Party like it's 1979
OK, so not quite as punchy as the chorus in Prince’s millennial hit, but the chances are that if you were male, aged 65 and were retiring in 1979, after 30 or 40 years of work on pay roughly in line with average earnings, you probably felt pretty good about your pension. Maybe even good enough to “party”. In fact, you probably didn’t give your pension too much thought; you’d been in decent final salary schemes all your working life, you’d always paid national insurance contributions towards your state pension and the government was increasing the pension every year in line with increases in earnings.
If you were female you perhaps hadn’t always been in full-time employment and when you were working, you possibly hadn’t always been enrolled into the company pension scheme. However, you might well have paid lower national insurance, you would have been receiving your state pension from age 60 and you could expect to receive a spouses’ pension from the state, based on your partner’s national insurance record.
1979 was a memorable year in the world of pensions because it marked the high water point in the value of the basic state pension, when expressed as a proportion of national average earnings. So, in the unlikely event that you had somehow missed out on your employers’ pension schemes over your working lifetime (up until 1988 membership of your employer’s pension scheme was often compulsory), you could still have expected to receive a basic state pension of 26% of whatever the national average earnings were at the time you retired – perhaps not enough for a life of luxury, but not a bad foundation.
Sign o' the times
The downward trend in the value of the basic state pension began in 1980, when the government decided that increases would be linked to price inflation, rather than to increases in earnings. The period from 1980 to 2007/08 was characterised by low price rises and relatively high wage inflation, so the real value of the state pension compared to average earnings gradually reduced, dropping to less than 16% by 2008. There has been a recovery since 2009, as price inflation has fallen behind the rate of wage increases, but the basic state pension is still worth less than 20% of average earnings. The current government’s guarantee to increase the state pension every year by the higher of inflation, average earnings increases or a minimum of 2.5% (known as the “triple lock”) will maintain and possibly increase the real value of the state pension each year it is applied, but it might be dangerous to assume that this unusually generous mechanism will be maintained for much longer; a return to wage inflation-related increases is widely expected.
A little bit more
Of course, many people will have built up an entitlement to an additional state pension which the government has provided for the last 55 years or so, known variously as the Graduated Pension, SERPS and, most recently, the State Second Pension. This additional entitlement (or its equivalent) might be paid directly by the state, or as an extra pension from an occupational scheme or a personal pension plan (known as ‘contracting out’ of the additional state pension).
It could be argued that a focus on the falling value of basic pension alone doesn’t do justice to the importance of the additional state pension. Because this is often combined with employer sponsored or personal arrangements, the dividing line between “state” and “private” has often become blurred, particularly as the amount of the additional element is directly or indirectly linked to earnings.
Nevertheless, a proper comparison with the new single tier pension should take account of the value of the additional element provided by the old basis. In the short term, the protection provided to people who have built up basic and additional entitlements suggests that the new basis will result in more winners than losers. However, under the new single tier basis, no additional pension will accrue after 2016, so the prospects for people joining the workforce after, say, 2000 look less rosy.
You can't always get what you want
The new single tier state pension that came into force for those reaching State Pension Age from 6 April 2016 will eventually remove the complexity resulting from this dual band approach to state pensions. The new system will produce winners and losers compared to the old basis, although if you have built up an entitlement to the full basic and additional pensions from your earnings prior to April 2016, the single tier pension will safeguard your pension for some years to come.
But for those of us who have joined the world of work more recently and are curretly saving for retirement, the new basis will be rather less generous, particularly for people born after 1980 who won’t reach their state pension age until 2050, or beyond. The ending of the additional element will have a significant impact, with a reduction of between 20% and 30% (depending on earnings) compared with the total that would have been paid under the old basis.
And there will be no spouses’ entitlement, whatever contributions your partner might have paid during their working lifetime
So whilst the state pension might be easier to understand in the future, it seems even less likely to provide an adequate income in retirement, whenever that might be.
With a little help from my friends (and family)
As the state pension is going to become less generous in the long term, what should people who expect to retire in 30 or 40 years’ time be doing now? If the aim is to be able to afford to stop working one day, we will all have to make separate provision, either through additional pension arrangements (personal and/or employer sponsored), or by investing in other types of savings arrangements, such as ISAs, property, fine wines or anything else that might produce a return in the future.
The bank (or, more likely, the house) of mum and dad may go some way towards providing a reasonable retirement pot, but it would be unwise to rely on an inheritance – parents have a habit of spending their money, particularly if they need to pay for medical treatment and long term care in their old age.
No one said it would be easy
Perhaps the first step is to decide what lifestyle you want after you stop working, as this will allow you to estimate how much you might need to be saving for retirement over your working lifetime. The cost of living in a tepee in mid-Wales, for example, is likely to be significantly lower than maintaining a four bedroom detached in the Home Counties, with frequent meals out and regular overseas holidays.
Whilst it is impossible to accurately predict the cost of living three or four decades into the future, (at whatever lifestyle you aim for) you can set a target of how much you want to save from earnings. The more you save now, the more you will build up for retirement. This will mean making difficult decisions about short term gratification vs long term security, but the cost of building a suitably sized pot in retirement will only increase for every year you delay making a start.
Money's too tight to mention
Of course, this assumes that there is any spare money from each month’s paycheck; transport, student loans, food and drink and housing take up a large proportion of earnings, particularly for people in the early years of their careers, so the prospect of putting away a meaningful amount into saving for retirement is challenging, to say the least.
However, there is assistance available. Automatic enrolment gives most employees the right to a pension contribution from their employer – joining your workplace pension scheme (or not opting-out of it) can only help to build a pension pot. Similarly, the new LISA (the Government’s new Lifetime ISA, to be introduced in April 2017) will give most contributors a bonus payment from the government, which can be used to help the purchase of a first home or go towards retirement, if left in the pot until age 60.
House purchase, where this is possible, can also assist in long term saving, although this might mean that down-sizing or releasing equity in some way will be required in order to provide money to live off in retirement.
Let's get the party started
Whatever you decide, you should do something. If nothing else, start to think about what sort of lifestyle you want in retirement; then you can decide how you’re going to pay for it. You may conclude that you can’t afford to save as much as you need to meet your target, but at least try to make a start – it won’t be any easier next year.
Topics: Next Generation Savings