n e w s Single tier pension and contracting out TEC HN ICA L APR 2016 Changes to the State Pension age

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1 APR 2016 [ PMI TEC HN ICA L n e w s [ Single tier pension and contracting out Significant changes have been made to the state pension system over recent years, and the introduction of a new single tier pension scheme in April 2016 aims to simplify what has previously been a complex set of rules. The Government has committed to ensuring that nobody will be worse off under the new legislation, so a comparison will be run to calculate a foundation amount based on entitlement as at April 2016 and which will also take into account any applicable contracting out periods. Whilst most people believe they will automatically qualify for the new single tier, flat rate of per week, the reality may be very different. With headlines such as I ll be 28,000 worse off with the new state pension and no-one told me 1, the only way to get a clear picture is to obtain a BR19 pension statement from the Department for Work and Pensions (DWP). The attempt to deliver a simple and straightforward retirement planning solution for everyone, is often met with plenty of technical pitfalls to navigate through. Therefore, this technical news aims to break down some of the complexities of this topic, and help you provide your clients and members with a better understanding of their entitlement under the new rules. Changes to the State Pension age The State Pension age (SPA) has undergone radical change since April 2010 and we are currently seeing women s SPA being aligned with that of men s at age 65. This exercise is due to be completed in November 2018, with further increases set to raise the SPA to age 66 between November 2018 and October 2020 and then to age 67 between 2026 and 2028, for both genders. Periodic reviews of the SPA were first introduced in the Pension Act 2014, and are aimed at maintaining a set portion of adult life as being in receipt of the state pension (linked to life expectancy). The first such government review is due by 7 May Those people whose SPA falls on or after 6 April 2016 will be entitled to a State Pension under the Single Tier scheme rules. This new system is designed to simplify the complex state pension. Whilst this new approach is to be welcomed, there are a number of complex transitional factors for those who have built up pension entitlement under the pre April 2016 rules. 1 I ll be 28,000 worse off with the new state pension and no-one told me, Nov 2015.

2 State Pension a quick recap The current provision for those in retirement is made up of three elements: n Basic state pension (BSP) Calculated by crediting each qualifying year of national insurance (NI) contribution at 1/30th of the full amount. The full amount is earned with 30 qualifying years. Once in payment, this increases each April in line with the triple lock which is the greater of either average earnings, the consumer price index (CPI), or 2.5% I ll be 28,000 worse off with the new state pension and no-one told me n Additional state pension (AP) Comprised of the State Earnings Related Pension (SERPS) and State Second Pension (S2P). The calculation of this entitlement is complex and the detail of this are beyond the scope of this technical news. Some individuals may also have accrued graduated retirement benefit (a forerunner to SERPS) n Contracting out of the additional state pension This applies between 6 April 1988 (backdated to April 1987) and 5 April 2012 on a defined contribution basis, or from 6 April 1978 to 5 April 2016 on a salary related basis. As we discuss further in this technical news, any period of contracting out will impact the amount of single tier pension that will be received Single tier pension The new single tier pension replaces the following type of pensions: n Basic state pension n Additional state pension n Category D state pension a non-contributory pension for people aged 80 and over, who either receive no state pension or have a state pension of less than the category D pension (set at in 2015/16) n Age addition and the savings credit element of pension credit a benefit for people on lower incomes, this is based on a qualifying age to provide extra money for those who have made some provision towards retirement, in addition to the basic state pension For those retiring after 6 April 2016, the single tier will provide a flat rate pension, confirmed as per week for the tax year The maximum amount is set at a level above the single person s pension credit, or guarantee credit. This figure doesn t include any adjustment for contracting out or those with a protected payment (determined via the Foundation Amount). Entitlement will be assessed on an individual basis, without the facility to inherit or claim national insurance (NI) credits from a spouse or civil partner. To qualify for the full level, an individual will have to have paid or been credited with 35 qualifying years of NI contributions. For each qualifying year of post April 2016 NI contribution/credit an additional 4.45 per week would accrue ( ), up to the maximum. However to qualify for any entitlement an individual must have at least ten qualifying years either through a combination of pre/post April 2016 and/or voluntary NI contributions. The pension must increase in payment at least in line with earnings (however current government policy is to extend the triple lock to the single tier pension until at least 2020). Foundation amount a way of ensuring that nobody misses out The government has committed to ensuring that nobody will be worse off under the new state arrangement. The only way for someone to get a realistic understanding of their entitlement is to obtain a BR19 Pension statement from the DWP s Future Pension Centre. 2 PMI TECHNICAL NEWS APR 2016

