The Big Idea In Pensions

The government has unveiled its solution to the problem of retirement saving: the personal account. Here's how it will work.

The government has unveiled its latest idea to solve the UK's pensions crisis: the personal account. The details were in yesterday's White Paper.

From 2012, workers aged at least 22 who are not in comparable company pension schemes will automatically be enrolled in personal accounts, although they will retain the right to opt out.

In this national scheme, working people will be required to contribute 4% of their salary, employers will add 3%, and the government will chip in 1% in the form of tax relief, making a total of 8%. Higher-rate (40%) taxpayers will be able to claim extra tax relief, probably in the usual way via their annual tax returns or by completing a form PP120.

However, contributions will be paid only on earnings between £5,000 and £33,500, with an annual limit for total contributions of £5,000 a year (£10,000 in the first year). Naturally, there will be choice of investment funds, so workers can decide into which they would like to contribute. However, they will not be able to transfer existing pension plans into their personal accounts, nor transfer money out.

The government estimates than around ten million workers (more than a third of the workforce) are not in employer-funded pension schemes. It also reckons that the introduction of personal accounts will boost pension contributions by up to £8 billion a year.

The good news is that the sheer size of this scheme will make it much cheaper to administer than company or personal pensions, so its ongoing charges should be modest. Estimates suggest that the ongoing cost of the scheme could be as low as 0.3% a year, making it an attractive alternative to personal pensions.

The introduction of this scheme is a step in the right direction, in particular because it will help tackle the lack of retirement planning among young people and lower-paid workers. However, any universal system is bound to have its critics.

Indeed, many employers (particularly small businesses) will be opposed to its introduction, because it forces them to contribute towards their workforce's retirement saving. Nevertheless, pensions are simply a form of deferred pay, so this 3% compulsory contribution could be paid for simply by skipping a single annual pay rise.

Although the government is keen to address the problem of pension funding, the odds are stacked against it. This is largely down to lengthening life expectancy and an ageing population. At present, there are three workers for each pensioner; by 2050, this ratio will have dropped to 1:1. Also, by 2012, the government plans to restore the link between the state pension and earnings. As earnings tend to rise faster than inflation, this extra cost will probably have to be paid for by higher taxation.

Hence, alongside these changes, the government has other plans to cut the ever-growing cost of providing state pensions, including raising the state pension age to 68 for both men and women. The state retirement age will rise to 66 in 2024, 67 in 2034 and then reach 68 in 2044.

Although it's tempting to hope that the government has your best interests at heart (yeah, right!), the only person who can properly plan your financial future is yourself. If you want a decent income in retirement, you'll perhaps need to pay in twice as much this scheme requires. For example, 16% of your income each year from age 25 to 68 would probably produce a pension worth half of the average wage at that time.

Finally, although the government is happily tinkering with the state pension, it displays a serious reluctance to tackle the massive, unfunded cost of public-sector pensions. With almost one in four workers (seven million people) being employed directly or indirectly by the state, the cost of providing generous pensions to public-sector workers is unimaginably vast.

One estimate puts this liability at around £1 trillion, which is around twice the 'official' total for the national debt, or £40,000 per household. Again, until the government grasps this particular nettle, its pension predictions simply won't hold water!

More: Learn more about retirement and pensions.