The pension book's fatter but we still need to save

Employees on lower than average earnings who retire in the 2050s could get £270 a week - in today's prices - in pension payments following sweeping changes to the system proposed last week. But they shouldn't bank on it, say experts.

This is the total amount a 21-year-old could receive at the new retirement age of 68 if reforms proposed in the pensions white paper go ahead unchanged. The figure includes the basic state and state second pensions - £135 in today's money - which has been worked out by the Department of Work and Pensions, and a calculation of the return on an investment in a new low-cost 'personal account' - also £135 in today's money - worked out by accountants Grant Thornton. We have listed the assumptions they made at the end of this story, but Grant Thornton stresses that the resulting pension could vary dramatically if these assumptions change by just a tiny amount.

Despite the fairly encouraging projection, investment and insurance companies warn employees that they should not rely on improvements in the state pension scheme to fund their retirement.

Simon Fraser of Fidelity International says: 'People should not be lulled into a false sense of security by these reforms. Obviously they are welcome, but for the typical household it will not have the impact on their standard of living in retirement that people are expecting, especially as these reforms are not going to happen overnight.

'It is important to note that the link to earnings will not even be implemented until 2012 and therefore will not begin improving the situation for another six years. On current trends, people are still facing a 50 per cent drop in income unless they start saving more now.'

Ian Naismith of Scottish Widows agrees: 'The only way to secure a comfortable retirement is to take matters into your own hands and start saving for yourself today, not tomorrow.'

As expected, the white paper incorporated most of the recommendations made by Lord Turner (pictured below) and the Pensions Commission. These included changes to the qualifying period for the basic state pension, enabling many mothers and carers to receive the full provision for the first time; introduction of a low cost private pension scheme to which employers must contribute; a higher retirement age of 68; and restoration of the link to earnings.

The white paper has been welcomed by all except the Confederation of British Industry, which had lobbied hard against the idea of obligatory employer contributions.

Gordon Lishman, Age Concern's director general, says: 'Women and carers are the clear winners today. For too long, women have been penalised by an outdated pensions system, designed for the world of the 1940s, not the 21st century.' However, he urged the government to introduce the changes immediately rather than wait until 2012, when most are due to come into effect.

What are the changes and who benefits?

· Men currently have to make National Insurance contributions (NICs) for 44 years and women for 39 years, but time off to care for children and others has led to only 30 per cent of women receiving a full pension, compared with 85 per cent of men. From 2010, men and women will have to have made NICs for 30 years to qualify for the full basic state pension. This is expected to enable 70 per cent of women reaching state pension age in 2010 to receive the full pension.

The government also plans to replace Home Responsibilities Protection with a weekly credit for those caring for children, and to introduce a contributory credit for those looking after severely disabled people for 20 hours or more a week. This means carers can build entitlement to the state pension without having to make a minimum level of NICs.

These changes mean that by the 2050s anyone who has been employed or has been a carer for about 40 years could receive £340 a week in total state pensions - £135 a week in today's money.

· The government aims to reinstate the link between earnings and the state pension by the end of the next Parliament at the latest. Justin Modray of Bestinvest says: 'When the link was scrapped in 1980 the state pension [£23.30 per week] was 23 per cent of average earnings, whereas it is now 15 per cent. Had the pension remained linked to earnings it would now be £119 per week rather than the current £82.05.'

· An increase in the state pension age to 68 will be phased in, beginning with a rise from 65 to 66 over a two-year period from 2024, then to 67 over the two years from 2034, and to 68 over the two years from 2044. This means anyone aged 47 or above now will still get the state pension at the age of 65. But someone aged 38 to 46 now will get their state pension at 66, someone aged 29 to 37 will get theirs at 67, and anyone aged 28 or under will have to wait until they are 68.

· A low-cost private pension savings scheme, called the personal account, will become available in 2012. Employers who do not already contribute to an occupational scheme on behalf of their employees will have to pay in a minimum of 3 per cent of a band of earnings - probably between £5,000 and £33,000 a year.

The white paper suggests the contributions could be phased in over three years to help businesses cope with this new cost. Employees will be automatically enrolled, paying in a minimum of 4 per cent of the same band of earnings, and will have to opt out if they don't want to make contributions (in which case employers will not have to make contributions either). The government will add a further 1 per cent for basic tax payers, and more for those paying the higher rate, in the form of normal tax relief.

The government believes about 10 million people will be eligible for automatic enrolment into a personal account, and estimates that between 5 million and 8 million will remain enrolled. The scheme will be thrown open to the self-employed and non-workers, although they will not benefit from employer contributions.

· Contracting out of the State Second Pension will be abolished and, from about 2030, it will be switched to a simple, flat payment to top up the basic pension.This will result in smaller pension payments for higher-rate tax payers.

· Means-testing will be limited to one third of pensions by 2050, compared to the expected three-quarters who would qualify if the system remained unchanged.

· The figures are based on based on assumptions that long-term inflation will be 2.87 per cent, earnings inflation 4.87 per cent, and investment inflation 6.37 per cent. The calculation by Grant Thornton assumes that the employee, earning a start salary of £23,700 in 2012 (£20,000 today), has benefited from 8 per cent contributions to this personal account from the age of 21 until retirement at 68. On retirement in 2059 he will have a fund worth £554,842 - equivalent to £146,757 in today's money. It also assumes that the contribution bands will increase by the retail price index each year (although this has yet to be determined), and that an annuity rate of 4.8 per cent will apply on retirement. This would produce a weekly pension of £135 in today's money. However, Grant Thornton points out that annuity rates will fall as medicine advances and people live longer, producing a lower pension income.