More than six million workers face paying hundreds of pounds more tax each year under the Coalition’s plans for a new flat-rate state pension, government sources have admitted.
The new pension could be worth as much as £155 a week when the scheme starts in 2017. It is expected to be announced early next week and will replace the current complex system under which pensions are linked to lifetime national insurance payments.
But millions of workers face paying more tax through increased national insurance contributions if they are currently part of final salary occupational pension schemes.
Those affected are expected to include around 1.4 million private sector staff who are enrolled in final salary schemes and contracted out. They are likely to be long-term employees of large companies. Another five million public sector workers in similar schemes, from teaching assistants to surgeons and top civil servants, will also face the higher tax.
It will give the Treasury a multi-billion pound windfall in the early years of the pension reform.
“A single-tier pension will be a huge improvement on the current system, but for some people, there is an upfront cost they will have to pay more,” a government source confirmed.
Under the current rules, workers in final salary schemes can opt out of the earnings-related State Second Pension known as S2P and formerly known as Serps and pay money into their occupational pension instead.
The majority choose to do so because it is financially beneficial.
To reflect the fact that they do not get the second state pension, such “contracted out” workers pay a lower rate of national insurance. Their employer’s bill is also reduced.
The new single-tier pension will do away with S2P and the contracting out rules, leaving many workers and employers paying more national insurance.
For workers, this is likely to mean an effective tax rise of 1.4p in the pound.
According to Hargreaves Lansdowne, a financial services firm, an employee on £25,000 will pay an extra £270 a year in national insurance. For someone paid £40,000, the increase will be £481.
Large organisations, including the NHS, will also have to increase their employer’s national insurance contributions by as much as 3.4p in the pound.
The biggest beneficiaries of the flat-rate pension will be part-time workers, carers and people who take time out of work to bring up their children. The self-employed could also gain. But some higher-paid workers will get a smaller state pension than they would have received under current rules.
Analysts said that many workers who would have to pay more national insurance would ultimately benefit, as the flat-rate pension they would get on retirement would be significantly more than they would get under the current rules.
Tom McPhail, of Hargreaves Lansdowne, said: “Employees are going to be upset because they’ll pay more, but many of them will end up doing better out of this.”
Employers who offer final salary pensions face much larger increases in their national insurance payments.
For each worker paid £25,000, an employer could have to contribute an extra £657. For a worker paid £40,000, the employer’s increase will be £1,168.
Those costs have led to warnings that many of the 6,300 or so remaining final salary schemes in the private sector will be forced to close.
Mr McPhail said: “It will prompt another round of scheme closures.”
Ministers have previously suggested that the flat-rate pension will be worth £140 a week when it is introduced after the next general election. However, the eventual level could be higher. The flat-rate pension was first promised in 2011, but final details of the scheme have been repeatedly delayed. The new rules will not be in place before 2017.
The impact of the national insurance changes on large public sector employers is understood to have caused a Whitehall row. Workers and employers will start paying higher contributions as soon as the reform is in place, but many staff will not receive the pension for decades.
That could mean a windfall of billions of pounds for the Treasury in the early years of the new rules.
The Department of Work and Pensions has said that the extra cash will not be needed to fund the pension itself, but other departments are seeking a share. The NHS and local education authorities are among employers facing the biggest costs because of the change, as their national insurance bills grow.
Jeremy Hunt, the Health Secretary, and Michael Gove, the Education Secretary, are said to be pressing for some of the windfall to be returned to them.
There are hopes that private pension incomes may rise by a quarter with a predicted recovery in the interest rates paid on government borrowing. Annuity rates are linked to government gilts, whose yields have fallen to record lows during the financial crisis. Some experts say they could double within two years.