Pensioners looking to turn their nest egg into regular income will soon have a new option to digest. From April 2015, the government will offer all those over age 65 the opportunity to buy anything up to £25 a week in extra state pension for the rest of their life by purchasing Class 3A National Insurance contributions.
Swapping a lump sum for government-funded income looks like good value for money when compared with an inflation-linked annuity, which would also give you guaranteed income for the rest of your life. Under the new scheme, a 65-year-old will be able to buy an extra £1 of Consumer Price Index (CPI)-linked pension a week (£52 a year) for £890. And an extra £25 CPI-linked income a week (£1,300 a year) of state pension will cost £22,250. The same income from an inflation-linked annuity would cost the same person significantly more at around £35,000.
But if you're a keen investor and not that fussed about having guaranteed pension income, you might be wondering if you'd be better off putting your money in the stock market and drawing income from that instead. Whether these new pension top-ups represent good value for money or not depends on your marital status, how old you are when you retire, and your life expectancy. Fidelity calculations done for Investors Chronicle reveal the returns different investors would need to get from their portfolio in order to beat the value of the new state pension top-ups. These are as follows:
The above-inflation returns an investor would need to beat the value of the new state pension top-ups
| Single | Married* | |
| Age died | Isa return (% above/below CPI inflation) | Isa return (% above/below CPI inflation) |
| 75 | -11.00 | 0.70 |
| 80 | -2.50 | 1.80 |
| 85 | 1.30 | 2.80 |
| 90 | 3.30 | 3.50 |
| 95 | 4.40 | 4.40 |
| 100 | 5.10 | 5.10 |
Source: Fidelity *Assumes spouse lives until age 92.
Our analysis shows that single people in poor health, and married couples who are both in poor health (or have a family history of early death) should think twice before buying extra state pension. This is because if you (and your spouse) die much younger than your average life expectancy, you'll have handed over a lump sum and hardly seen any of the benefits because your annual income dies with you. But if you'd invested the money, anything you hadn't spent would remain in your estate even after you died. The top-ups are particularly inefficient for a single person aged 65 who dies aged 75: our calculations reveal they would be better off if they invested the money in an individual savings account (Isa) and achieved anything upwards of 11 per cent below inflation. And if you are in ill health, bear in mind that you might need the capital to help fund someone to look after you when you are unable to do so yourself.
| Life expectancy for men at age 65 is currently 18.5 years (expected age of death = 83.5 years), and females on average are expected to live 21.1 years beyond this age (average age of death = 86.1 years), according to the latest Office for National Statistics data. |
However, the story is rosier for retirees who exceed their life expectancy and live 20 to 25 years after they retire aged 65. They would need their investments to produce a real return of 3 to 3.5 per cent a year above CPI inflation (currently 1.7 per cent) to match the value they would get from buying extra state pension under the new scheme.
Our data suggests that a married couple, one of whom has an incomplete state pension history, would be very unlucky if the state pension top-up didn't prove to be good value for money. If you have more than enough secure income and are more interested in preserving your capital to give away after your death, you might wish to keep the money despite the top-up being good value. However, this assumes you have worked out how to pass it on without incurring inheritance tax. Even if you bought the state pension Income, there is nothing stopping you using your regular gifts out of surplus income allowance to gift it to your loved ones while you are still alive.
If you die before your average life expectancy, but your spouse outlives you, they can continue to benefit from 50 per cent of your extra state pension contributions until they die, so this is worth bearing in mind. A married person who starts drawing extra state pension top-ups from his investments at age 65 and then dies aged 75 with a spouse who lives for a further 17 years (dies aged 92) would need to produce a real interest or return of 0.7 per cent above CPI inflation a year to provide the same income.
Alan Higham, head of retirement insight at Fidelity, says your investments would need to return "decent" equity returns to deliver this, which could mean taking a level of risk that might mean you wouldn't reach this level during some years. "For some people, the comfort of knowing the income stream is going to be steady will be enough to make them plump for the state pension top-ups," he added.
Footnote
Our calculations assume the state pension will increase by 1 per cent a year above inflation. It also assumes income from the state pension is taxed at basic rates, and that the alternative income from investments are derived from Isa investments. If non-tax advantaged funds are used, then the return earned would have to allow for tax paid on income and capital gains of the fund. Calculations allow for charges of 1 per cent a year on the investments.
