State Pension Top Up
From October 2015, existing pensioners and those retiring before 6 April 2016, will have the option of making additional National Insurance Contributions (Class 3A) in order to increase their state pension by a maximum of £25 a week / £1,300 a year.
The income is taxable, linked to inflation (CPI) and 50% can be inherited by a surviving spouse. The scheme operates like an annuity in the sense that the individual pays a lump sum in exchange for a guaranteed income for life. The amount of the lump sum required will depend on the individual’s age.
As an example, in order to receive the maximum £1,300 a year, the following lump sums would be required:
- 65 year old £22,250
- 75 year old £16,850
These figures equate to equivalent annuity rates of 5.84% for a 65 year old or 7.71% for a 75 year old, which are far in excess of the rates available from an insurance company. At current annuity rates, it would cost a 65 year old £37,420 to purchase this level of income and a 75 year old £25,550, so it is apparent that it will cost much less to secure an income via State Pension top up compared to buying an annuity.
Who will benefit and who will not?
Whilst the aforementioned figures look attractive, especially in the current low interest rate environment, they will not represent value for everyone.
The major disadvantage is that it is an annuity style arrangement, which means that once the individual has paid the initial lump sum, they cannot get their capital back. Therefore, it will not be suitable for people who require ready access to capital. People who will benefit the most are those who live long enough to receive their capital back in the form of additional income and due to the 50% spouse’s benefit, those with a younger spouse could benefit further. As an example, a 65 year old would need to live to age 82 to see their money returned (not factoring in tax and inflation).
Based on current cohort mortality tables from the Office of National Statistics, a 65 year old can on average, expect to live to 86 years old so it is likely that the top up will represent value. As individuals in good health can expect to live even longer than the average, they should benefit to an even greater extent. On the contrary, those in ill health or with a family history of early death are at higher risk of not recouping the initial capital outlay. In any case, individuals in ill health should explore the rates available from enhanced or impaired life annuity providers before making any decision.
The income is taxable so is unlikely to be suitable for higher rate taxpayers, who may find it more beneficial to draw income from alternative sources, where their tax position can be managed more efficiently. Nontaxpayers will benefit the most.
Also, it is worth noting that there is already a top up system in place for those who do not qualify for the full state pension. Therefore individuals should ensure they have full entitlement to the state pension before purchasing a top up, as the existing scheme is even cheaper.
There is a small window to apply – from 12 October 2015 to 5 April 2017 and individuals need to consider their own individual circumstances before making a decision.