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One of the best ‘income’ investments you can make

Yield hunters shouldn't forget the state pension, writes Citywire's Income Investor columnist.

 
One of the best ‘income’ investments you can make

There are many ways to be an ‘income investor’, in the sense that many investments yield an income stream.

This does not have to be restricted to savings accounts and stock market securities (which I focus on). For example, property acquired on a buy-to-let basis will (usually) yield an income stream, although this strikes me as hard work, in terms of the admin and uncertainty involved. (My litmus test for ‘effort’ is: can I do it on my laptop, lying in bed in the morning?)

So looking at a paper from the University of Birmingham on the distribution of wealth (identified by the quirky Simple Living in Suffolk blog) made me think a bit more about my state pension.

Because my entitlement to state pension grew without much fanfare in my early working life – and required virtually no decisions – it receded into the background noise of my finances. Much more front and center were decisions about my company pension, including Additional Voluntary Contributions – primarily as a way of avoiding higher-rate tax. So, over my working life (which has recently come to a possibly premature end) I haven’t thought much about my state pension.

For simplicity, let’s consider just the basic state pension for a single person (and ignore other state pensions and related benefits): this is worth up to £107.45 a week or £5,587.40 a year. Not a huge amount (compared to the average salary), although it is expected to increase respectably over the next couple of years. But the point about the Birmingham University study is that they included the entitlement to state pension as part of ‘wealth’. This makes sense, of course, as pension entitlement is – in income terms – no different to any other financial asset. Indeed, the study defines wealth as: ‘a stock of economic resources compared with income which is a flow of resources’.

So how to value this (potential) income stream? I couldn’t find an explanation of how this was done for the Birmingham University study but it is possible to do this fairly crudely, using a benchmark yield - for example those used in calculating annuities. It turns out that these vary, so taking what seems to me to be a reasonable range of investment yields - 4% to 5% - gives an equivalent capital value of £110-140k.

Now, it seems to me that this is a non-insignificant amount of capital and I am glad to be able to add that to my notional wealth.

There is an interesting footnote to add. Payment of the full state pension is contingent on having 30 years’ accumulated contributions. If for any reason you are likely to be short of this minimum, it might well be worth your while to consider making up the difference by voluntary contributions. I myself have made up some missing years, as a result of being out of the country for a while. Another area where this might be relevant is a result of changes in the rules for ‘stay at home’ mothers, which means that those with older children no longer receive an annual state pension credit. As a result they may be invited to pay a one-off annual contribution to help complete their 30-year total contribution record.

Compare the stream of increased pension payments against the cost of the contribution (and making assumptions about - not to put too fine a point about it - survival) and this may be one of the best ‘income’ investments you can make.

If you've enjoyed this article, why not visit DIY Income Investor's blog. The views in this article are the author's own, and do not constitute advice.

20 comments so far. Why not have your say?

sgjhaghsdg

Feb 14, 2013 at 11:53

Those with fewer than 35 years of contributions (and no S2P to plug the gap) will need to look carefully at the changes coming along in 2017 before deciding whether to buy past years via Class 3 contributions.

They may also want to see whether voluntarily paying class 2 might be better for them as these years or self employment *will* count towards the new £144 pw flat rate.

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Keith Hilton

Feb 14, 2013 at 12:32

As this is RPI linked (for now) it's worth more like £160K, based on a 3.5% annuity at age 65.

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Andrew McDonald

Feb 14, 2013 at 13:55

Silly article. there will be no state pension as in the future it will be means tested. Those who have saved will be disadvantaged.

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steven fieldfare

Feb 14, 2013 at 14:08

This article is useful in illustrating the attraction of full qualification.

A sequel article would be even more useful over how or whether to draw State Pension on qualifying. Much depends on health and circumstance but there seem choices, iniquities and potential pitfalls.

First, is it worth accumulating the State Pension under the Government's interest scheme? Is it worth drawing State Pension and diverting it into a SIPP?

