Short-changed by the state

Many retirees are in for a rude shock when it comes to qualifying for the new state pension headline rate, says David Prosser.


People may find they don't get the full pension
(Image credit: Credit: fStop Images GmbH / Alamy Stock Photo)

Well over half the people who have retired since the introduction of the new flat-rate state pension last April do not qualify for the headline rate paid by the scheme. Of 154,000 people who became eligible for state pensions in the five months between April and August last year, just 63,440 qualified for the full pension of £159.55 a week, according to data from the Department for Work & Pensions (DWP), published by the "i" newspaper. This implies that 200,000 people may have missed out in the full first year of the new pension.

The new flat-rate state pension scheme was intended to be more straightforward than the old system, under which everyone received the basic state pension and some people qualified for additional payments depending on their earnings. Ministers also guaranteed no one would be worse off under the new arrangements. However, the new pension comes with more demanding qualification criteria for those hoping to receive the full amount. To get the headline rate, people must have made national insurance contributions (NICs) for at least 35 years, five years more than required under the old rules.

These contributions must have been made at the full rate. In practice, millions of people have paid reduced NICs for periods of their working lives because they were members of a contracted-out private pension scheme run by an employer or an insurance company. In return for paying lower rates, these people received a rebate from the state pension system that was invested in their private pensions. In many cases, people were contracted out without realising it.

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While many people may have benefited from the arrangement, receiving more private pension (thanks to support from a sponsoring employer or good investment returns) than they would now be getting from the state pension, there will also be losers. The contracting-out system was effectively abolished in 2012, and the DWP forecasts that 85% of people retiring by the mid-2030s will get the full flat-rate state pension. But for now, large numbers are set to discover they do not qualify for the full £159.55 per week that they may be expecting.

How to top up your national insurance contributions

Those who think they may fall short of the full 35 years required for the headline flat-rate pension scheme should consider the government's top-up scheme. This enables you to make extra Class 3 national insurance contributions for any missing years since the 2006-7 financial year. The scheme is due to run until 2023, after which people will be limited to making top-up contributions only for the previous six financial years (this was the rule that applied before the flat-rate state pension was introduced).

To replace a missing year of national insurance will cost you £741, though you can also buy as little as an extra week, if you have some years with partial contributions. The £741 buys you an extra £237 a year in the new flat-rate pension in today's money, so you'll need to live for a little over three years after claiming your benefit in retirement to profit from the scheme.

The scheme is relatively generous under the old system, topping up only bought you £212 in extra pension. For someone who lives 25 years after retirement, this represents an annualised return of more than 30%.

Given how attractive this is, it seems entirely possible that the top-up scheme won't survive until 2023, so it's worth considering your options sooner rather than later. Start by obtaining a state pension forecastto assess whether you are currently on target to hit the 35 years of national insurance contributions. Keep in mind that time spent out of work to raise children aged under 12, or to care for a relative, also count as qualifying years. Unfortunately, these aren't always recorded properly, so check that you've been credited.

Why retirees struggle to get mortgages

As average life expectancies continue to rise and more people seek to spend their retirement years in different ways, mortgage lenders are reconsidering their approach to older borrowers. In the past, lenders have routinely refused to lend to retired borrowers, or stipulated that all lending must be repaid by a certain age 75, 70 and even 65 are common age caps. But the marketplace is now changing. Both Halifax and Nationwide Building Society, for example, have recently said they will consider loans repayable up to 80 and 85 respectively. Some smaller lenders have even higher caps.

However, while many older people will appreciate this more liberal approach something regulators have been pressing for they may still find themselves turned down for lending in their fifties, sixties and seventies because of the pensions freedom reforms. While these have given people over the age of 55 greater flexibility over how they access their pension savings, they also introduced uncertainties that can unnerve mortgage lenders.

Older borrowers receiving a set pension from their savings, through an employer scheme or where they've used a personal pension to buy an annuity, are able to give lenders a very good idea of what their future income will be. In contrast, the outlook is much less clear for those drawing income directly from their pension savings while continuing to invest the remainder. Their income may fall substantially in the future, should investment returns disappoint, or if they withdraw too much money early on in retirement.

Large lenders that rely on computerised affordability calculations to assess applications for loans are struggling to cope with borrowers in such circumstances. Older people who should be in a strong position to take on mortgage debt are being turned down because lenders are worried about their unpredictable income stream or simply because their automated credit scoring systems can't cope with the complexities of income drawdown and pensions freedom.

It's also worth being aware that while smaller lenders tend to be better at taking a more flexible approach to older borrowers, these lenders often charge higher rates. This problem is likely to become more common, particularly as pensions freedom is exploited by a broader range of people, including those more likely to seek borrowing.

David Prosser
Business Columnist

David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.