Flat rate pension top-ups are a waste of money

by George Hatjoullis

This is really a mea culpa. When I first saw the governments proposals I thought it looked like a cheap annuity. I wrote nothing except an anonymous comment on a website praising the idea. It does not apply to me so I did not think about it too carefully. Credit to Merryn Somerset Webb of the FT for blowing this nonsense out of the water. The article is quite accessible but I shall, as always, add a little summary as the FT is a subscription service. If you are thinking of topping up your state pension, read the original.

The government is eventually moving everyone onto a flat rate state pension from April next year (£151 pw at the moment). Those that have already reached pension age or will do so before April next year can make class 3A contributions in the next 18 months to boost their pension by £25 pw. Unlike the basic state pension this proportion will be indexed only to the CPI (the basic pension is indexed to the higher of CPI, Average Earnings or 2.5%) but 50% will carry over to a surviving spouse. If you are 65 it will cost £22,250 to buy an extra £25 pw. This sounds like a good deal because it is an Indexed annuity rate of 5.84% with a 50% spousal pension. You cannot get a deal like that from the private sector. However, the comparison is not quite justified as MSW has reminded us.

The problem is that when you buy a pension from a pension plan you have been contributing tax free and it has been growing tax free. This top up is out of taxed income. The £22250 is capital on which tax is paid and none due. If you use it to top up it becomes taxable income. If you hand over the cash for £25 pw at 65 it will take over 17 years for the state to return your money. You will be over 82. If you pay tax at 20% you will be 86 before you break even. If you pay tax at 45%, your break even age is 95. Not sounding quite so good is it unless you expect your wife to live a very long time after you.

These break even figures should be compared to keeping £22250 in an ISA. The income is tax free. They should also be compared with deferring the basic state pension. Each deferral year has a break even of under 10 years. Moreover the indexing of the basic state pension is better. As MSW points out, if a private provider made such a proposal without suitable clarification, there would be a mis-selling scandal. You have been warned.