Next, while Government now allows additional earning while drawing State Pension, no such opportunity has been extended to Carers who have to choose one or the other (de facto meaning that they lose Carer's Allowance on qualifying for State Pension, without opportunity to work).

And potential pitfalls over tax. OK for Government to add interest to reward deferred pensions, but what happens when this is eventully drawn. Is all the tax sledged on in one year where a 40% rate might well more than clawback the interest reward?

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David West

Feb 14, 2013 at 14:43

@ Andrew McDonald

Not a silly article at all. Well written and very informative. Who knows what will happen in the future. All one can go on is the information we have now and to be overly pessimistic about what might happen decades down the road, is in my opinion silly. Articles of this type should be encouraged and not dismissed out of hand in 24 words.

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StepM

Feb 14, 2013 at 15:04

Agree with Andrew, state pension will disappear for those who have made their own provisions, or will be so heavily taxed it won't be worth having. To me one of the biggest injustices (brought on by politicians incompetence) is making future pensioners suffer whilst not making curent pensioners share some of the pain. After all, most curent pensioners have paid in only a fraction of what they get out. Not fare at all.

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jeffian

Feb 14, 2013 at 15:27

Indeed not silly. Who knows what may happen in the future, but for those approaching retirement age in the near to medium term this is very sensible advice. My wife was a stay-at-home mother and I discovered in 2005 that without AVC's she would only be entitled to only 31% of the state pension (in those days you had to clock up 39 working years). I paid £2719.60 to cover the years 1996-2004 and £3075.80 to cover 2004-2009 (by which time she only had to show 30 working years) and she obtained her full pension last year. By increasing her entitlement from 31% to 100%, that produces an additional £3940 per annum for a cost of £5795.40. That's a 68% return on capital or payback in 1.5 years. You'd be mad not to.

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simon mulliner

Feb 14, 2013 at 16:51

The government should adopt the state pension system operating in Australia - has to be invested in the Stock Market not paid out of taxation

Investing in the Stock Market can help keep the market buoyant even in an economic downturn)

The state owns the pension fund until retirement at 60 for both sexes when each person takes over ownership of their state pension fund

Compulsory for all citizens (born in the country or granted citizenship after entry)

The state pension is tax-free for life - annual payments from the pension fund are capped to ensure there is sufficient funds in the pension pot

The government only taxes the state pension when it is spent on goods and services - you have greater choice in how much of your annual pension you want to spend, on what and when and where

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William Phillips

Feb 14, 2013 at 17:14

"Silly article. there will be no state pension as in the future it will be means tested. Those who have saved will be disadvantaged."

Lord save us from knowall prophets of doom.

Good article, btw.

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Brian Barber

Feb 14, 2013 at 17:17

@StepM

No, not silly but well-reasoned. As far as current pensioners only having paid in a fraction of the payout goes, I think this is wrong. Of course, to test this claim would require a complex calculation adjusting past values (right back before the great inflation of the 1970s) to the present day. I doubt if StepM has done this, and therefore would be well advised not to make unsupported claims! An additional point is that employees who were compulsory members of their occupational pension scheme, also had to make an enhanced " opted out" contribution to the state pension scheme. In truth, I have no idea whether or not the State Pension is a good deal, but as we can't avoid it , it's an academic question!

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gggggg hjhjkl;'

Feb 14, 2013 at 17:36

Good article!!

I have just received my state pension. The government changed the rules to 30 years and saved me having to buy 8 years of additional contributions.

Had I needed to, I would have purchased the additional years without hesitation.

For me, like taking my pension immediately, it was a no brainer.

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ruth karp

Feb 14, 2013 at 18:53

carers allowance is stopped when the pension is awarded..

so unfair! after all other people can go to work to earn

extra money.. the carer works very hard for the pittance

available.. then as they get to pension age, it stops!

so unfair... on call usually day and night.. more than the

hours required. help the CARERS

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David West

Feb 14, 2013 at 21:56

@ StepM

Just how should current pensioners, in your opinion, share some of the pain. I am three years away from drawing my retirement pension. I left school at 15 and have worked ever since. What should I do, in your opinion, to share some of the pain. Incidentally I have not rawn any kind of benefit over those years.