3 But if you re interested in the technical explanation of how this works: 1. The pension someone would have been entitled to on the pre April 2016 rules will be calculated as:- 2. The equivalent is calculated under the new regime single tier state pension as:- Contracting Out Deduction (COD) This is a calculation used under the pre April 2016 rules to reduce the Additional State Pension (AP) payable. This reduction is applied where someone has been contracting out of the state system before April It is calculated with reference to an individual s earnings history for contracting out periods before 6 April 1997, and broadly matches the AP built up. Thereafter it is a notional deduction, as the reduced amount is treated as being exactly the same as the AP amount that would have been accrued. Rebate Driven Amount (RDA) Similar to a COD deduction, however this is used under the post April 2016 rules to reduce the amount of single tier pension payable. Unlike a COD, an exact figure is calculated for each period of contracting out. The highest entitlement (based on the 5 April 2016 calculations) is the one which will apply, becoming the foundation amount that is then carried forward to SPA So what does this mean in practice? Take an example client Mr Jones has 28 years of NI contribution and an Additional State Pension of 53 per week (with no contracting out periods) so the comparison calculation would be as follows: Entitlement under the pre 2016 state pension calculation Entitlement under the new regime This means several things: 1. In this example, the calculation under the pre 2016 system would result in a higher entitlement ( compared to under the new regime). The foundation amount that Mr Jones would carry forward to SPA would be the pre 2016 entitlement ( ). 3 PMI TECHNICAL NEWS APR 2016

4 2. Because the entitlement under the old regime is higher than that from the new regime, the difference of 8.70 ( ) is classed as a protected payment and will only increase in line with CPI, as opposed to the triple lock. If Mr Jones continues to earn he would be required to pay further NI contributions, up to his State Pension age (which could be up to or beyond the maximum of 35 years worth). However, even if he does this, it will not add to his final State Pension entitlement whilst the foundation amount exceeds the maximum single tier figure (i.e vs ). Implications for those who have contracted out For those who have contracted out meaning they have private pension benefits accrued outside the state system, the single tier pension calculation will be adjusted via the rebate derived amount (RDA) to account for this. This adjustment works in a similar way to the deduction for contracting out of the AP. The first element to consider is the point at which someone contracted out: Period within which individual contracted out Contracting out deduction (COD) n calculates a guaranteed minimum pension (GMP) amount (or an equivalent earnings related amount for a DC scheme) which is then deducted from the single tier figure Notional deduction n notional amount is calculated as being equal to the amount of SERPS that would have accrued had the individual remained contracted in during the period, which is then deducted from the single tier figure Deduction from gross S2P n equivalent to the amount of the S2P that would have been accrued, which is then deducted from the single tier figure Contracting out can be either: n on a salary related basis, where an employee pays a reduced NI of 10.6% (a 1.4% rebate) on earnings between the Lower Earnings Limit and Upper Accrual Point (since 1978) OR n on a money purchase basis, where a NI rebate was directed into a contracted out money purchase occupational pension scheme, personal or stakeholder pension ( ) Each of the above elements are combined in further calculations to determine a rebate derived amount. So what would this mean for our example client, Mr Jones? If we assume that Mr Jones had contracted out via a salary related scheme, it is possible to demonstrate how both an assumed COD and RDA figure would be used to establish the appropriate foundation amount. The government has committed to ensuring that nobody will be worse off under the new state arrangement PMI TECHNICAL NEWS APR

5 COD/RDA calculations Period Gross AP COD Net AP RDA 06/04/ /04/ /04/ /04/ /04/ /04/ Total equivalent to SERPS accrued 3 assumes an S2P top up for low/medium earners Calculation 1 - entitlement under the current state system, taking into account the contracted out periods BSP plus minus plus minus Total Gross SERPS COD Gross S2P S2P COD Calculation 2 - entitlement under the single state tier, taking into account the Rebate Derived Amount Single Tier Minus RDA Total Just as in the first time we looked at Mr Jones case, the entitlement under the pre 2016 system is higher than the equivalent under the future regime ( versus 72.52). Therefore the entitlement under the pre 2016 system will be used as the foundation amount. There are two important considerations to be aware of: n where an individual has gaps in their NI history it may be possible to use NI Class 3 voluntary contributions, especially if someone has less than the 10 year minimum. This option is distinct from those who have reached SPA before 6 April 2016 and can buy additional state pension via a Class 3A top up payment n for those whose GMP is revalued on a fixed rate (as a result of leaving service) there is a further complication any Additional State Pension will be revalued with reference to an earnings index (under Section 148 orders) but the Contracting Out Deduction calculation will make a deduction from that fixed rate and revalued GMP. In extremes this can lead to the entire AP entitlement for the period 1978/97 period being reduced by a GMP that was actually only accrued by contracting out for part of that period Given the complexity involved in calculating the foundation amount, the practical way for many people to get a realistic understanding of their entitlement will be to request a BR19 Pension statement from the DWP s Future Pension Centre 5 PMI TECHNICAL NEWS APR 2016

6 Conclusion Given the complexity involved in calculating the foundation amount, the practical way for many people to get a realistic understanding of their entitlement will be to request a BR19 Pension statement from the DWP s Future Pension Centre. As ever, the attempt to deliver a simple and straight forward retirement planning solution often contains plenty of technical concepts for clients and members to grasp and to navigate through. It means that, as we ve said before, the reforms may bring greater choice, but also greater complexity and that as a result, professional advice will be of even greater value when helping members unravel the detail behind their choices. Adam Cole Technical Consultant Just Retirement Limited Further reading n Single tier pension, July 2013 n Get a State Pension statement, December 2015 Opinions expressed in this publication are the personal views of the contibutor and should not be regarded as the official views of the PMI. Published by: The Pensions Managment Institute PMI House 4-10 Artillery Lane London, E1 7LS T: F: E: pmiservices@pensions-pmi.org.uk 6 PMI TECHNICAL NEWS APR 2016