Magical Penny continues the series on pensions.
Last week we looked into the state pension, which is paid for through your national insurance contributions. Even if you don’t save anything for retirement you will most likely retire with a state pension.
But did you know you probably have extra money coming to you in retirement (in addition to the state pension)? Money you don’t even know about?
Could you be getting extra money?
If you live in the UK and fit into any of these categories you’ll currently due to receive extra money on top of your normal state pension:
- employed and earning over £5,044 (from any one job)
- looking after children under 12 years old and claiming child benefit
- caring for a sick or disabled person for more than 20 hours a week and claiming Carer’s Credit
- a registered foster carer and claiming Carer’s Credit
- receiving certain other benefits due to illness or disab
So what is this extra money?
The Second State Pension.
You may have noticed that the more you earn the higher your National Insurance contributions become. Certainly the more you earn the more you contribute to the state’s coffers but some of your extra contributions go towards a ‘top-up’ pension known as the State Second Pension.
The State Second Pension is one of the most confusing parts of the current pension provision but its worth knowing the basics to make sure you’re not caught.
The most important thing you should know about it is that you may be faced with the option to ‘contract out’ –meaning you give up your Second Pension, start paying less national insurance and have the state to start contributing to your own personal pension.
It may sound good but you shouldn’t do it. Here’s why:
Don’t be tempted by the ‘free money’
If you have a pension at your place of work you should be given the option to ‘contract out’ of the state pension and choose for the state to put money into your own personal pension.
‘Contracting out’, essentially giving up your second pension might seem like a good idea as you are given a rebate from the state that goes into your own pension that you control. The amount you could get varies by age and salary but, for example, someone aged 25 in 2009 earning £20,000 would have got £1,128 paid into a personal pension on their behalf. A 45-year-old on the same earnings would have got £1,546 (slightly more as they are older and closer to retirement) Source
The money might seem nice but its debatable if it’s good value for money -you are trading away a safe monthly income at retirement for cash today. Will you be able to invest it well enough?
Being Proactive with your pension is not always a good thing
Magical Penny recommends being proactive with your long term savings but being proactive by ‘contracting out’ of the State Second Pension is the exception!
Whilst it is possible to do better than the state with good investing, you are most likely to underperform according to research undertaken by Which? in late 2005 which found that, contrary to expectations back in the 80s when contracting out was encouraged by many financial advisers and the government itself, millions of people are on course to be worse off in retirement as a result of contracting out.
By ‘ contracting out’ you are giving yourself an opportunity to try to better the returns the state promises for your retirement. This is a risk you shouldn’t take because it is the equivalent of leaving your eggs in one basket –you are banking 100% on your own investments – if your long term investments don’t grow as you expected you do not have the state second pension to help supplement your retirement. Why not invest on your own and have the Second state pension to fall back on?
That said, staying with the second state pension also carries a risk as the pension rules are always changing and there might not even be a second state pension by the time you retire. However what the second pension automatically provides you with should not be dismissed:
Saving for your long term is all about balance.
Certainly you should also be investing in your own savings plans rather than relying on the state to look after you in your old age, but if you choose to ‘contract-out’ you risk losing a safe and reliable income stream when you come to retire. If you ‘contract out’ your own investments will need to grow significantly to do as well as you would have done with the State Second pension, and when it comes to your retirement that’s a risk you don’t need to take.
The good news is that you don’t have to: most of us are automatically given a second state pension, a helpful supplement to your income during retirement. You should leave it well alone.
If you’ve never been a member of a private pension scheme then you can’t be contracted out. But if you’re an employee you’ll be able to contract through an ASP or APP. If you’re self-employed you don’t contribute to the state second pension and so can’t contract out of it. Also, if you’re not sure whether you’re currently contracted in or out, you can find out by calling the Inland Revenue Pensions Helpline on 08459 150 150. You’ll need your National Insurance number.
As with most tax issues, the calculations are quite complex so you should never rely on the state to provide you with the money you need in retirement. But don’t worry, Magical Penny is here to help you grow your pennies without needing to rely on the state. If you do get a State Second pension, treat it as a bonus.
Further reading on the State Second Pension