Pay attention if you earn less than £33,500

If you earn between £5,034 and £33,540, new pension plans could push down your pay packet by 4% a year.

Stakeholder pensions were once thought of as the white knight which would come to the rescue of a very distressed UK pension system. The initiative saw many employers setting up brand new schemes which promised easy access to employees across the land, while promoting a vast increase in pension saving into the bargain.

Several years on, four out of five schemes lie as nothing more than empty shells and the system continues to teeter on the brink of disaster. Worse still, 750,000 employers still offer no work-based pension provision at all.

NEST

Now that can hardly be considered a resounding success, so what's the answer?

Government reforms to private pensions will see the introduction of NEST - or the National Employment Savings Trust – which is scheduled for launch in 2012. The legislation is expected to be phased in, affecting the largest employers from 1 October 2012 and the smallest from 2016.

The scheme will apply to you if you’re aged between 22 and State pension age, and you earn more than £5,034 but less than £33,540. (These earnings figures are based on 2006/07 earning terms and will be uprated to 2012 levels when the scheme is due to launch.)

NEST - which was previously known as Personal Account – has a similar underlying purpose as low-charging stakeholder pensions. That is, to encourage more people to save for their retirement - but this time there will one or two key differences that will set them apart from schemes that have gone before. 

Auto-enrolment & compulsory contributions

For one thing NEST will operate under a system of auto-enrolment. This means you’ll automatically become a member unless you specifically choose to opt out.

What's more, employers will eventually be expected to make compulsory contributions of 3% of band earnings (remember the band is expected to range between £5,034 and £33,540 and uprated for 2012). Meanwhile, employees will make their own contributions of 4% with the Government topping that up by a further 1% through tax relief.

So that means, if you aren’t already making contributions into a pension, your salary will have to drop by 4% to meet the new pension rules – unless you choose to opt out.

Total payments to the scheme will equal 8% of earnings between £5,034 and £33,540. Employers which offer an existing pension will have the right to retain their original scheme as long as employees are auto-enrolled and the minimum contributions are made.

NEST also has an overall annual contribution limit of up to £3,600 a year. An annual 8% contribution of salary for an average earner would be around £1,605. This is based on average earnings for 2009 of £25,100 (according to the ONS). This means you and/or your employer could double contributions without exceeding the contribution cap.

NEST will offer flexibility over contribution levels as long as the minimum levels are met. The scheme will also be portable so you can take it with you as you move onto new jobs.

Will it work?

Estimates suggest that NEST will create around five million new pension savers. But given that the self-employed will be excluded and the opt-out rate is unknown, I'm concerned that the proportion of people who will fail to see any benefit from the new scheme could be significant.

It's easy to see how auto-enrolment should do away with people's inertia about making pension contributions, but the principle comes with inherent drawbacks. After all, participation will be forced when it isn't necessarily suitable for you. For example, compulsory contributions may be not affordable, particularly if you’re a low earner or you have higher levels of personal debt.

The additional costs faced by employers in setting up the scheme and enrolling members could result in a lower incidence of more generous contributions rates. Currently, 15% of private sector work-based schemes provide employer contributions which exceed 3%, but the new scheme could see this percentage fall as costs rise. Should employers choose to contribute no more than the 3% minimum, then by 2050 total contributions could be £10 billion lower than it would have been without these reforms.

If, however, employers decide not to pass on the costs of the new scheme, the total annual pension contribution made by a combination of you, your employee and tax relief, could increase by around £10 billion in 2012, according to the Pensions Policy Institute. That's why it's widely accepted that for NEST to be considered a success, employer contributions must exceed the compulsory 3% rate.

Pension income disregard

The Government's attitude to UK pension provision has often been criticised for its impact on means-tested benefits, and the subsequent disincentive for lower earners to save for retirement. Savers have found that low levels of pension income have made them ineligible for means-tested benefits including the pension credit, housing and council tax benefit.

It seems a ridiculous scenario that you could be no better off after saving into a pension, if those savings are effectively ‘cancelled-out' by a reduced entitlement to state benefits. For NEST to work there’s a need for what’s known as a ‘pension income disregard' which means the first slice of your pension income won't have an impact on means-tested benefits.

Under the current system there is a disregard for capital which allows the first £10,000 of capital - such as savings or ISAs - to be discounted when calculating your entitlement to means-tested benefits. Treating pension income in a similar way is, in my view, crucial to the success of the reforms as this reduces the risk of participating in a system which might be unsuitable.

This should give a clear message of the value of saving in NEST.

To combat the pensions crisis it must specifically target low to moderate earners who don't already have access to work-based pension schemes, while ensuring that disincentives to save are effectively dealt with first. Auto-enrolment and compulsory contributions are certainly more radical than previous initiatives. Only time will tell if they’re the solution...

This is a classic lovemoney.com article which has been updated for 2010.

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