How to avoid retiring on state benefits

New figures from the Government reveal just how much Britons need to save to avoid retiring on means-tested state benefits - and the numbers make daunting reading.

Aileen Caskie
At 42, Aileen Caskie, has a pension pot of just £7,000

The Department for Work and Pensions (DWP) admits that low earners will see their retirement income increased by only 1 per cent of their salary, or £2 a week, after 10 years' saving in the Government's flagship new pension scheme to be launched in 2012, because their savings are eaten away by means-testing.

Even someone earning £25,000 a year who contributes to the new Personal Accounts for 20 years will only see their income in retirement increased from 31 per cent of salary to 34 per cent.

Experts say the figures highlight the way Pension Credit, the means-tested benefit paid to pensioners with small pensions, reduces the incentive for many people to save.

Hargreaves Lansdown says the figures also underline how much even middle-class people need to put away to avoid being on benefits in retirement. Research by the IFA firm shows that the average UK saver needs to build up a pension pot of £43,789 to avoid retiring on benefits at age 65.

Self-employed people, who get basic state pension but not state second pension, will need to save £91,191 to beat the benefits trap. To put this in context, the average pension pot of today's retirees is under £30,000, although some also have final salary pension income.

"People who have been self-employed throughout their lives will get no state second pension and if they haven't saved in a pension of their own will have their basic state pension topped up by means-tested benefits," says Chris Curry, research director of the Pensions Policy Institute (PPI), an independent research body.

"This is a hangover of offering Pension Credit to today's pensioners, which has helped millions of elderly people, but has also had an effect on the incentive to save."

Curry says these figures are only enough to keep you off benefits on the day you retire - to remain so throughout your retirement will cost even more. Many people will fall on benefits as they get older because while basic state pension rises each year in line with prices, and most annuities have no inflation protection at all, the threshold for benefits goes up in line with wage inflation, which increases at a higher rate.

The PPI estimates that between 40 and 45 per cent of Britons will retire on benefits over the next four decades.

"People in their 40s and 50s with small pension pots who think they have any chance of retiring early or on a high income face a reality check," says Graham Barber, head of financial planning at Rensburg Sheppards.

Non-means tested state pension comes in two parts. Basic state pension, currently £90.70, and state second pension, which varies in amount depending on earnings over your working life.

The average combined basic and state second pension is currently £134 a week, but people who have always been self-employed will get only basic state pension, while those with broken work records, particularly women, may get less basic and state second pension.

State help for pensioners on low incomes is called Pension Credit. This comes in two forms: the Guarantee Credit and the Savings Credit. The Guarantee Credit is the minimum the Government says you need to live off - currently £124.05 a week.

But people who save for themselves above this figure get rewarded with Savings Credit if their total weekly income is £173.33 or less.

For people on track to receive a pension lower than the Guarantee Credit of £124.05, the disincentive to save is huge. Saving will give you no increase in income until you cross that threshold.

For example, a self-employed person with full basic state pension of £90.70 but no other pension, who builds up a pot of £17,478 will gain no benefit whatsoever for saving, because this will only generate an extra £33.35 a week - exactly what he would have got through Guarantee Credit by not saving.

For all private income up to the £173.33 a week level of the Savings Credit, he will be rewarded with 60p for every £1 saved - losing 40p through means-testing.

Curry says: "If you think you are only going to save a bit more, you need to be aware that you might not be getting good returns for doing so. On the other hand, you do not know what the pension rules will be by the time you come to retire, so the only way to be sure is to put money aside yourself."

Tom McPhail, head of pensions policy at Hargreaves Lansdown, says: "If you think your pension saving will never take you above the Guarantee Credit level, you may decide that you have missed the boat and accept a future on benefits as your fate.

For some people in their 40s and 50s who don't have pensions, this is a real possibility. The alternative is to go hell for leather and attempt to beat the threshold and risk having it all be a waste of time."

Barber counters that the alternative of having nothing in retirement is a depressing prospect. "The bottom line is that 60p in the pound is better than nothing.

The other thing to bear in mind is that while there may be a disincentive to save under today's rules, there is no guarantee that future governments won't change these rules. I think it is almost inevitable that they will, so having your own money tucked away is the only way to plan for that."

Advisers also point out that there are advantages to saving in a pension, even for those close to the benefit line. You can take 25 per cent of your pot as a tax-free lump sum when you retire, and if your pension is less than £16,500 you can take it all back as cash rather than having to buy an annuity with it, although three-quarters of it will be counted as income for tax purposes.

Further, if your employer agrees to match your contributions it is usually worthwhile joining a scheme.

To understand how the means-testing system will affect your pension saving, you need to know how much state pension you are likely to get. You can do this by contacting the Pensions Service on the number below.

You can also work out how much pension you are likely to accrue through your own saving by using one of the many online calculators. Hargreaves Lansdown's, at the address below, is one of the better ones.

Finding out just how much you need to save to take yourself out of the benefits system can come as a shock, and the older you are, the harder it is. Hargreaves Lansdown calculates that a 35-year-old on course for average state pension needs to pay £66 a month just to beat the benefits trap.

Leave it another 10 years and that figure rises to £115.

But burying your head in the sand is not an option, unless you are comfortable with the idea of relying solely on the state in retirement.

A late start

Aileen Caskie, a freelance marketing director from London, is only now starting to realise the cost of not having been a member of a company pension scheme for the past two decades.

At 42, she has a pension pot of just £7,000, only enough to buy her an income in retirement of barely £350 a year.

She says: "I am horrified to realise that I need to save so much more just to get off benefits in retirement."

Ms Caskie has just taken advice from Bestinvest, an independent financial adviser, and is now going to put £300 a month into a low-cost Self-Invested Personal Pension (SIPP), investing into the firm's multi-asset portfolio.

She said: "£300 a month is a lot to pay in, but if I don't start now then I could be living off the state in retirement."