Amid the enormous publicity being given to the introduction of stakeholder pensions next April, it w...
Amid the enormous publicity being given to the introduction of stakeholder pensions next April, it would be easy to forget the other key plank in New Labour's pensions strategy. The transformation of private pension provision is to be accompanied by probably the biggest overhaul of state pensions since the last Labour government introduced Serps back in 1978. It will be several years before the changes are complete, but they cannot be ignored when advising clients now, particularly on contracting-out.
State pension provision in the future will come in three forms:
The basic state pension (currently £3,510 a year for a single person) is likely to continue in its current form. Despite considerable pressure from trade unions and pensioner bodies, it will almost certainly remain linked to prices although there may be a one-off special increase next year. This means that its value relative to average earnings will fall by something like 2% a year.
The state second pension (S2P) will be introduced in April 2002 as a replacement for Serps. Initially it will mean an increase in the earnings-related pension for those on average earnings and below. The biggest increase will be for those earning between the lower earnings limit (currently £3,484 a year) and a new low earnings threshold (around £9,900 based on 2000-2001 earnings). For them, S2P will be equal to twice the current Serps entitlement of someone earning exactly the low earnings threshold. A similar S2P credit will also be given to carers with no earnings.
For those earning between about £9,900 and £22,800 S2P will be higher than the current Serps, while higher earners will receive the same entitlement as at present.
After a few years possibly in April 2006 the earnings-related part of S2P will be removed completely, and for most people it will become flat-rate like the basic state pension. However, those over about 45years at that time will still have an earnings-related element. The graph on the other page illustrates how S2P will work.
The third element of state pensions is the minimum income guarantee (MIG). This is designed to ensure that every pensioner has decency-standard income (£4,080 in 2000-2001). The Government has recently announced a review of MIG to remove its major drawback - that those who have modest savings or pensions are effectively penalised for their thrift because their state benefit is reduced.
A consultation paper outlining how this disincentive to save could be removed is due later in the autumn.
The move from Serps to S2P clearly has an effect on those who are contracted-out of second tier state pensions. In brief, the new position will be:
u Final salary contracting-out will be unchanged. Those earning below £22,800 will receive a top-up from the State.
u Money purchase rebates for those earning between £9,900 and £22,800 will receive higher rebates to reflect the increased S2P entitlement.
u Money purchase rebates for those earning below £9,900 will be twice those at present. They will also receive a top-up from the State to make up the difference between this and the S2P entitlement.
u When S2P goes flat-rate, earnings-related rebates will continue. The current intention is that they should be at the level initially established for S2P, but a lot can change in 5 years.
In addition, and perhaps more significantly for advisers, the level of rebates for everyone is changing from April 2002. This is as a result of the normal five-yearly review by the Government Actuary, and would have happened even without the S2P changes.
The Government Actuary's job is to consider what would be an appropriate level for rebates, mainly based on four key assumptions:
u Likely investment returns before retirement compared with earnings increases
u Likely investment returns after retirement compared with price inflation
u Mortality rates of pensioners
u Reasonable levels of costs and charges
Over the past five years there have been significant changes affecting all four assumptions.
The main change impacting on the likely return before retirement was the removal of advance corporation tax (ACT) credits from pension schemes in 1997. This has reduced dividend income, and so means lower investment returns.
For a typical managed fund, the reduction in investment return could be about 0.25% a year, and this is reflected in the new assumed return.
It falls from 2.25% a year to 2%. This assumption is fairly cautious, and it is certainly well below the average return in the past.
The return from index-linked gilts, has fallen dramatically in recent years. Five years ago the assumed yield was 3.75% a year, which was a reasonable reflection of returns available then.
However, they have since fallen to about 2% a year and the old assumption is now unrealistic. But the Government Actuary has decided that in the longer term the yield will bounce back to 3.5%. He has therefore based the rebate assumptions on a return of 2% a year for those retiring in 2002-03, rising by 0.1% a year until it reaches 3.5% for those retiring in 2017-18 and later. It remains to be seen whether this assumption is reasonable. The current low yield is directly related to a shortage of index-linked gilts caused by high demand and low supply.
Demand may reduce when reforms to the minimum funding requirement (MFR) for final salary schemes are implemented, but it is unlikely that supply will increase in the foreseeable future. The Government Actuary's assumption here looks rather optimistic.
The change to mortality assumptions is much less controversial. The trend towards longer life-spans shows no
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