A Financial Planning Opportunity - Maximising Your UK State Pension
While the interpretation of life as “a game of inches” is usually reserved for American Football, I believe it is particularly analogous to financial planning because the long-term success of a plan tends to be dictated by the smallest of marginal gains in the long term run. A fundamental source of retirement income that falls into the marginal gains category and that can be commonly overlooked within planning discussions is the UK State Pension. Although receiving the UK State Pension is unlikely to materially change an individual’s lifestyle in retirement, considering the available options for maximising the UK State Pension can offer an ‘easy-win’ for increasing income in retirement. By focusing on the fundamentals of financial planning and taking the ‘easy-wins’, the chance of a successful investment experience can be greatly increased.
Generally, anyone living and working in the UK earning a salary will make National Insurance contributions which help to build a UK State Pension retirement benefit. Individuals who qualify can make a claim when they reach ‘State Pension Age’, which is currently age 66 (this is scheduled to increase to age 67 between 2026 – 2028).
To be eligible to claim the new UK State Pension, you must have at least ten qualifying years of National Insurance (NI) contributions on your record. And, to receive the full new UK State Pension entitlement, you will need 35 years of qualifying NI contributions on your record. A qualifying year is typically when you were employed and paying NI contributions or where you made voluntary NI contributions. In certain instances, you may be eligible to receive NI Credits for illness or unemployment to accrue a qualifying year of contributions.
In the 2021/22 tax year, the full new UK State Pension entitlement is £179.60 per week or £9,339.20 per annum. If you do not have 35 qualifying years of NI contributions on your record, you will not be eligible to receive the full UK State Pension benefit. Fear not readers with gaps in their record, a temporary opportunity to increase your entitlement is currently available until 5th April 2023. The opportunity provides those with gaps in their record to make voluntary NI contributions to make up for gaps between April 2006 and April 2016. As the UK government typically allows you to make voluntary contributions for the prior six tax years, this opportunity can provide you with the potential ability to attain an additional nine qualifying years on your NI record compared to the normal allowance for retrospective contributions.
Under the 2021/22 rates applicable, a qualifying year will generally cost you £800.80. Each additional qualifying year accrued through voluntary contributions currently increases your benefit pension entitlement by £266.83 per year which means that you can increase your annual pension entitlement and it would only take around three years of UK State Pension income to ‘breakeven’ on the voluntary contribution. For our American readers, even if you end up being subject to the Windfall Elimination Provision (WEP) on a separate US Social Security benefit, the ‘breakeven’ point for making voluntary NI contributions is still generally a modest six or seven years, therefore backfilling contributions is something very much worth considering despite the WEP.
We can see the long-term benefits of making voluntary NI contributions in the following illustration.
John is 65 years of age and exactly one year away from reaching State Pension age. As John retired at the age of 40, he only has 20 qualifying years of NI contributions on his record and is therefore entitled to only 20/35 or £5,336.69 of the full entitlement. For John to increase his annual pension benefit to £9,339.20, he would need to make voluntary Class 3 NI contributions for 15 tax years which, using 2021/22 rates, would cost roughly £12,012. The below illustration highlights the monetary impact of making the voluntary contributions providing that John lives until the age of 86 and the UK State Pension increases by 2.5% per annum in each scenario.
As you can see, by paying £12,012 in voluntary NI contributions, John is able to receive an additional £111,521.48 of UK State Pension income in retirement. From an investment return perspective, this would represent an eyewatering return on capital of 928% on the initial £12,012 voluntary NI Insurance contribution over the 21-year period which, in the current ultra-low interest rate environment, represents an attractively easy option for increasing retirement income with no market risk.
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