People like me who have worked all their lives deserve something back surely. What I am likely to receive will not be a lot of money but I will be grateful that I have it. Get real StepM and stop being so mean minded. The world does not owe you a living at the expense of people currently drawing or about to draw their retirement pension.

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Kristine S-O

Feb 15, 2013 at 07:19

State Pension-wise I lost out in the past, present and will loose out in the future just because of rules - and changing rules.

For people in my age group who retired at 6o ten years ago, full contributions for a full state pension meant having 38 years that qualified as contribution years. You could buy contributions to turn past non-contribution years into contribution years, but not further back than the last 6 years. So I do not get the full state pension which does not seem very fair.

Someone retiring now with the same number of contribution years as I had, gets full state pension and without needing to back pay any years, because the "working life" you need for a state pension has been changed to a mere 30 years. Is this fair!

For the future, people in my age group already retired will not qualify for the new flat rate pension of £144 a week, so I still will not get the full state pension. In fact, very far from it. Unfair again!

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Graham Barlow

Feb 15, 2013 at 09:48

My advice to anyone who are keen to put something by for retirement is take every advantage of the Tax savings for Pensions .and do your homework constantly on the ever changing State system. Through vigilance I managed to put a company scheme into Serps at the most propitious moment for the bulk of the Pensioners, which turned out to be a batgain in relation to commercial Pension investment returns. The state boosted everybody's annuity rather nicely , index linked. Also the opportunities to build an ISA are fantastic. Nearly £12000 allowed this year. If you have the ability to put money by, an ISA invested in high yield securities is a must. You could build a £200000 fund with Tax free income and free from capital gains, and for those who have a bit of knowledge you can manage your own portfolio on an execution only basis.

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Steve Wilson

Feb 15, 2013 at 17:28

And if you don't 'need' to take your state pension when you reach the magic age, you may defer it. When you do eventually take it, you may opt for the back payments to be taken as a lump sum (with interest at 2% over base rate p.a.), or for increased future regular payments (10.4% per deferred year, above what they otherwise would have been - but consider survival prospects!). Particularly useful if you are a higher rate taxpayer at state retirement age, but plan to become a lower rate payer later.

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sgjhaghsdg

Feb 15, 2013 at 17:38

After 2017, deferred SP won't accumulate as quickly and the option to take as a lump sum will be removed.

Lump sums work very well now as they don't push you into higher tax brackets. You can even take the whole lump at 0% tax if you reduce your drawdown to below your personal allowances.

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GARRY TAYLOR

Feb 17, 2013 at 08:46

I Retired early and had my full 30 years contributions the year i retired, which was 2005-2006. Now they say i have to have 35 years and remember you can only go back six years for the then rate of class 3 voluntary contributions. When they do finally make the 35 years the law, i like many others will have to pay another £3500 for those five years. This is not fair and many people will not have that cash saved for something they had already contributed enough.

When does this country ever do anything correct.

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P A Williams

Feb 17, 2013 at 10:24

@Stepm

You should stop making unfounded and incorrect, unsubstantiated comment.

The majority of those either retired or approaching retirement were forced to pay NI and additional contributions into SERPS (unless formally contracted out and then you still had to pay into a personal or private scheme) and therefore have paid for their state pension. The biggest injustice (brought on by politicians incompetence) is diluting the contribution rules i.e length of time to qualify, so ALL or more often underserving retiring people can be paid. Do your homework Stepm before making any more stupid comments.

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sgjhaghsdg

Feb 17, 2013 at 10:40

I have made my own pension contributions, and also paid heavily into the state pension via both employee's and employer's NI. As a result, my projections show that I will be paying more tax pa in retirement than I will be getting in state pension!

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