State pension top-ups: stupidly complicated and very expensive

Last week I told you that our pension system is stupidly complicated and that something must be done. No one disagreed. The government doesn’t disagree either – that’s why it has been making the odd effort to make things look a little simpler, pensions freedom being the obvious example.

However, attempting to simplify any nastily complicated system that involves both money and a variety of vested interests always comes with short-term complications. And that’s exactly what’s happening with the new flat-rate pension top-up. The idea is very straightforward: ensure that everyone who has paid a full 35 years of National Insurance contributions gets the same weekly payment (£151) from April next year.

But the transition to it is not so straightforward. The government has been worried about (and heavily lobbied by) those who have already hit state pension age or will hit it before the flat-rate pension is introduced and so will lose out one way or another.

To placate them it has come up with an interim solution: “Class 3A voluntary National Insurance contributions”. Pay these in the next 18 months (the window is limited) and you will be able to boost the amount of state pension you get by up to £25 a week. That sum will go up with the consumer prices index every year, and if you leave a spouse when you die they’ll get 50% of it until they die too.

How much you have to pay upfront for that depends on your age. But if you are 65 now and you want to buy an additional £1 a week for life it will cost you £890. If you want to buy the full £25 (or £1,300 a year) it will cost you £22,250. Do that at 75 and the costs come down to £674 and £16,850 respectively.

The reaction to this has been generally good, with a string of experts pointing out that this is effectively a very cheap annuity. If you wanted to buy an income of £1,300 on the open market, they say, it would cost you somewhere in the region of £40,000 rather than £22,250. You’re effectively getting an annuity rate of about 6% rather than 3%. Add in the kicker of the 50% inheritance, and it looks like a pretty super deal.

It isn’t. Well, it isn’t for most people, anyway. To see why, we need to look at how the alternatives are structured. If you put your money into an individual savings account you do so out of taxed income. The capital and income are then untaxed while they grow and when you take the cash out to spend it. This is known in the business as “taxed, exempt, exempt” (TEE).

Pensions work the other way round. The money goes in free of income tax, grows tax-free and is taxed (as income — everything inside a pension is technically classified as taxable income, not as capital) when it is withdrawn. That’s “EET”. If you buy an annuity with the cash, the first time you pay tax on it is when the annuity pays you an income.

Now look at the government’s new deal. Assuming the money isn’t already in an Isa and you are a taxpayer, money you use to buy more state pension will be money that has already been taxed when you earned it, had any interest it has earned since then taxed and that will be taxed again when it is paid out as pension. So TTT.

The key here is that if you have £22,250 sitting around it is capital. Capital on which no tax is due. If you turn it into state pension it becomes income. Income subject to income tax. So let’s say you are a 65-year-old male 20% taxpayer. You hand over the cash for £25 extra a week. With no tax it would take 17 years for the state to return to you the money that was yours anyway (£22,250/£1,300). You’ll need to live to 82 to break even.

At 20% it is 21 years (breaking even at 86). At 45% it is nearly 30 years (95). Not looking such a good deal now, is it? More like a totally rubbish one (unless you happen to be married to someone who might live 20-odd years longer than you and keep trousering the 50% payout).

The truth is that even if you can’t make a post-tax return greater than inflation on keeping your capital in the bank account, hanging on to your capital (and putting it into an Isa as and when you can) has got to be a better bet for taxpayers than turning it into income.

It’s also worth noting that there are other – much better – ways to top up a state pension. If you haven’t already got 30 years of National Insurance contributions, you can pay to fill in the gaps. Each year costs you £733.20 and then pays you an extra £200 a year. That’s a payback of less than four years for non-taxpayers and just over four years for 20% payers. That’s got to be better than 17 and 21.

If you’ve got your 30 years of NI there’s another fabulous way to bump things up: defer your pension. For every year you defer you get a 10.4% uplift in your annual payout. So deny yourself the basic pension of £6,029.40 for one year and you’ll get an extra £627 the next year. The payback there? 9.6 years. Not bad is it? Put £6,000-odd into buying a new state pension and you’d only get £364 a year extra.

This is complicated stuff. Shockingly complicated, actually. Do most people know the difference between TEE, EET and TTT? Can most people figure out the difference in value between an annuity indexed to the CPI and one indexed to wages? Will most people think to factor in their personal tax rates, the life expectancies of their partners and the comparisons between using spare capital for Sipp top-ups over state pension top-ups? No, no and no.

If a private company offered this range of deals (Isas, Sipps, Class 3, Class 3A, pension deferral) without making sure anyone trying to figure out what to do was receiving full-on financial advice, they’d be pursued to their graves by furious personal-finance journalists, the Financial Conduct Authority, and aggressive gangs of class action-obsessed ambulance chasers.

Perhaps the FCA might find time to mention this to the pensions minister — or anyone else in government who thinks that today’s policies are any easier for anyone.

• A version of this article was first published in the Financial Times 

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