pension (other significant sources of income the government provides include benefits such as Attendance Allowance, Winter Fuel Payments and Housing/Council Tax Benefit).

Basic State Pension

The value of the Basic State Pension has slowly been eroded in recent years and by the time some of you reading this come to retire you'll be lucky if it buys you a packet of Mr Kipling's jam tarts and a box of teabags! It's also worth bearing in mind that not everybody qualifies for it - you have to have made a minimum level of National Insurance contributions. Currently, about 10% of men and 50% of women receive less than the full Basic State Pension because they haven't contributed enough.

You can get a state pension forecast from the Department of Social Security to check if you're up to date with your NI contributions and if not, you may be in a position to top it up. But don't rely on the Basic State Pension too much when you're making your retirement calculations as it'll amount to a pittance by the time you're able to claim it.

It's currently worth £84.25 per week (around £4,400 a year). Married couples currently get £134.75 per week but, if you qualify for more than this with two single pensions, then you get those instead. Pension rates used to increase in line with wages (which typically increase at a higher rate than inflation) but this link was broken in the 1980s. The recent Pensions Commission report suggested this link should be restored but there are doubts as to whether this will happen.

Men receive their state pension from the sixty-fifth birthday onwards. Women currently get theirs from age 60, but their retirement age will be gradually be moved from 60 to 65 from 2010 to 2020. Looking ahead further, the recent Pensions Commission report recommended that the state pension age for all should be raised to 68 by 2050.

Pension Credit

In 2003 the Pension Credit was introduced to help combat pensioner poverty (it replaced a similar benefit called the Minimum Income Guarantee). It's a means-tested benefit which sets a floor to what the State will give you in retirement. The floor is a little some way above the Basic State Pension, so if that's all you get, then you'll qualify for additional money (although the benefit reduces rapidly if you have £6,000 or more in savings). Currently, Pension Credit ensures you'll get a minimum of £114.05 as a single person and £174.05 as a couple.

It's reckoned almost 5m of the UK's 11m pensioners are entitled to claim Pension Credit but only around 3m actually do so, either because they are unaware of its existence, find the application forms too complex or don't wish to disclose their financial details. Despite the fact that it's helped to reduce pensioner poverty, it's widely criticised as it provides a powerful disincentive for people on lower incomes to save money for their retirement.

Taken together a full Basic State Pension and Pension Credit for a married couple is only about £8,700 a year. Few people would wish to live on that and that's why there is so much talk about us having to make extra provision for our retirement out of our own pockets.