The state pension has hit the headlines again in the last week, with the Centre for Social Justice proposing increases to the age at which we become entitled to it.
The proposed state pension age rise got me thinking about the state pension and what it is worth.
The typical starting state pension is currently around £8,500 per year.
Many people are not entitled to the maximum state pension, as you need 35 “qualifying” years to receive the maximum, while others are entitled to more than this, as they have built up additional earnings related state pension entitlements.
If you don’t know how much state pension you have built up, you can either find out by logging in through your Government Gateway or by completing and sending off a form BR19.
If you were born between 6th March and 5th April 1954, you will become entitled to your state pension on 6th September 2019, so the current state pension age stands at about 65½.
You don’t have to draw your state pension then, and it can make sense to defer.
The state pension is often undervalued by people when they plan retirement, so I thought it would be interesting to see what it might be worth.
Imagine that the government were to offer you the option of a tax free lump sum instead of a weekly pension. How big would that lump sum need to be, in order for you to give up the state pension?
In order to work this out, you would need to think about:
• How long you expect to live (and receive the pension).
• How important the guaranteed income is to you – how would you be affected if you spent all of the lump sum and had no other income (let’s assume that the Welfare State has been scrapped)?
• How important the inflation guarantee is to you. The state pension goes up every year by inflation, by the same amount as average earnings or 2.5% (whichever is highest).
• Your risk personality and the sort of things that you would be happy to invest in.
• You should also think about how much tax you would pay on the pension and the lump sum (I’ve ignored this in my calculations though as the government isn’t about to start offering us a lump sum instead of a pension!)
I asked a few other people in the financial planning profession what they thought (and didn’t give them any time to think too much about it!), and the lowest figure they came up with was £200,000, whilst the highest was £288,000.
I crunched some numbers. I assumed that the money was being offered to a man who had standard life expectancy (21 years for a man aged 65) for whom the guaranteed income and inflation guarantee were essential, and who had a middle of the road view of investment risk.
I assumed that he would have to pay annual charges of 1.75% per year of the value of the money he was given by the government.
My calculation showed that the government would need to give him at least £280,800 to make it worth giving up the state pension.
Data shows us that, if he was give £280,800 at 65, he could withdraw a starting figure of £8,500 per year, and increase this amount by inflation in every subsequent, and have a 99% probability of not running out of money during his lifetime.
If he chose to give up his state pension for that amount of money, he could be fairly certain that he would be able to have as much income as the state pension would provide, and he could be pretty certain that there would be some money left to pass on to his family.
That seems like a fair deal as the 99% probability is based on investment data going back over the last hundred years (and we still don’t know what future investment returns will be!).
Incidentally, if you decided that you would just use the money that the government was giving you to buy an annuity, you’d need the government to give you £354,000 (but you’d just be giving up a government guarantee and replacing it with a guarantee from an insurance company, and what would be the point in that?)
The Centre for Social Justice was suggesting a rise in the state pension age to 75. If that was the case, then the cash value of the state pension would only be £227,800 (using the same assumptions as before).
So, the CSJ’s proposal would reduce the value of the state pension by around 19% (as well as giving the government extra time to find the money!).
But it is useful to know that the state pension has an enormous value, and, for many people, it will be their biggest retirement resource.
And I can’t help thinking that the government is missing a trick by not telling people just how much the state pension is worth.
