For many of the 12m people with a broken work record, making up missed National Insurance contributions could be the best financial decision they ever take. John Greenwood does the sums
Millions of mothers, part-time employees and people who have worked abroad are missing out on the best value pension on the market by not buying back state pension credits.
Bargain hunt: buying back missed years of state pension credits is 'staggeringly good value'
Some 12m people, the majority of them women, are on course to retire without a full basic state pension because they have broken work records. But for just £7.55 a week, roughly the cost of a packet of nappies or a couple of glasses of wine, anyone who does not pay National Insurance Contributions (NICs) can buy a pension worth more than £125,000.
That is the pension pot a woman aged 60 would need to buy an annuity to match the inflation-linked income she would get from a full basic state pension, which is currently £84.25 a week.
If you have a broken work record, the chances are that you will have received a letter from HM Revenue & Customs reminding you of your right to buy extra entitlement through "Class 3 National Insurance contributions". What that letter will not tell you is what a fantastic deal you are being offered.
Buying back missed years of basic state pension entitlement is staggeringly good value, provided you do not expect to be relying on benefits for the majority of your retirement income, which is probably why the Government does so little to advertise it.
The Revenue says less than one person in 20 takes up their right to buy back state pension entitlement, which means that a massive number of people with broken work records are missing out.
Experts say filling gaps in your National Insurance contribution record with Class 3 contributions, also known as "voluntary contributions", is the first priority for anyone who is not on course to retire with a full basic state pension, particularly for those nearing retirement, who save most by buying back earlier years' contributions.
"Making voluntary contributions is a no-brainer if you haven't built up enough to get a full state pension when you retire," says Michelle Cracknell of Origen, the independent financial adviser.
"Whether it is women who have had career breaks for children or anybody who has worked overseas for a considerable period, buying back years is the most cost-effective form of pension saving you can make."
It costs just £7.55 a week to buy back the basic state pension entitlement, which adds up to £392.60 a year. If a woman paid an equivalent amount into a private pension for the 39 years it would take her to get the full entitlement, she would build up a pot of just £57,264, assuming annual growth of 5 per cent a year on her fund and tax relief of 22 per cent. This is less than half the £125,000 she would need to buy an equivalent income privately through an annuity. Put another way, she needs only to live to just under 64 to be better off.
"Most people think £84 a week or £4,400 a year is nothing, but they don't realise how much money they need to get this income when they are retired," says Billy Burrows of William Burrows Annuities.
And buying back state pension rights is set to get even cheaper for anyone under the age of 60 on April 6 2010 because the Government is planning to reduce the qualifying period for a full pension from 39 to 30 years for women and from 44 to 30 years for men.
A woman under the age of 56 today who is saving in a private pension rather than buying back missing state pension credits would see her pot grow to a meagre £35,019 in the 30 years she could have been buying her state pension worth £125,000.
While making claiming back extra years even more valuable than it already is, the new rules, which are expected to go through Parliament before April, also mean fewer people will need to claim extra years to get the full state pension.
Last month the Revenue issued a warning that anyone who is currently making voluntary contributions and is on course to retire with more than 30 years' credits may want to stop paying into the state system because it will not make them any better off.
You can claim back voluntary contributions for gaps in your National Insurance payments going back as far as 1996, although from 2009 you will be allowed to backdate only six years. If you have already reached state pension age and find you are not entitled to a full basic state pension, you are still allowed to buy back credits as far back as 1996 although you cannot buy them back for the year of your retirement.
Parents with children under 16 and people who care for disabled or elderly friends or relatives for more than 35 hours a week get help towards their state pension through Home Responsibilities Protection, but this does not fill in missed years of basic state pension; it simply reduces the number of years someone needs to contribute to get a full state pension.
But the basic state pension does not pay out at all if you do not have a minimum 25 per cent of the contributions you need for a full pension. This means that even though Home Responsibilities Protection could reduce the number of years you need to qualify for full pension to perhaps 20 years, if you do not have five years' contributions you still get nothing.
This can mean that many women who do not work because they are looking after children or are stuck in part-time jobs below the National Insurance threshold can end up with no basic state pension at all.
Married people who have not worked throughout their working life can opt to be treated for state pension on their spouse's contribution and will receive 60 per cent of their entitlement. Alternatively, they can buy extra years if they think this will take them above the 60 per cent pension they would get through their spouse. Where both spouses have a full contribution record, both receive the full pension of £84.25p a week.
The Government's pensions White Paper proposes changing this complex system to make it fairer to non-working parents and other carers. Changes are set to take effect in 2010 and a lot of people will no longer need to make voluntary contributions. But despite this, millions of people, whether they reach 60 before then or not, could be missing the bargain of a lifetime by not buying back those years they have missed out of the National Insurance system.
The key questions about extra contributions
How do I know whether I should claim or not?
You need to get a pension forecast by completing form BR19 at the Pension Service website www.pensionservice.gov.uk. Alternatively, you can seek advice by telephoning the HM Revenue & Customs National Insurance inquiry line on 0845 302 1479 or by contacting the State Pension Forecasting Team inquiry line on 0845 3000 168. You can then calculate whether you will have enough years' contributions by the time you retire.
How many years' contributions do I need to get the full basic state pension? Women currently need 39 years and men need 44 years. However, from 2010 this is expected to be reduced to 30 years for both sexes. This means anyone born after April 5 1950 will need only 30 years' contributions for a full pension.
Why do men have to pay more than women? This is because the retirement age for women is currently 60 (but it will rise to 65 by 2015). If you are a man aged between 60 and 65 and you are not paying contributions on earnings because, for example, you have taken early retirement, you will get NI credits.
Are there any other benefits of paying National Insurance contributions? Your spouse will get a bereavement payment in the form of an immediate tax-free lump sum payment of £2,000 if he or she is widowed before you draw the state pension.
How are voluntary contributions paid? You can pay by cheque direct to HR Revenue & Customs for previous years. You can pay for the current tax year by direct debit.
Will anyone lose out by buying extra years? Some people on very low incomes will lose out because their means-tested benefits will be reduced. Buying extra years is less beneficial for younger people because the money they pay into the system would grow for longer if it was invested rather than put into the state pension.
The above article is reproduced with kind permission of Telegraph Media Group Limited