“What’s it worth?” Valuing the UK state pension for an individual.
By ONFife / Fife Cultural Trust, CC BY-SA 3.0, https://commons.wikimedia.org/w/index.php?curid=107546951
by Doug Brodie
/5. The arithmetic, in full…
State Pension Replication Using the 0.25% IL Treasury Gilt 2052
Health warning – this is overkill and will not provide a finite sum.
Firstly: the outline that the government follows you can find on the Debt Management Office’s website here: https://www.dmo.gov.uk/media/0ltegugd/igcalc.pdf
Secondly: if you want an income of £X that lasts in perpetuity and has no risk of running out of money – which is always our preferred approach – take the income needed (in this case £12,547 the UK state pension) and divide by the yield of that investment. For matching the pension in last week’s article, we assumed 26 years till the pensioner dies, so picked an index linked gilt maturing in 2052, with a yield of 1.65%. Hence £12,547 / 0.0165 = £760,485 (and wait till you see what index linking does to the maturity value).
Thirdly: both an annuity and the State Pension will continue to pay until you die at what ever age that may be, without limit. A gilt solution always requires an end date as to when the income stops / the gilt matures.
When you die, your state pension dies with you, so we could have / should have used an annuity rate for comparison. In the table above that shows a value of £229,762 for an RPI-linked annuity for life. However:
The RPI annuity does not include a minimum annual increase of 2.5% like the state pension
Unless the strategy to generate income is yield only, the income will be driven by selling down capital which has two unsolvable factors:
Selling down the capital means the money will run out, perhaps before your life does.
When you sell down the gilts you sell them in the market and you will only receive the market price at the time. Theoretical modelling of long-term income from gilts assumes a constant RPI linked capital value, and this is not going to be correct. However, given we don’t know what the future prices will be when we need to sell down, we have modelled the income table assuming constant pricing.
Lastly, the gilts pay coupons twice per year, so we really should do date-based calculations but…
/5.1 Conventional Gilt Yield Calculations
The starting point of the conversation was a conventional gilt with the following characteristics:
Annual income yield (running yield)
Income yield = Annual coupon ÷ Price = £0.625 ÷ £68.00 = 0.92%
Approximate gross redemption yield
GRY = [Coupon + (Redemption − Price) / Years] ÷ [(Redemption + Price) / 2]
= [0.625 + (100 − 68) / 9.2] ÷ [(100 + 68) / 2]
= [0.625 + 3.478] ÷ 84 = 4.88% (approximate)
A more precise iterative calculation places the GRY at approximately 5.0% to 5.1%.
/5.2 Replicating the State Pension
The objective is to use the 0.25% Index-Linked Treasury Gilt 2052 to fund an income equivalent to the full UK State Pension of £12,547 per annum, rising with RPI at a fix of 2.5% per year.
Key gilt characteristics:
/5.3 Capital Required
Two approaches were compared.
/1. Coupon income only (capital preserved intact)
If the £12,547 must be funded entirely from coupon income, without selling any gilt:
Capital = annual income ÷ running yield
£12,547 ÷ 0.41% = approximately £3,060,244
[0.41% is the real coupon / the real price: 0.25p / £61.66]
The capital is preserved and returned (RPI-adjusted) at redemption in 2052. This is the cost of certainty in its purest form.
/2. Coupon plus capital drawdown to nil
First, you need to decide when the money is to run out. If both coupon income and progressive capital drawdown are used, with the redemption proceeds funding the final year's income, the present value of the income stream is calculated using the growing annuity formula:
Capital = £12,547 × [1 − (1.025 / 1.04755)²⁶] ÷ (0.04755 − 0.025)
£12,547 × [1 − 0.568] / 0.02255
£12,547 × 19.15 = approximately £240,316
Summary comparison:
/5.4 Year-by-Year Drawdown Table
The table below shows the full 26-year schedule on the coupon-plus-capital basis, using the corrected coupon rate of 0.42% (the actual RPI-adjusted current coupon). Income grows at 2.5% per annum in nominal terms. All figures are in nominal (current pound) terms.
Key parameters:
† Year 26 capital drawn represents redemption proceeds at par, not a market sale.
Coupon income declines as a proportion of total income in later years as the real gilt price rises toward par (pull to par). Capital drawn increases correspondingly.
/5.5 Key Conclusions
The State Pension of £12,547 per annum, rising with RPI, requires investment of approximately £3,060,244 if funded from coupon income alone on the 2052 IL gilt without spending any of the underlying capital.
If capital is also drawn down progressively, and the holding is run down to nil at redemption, the starting capital required is approximately £240,316.
The only certain yield on an index-linked gilt is the real gross redemption yield of 2.20%. The nominal yield of 4.755% is an assumed figure that depends entirely on what the inflation will be over the coming 26 years: in this example we have used a fixed 2.5% throughout the 26-year term.
The coupon provides only a small fraction of annual income throughout (approximately 13% in year 1, and 5.6% of all the 26-year income). Capital appreciation through the pull from £61.66 to par does the heavy lifting.
The RPI reform from 2030 (aligning RPI with CPIH) will reduce the effective inflation protection on this gilt. CPIH typically runs approximately one percentage point below RPI. This is a material consideration over a 26-year horizon.
In nominal terms, the income stream grows from £12,547 in 2027 to approximately £23,261 in 2052, with total nominal payments of approximately £451,839.
All calculations are illustrative and assume a fixed inflation rate of 2.5% per annum. Real-world outcomes will depend on actual RPI, gilt market prices, and legislative changes.
So - is it actually the right answer?
This is a technical piece, and some readers will read it twice, some will read it once, and a few will skip straight to the table. All three are reasonable responses. What matters is that the option is now on the table, in pounds and pence rather than in theory. How much is required to duplicate the state pension can either be £240k, £760k, £3.1m or myriad options in between: it very much depends on what the question is, and bear in mind that not even a contractually guaranteed RPI-linked annuity also includes a minimum 2.5% triple lock!
For a surviving spouse facing the loss of half the household State Pension, a single index-linked gilt held to maturity offers, today, a way to buy back the inflation-linked income that has disappeared, for approximately £240,000, with the income covered for 26 years and the capital running to zero at the end. For roughly another £2.8 million on top, the same income can be funded from coupon alone, with the inflation-adjusted capital intact at maturity in 2052. Most of our clients will find their own answer sitting somewhere between the two. (Holding the gilts in an income in possession trust with children as remaindermen would be an interesting scenario).
There are caveats, properly noted in Section 5.5, the RPI to CPIH transition from 2030 is one. The fact that the gilt produces lumpy semi-annual income rather than monthly is another and we have not considered the three-month indexation lag – none of these adjustments are relevant to the retail investor when comparing the alternatives being discussed. Tax on the coupon, where the gilt is held outside an ISA or pension, is another consideration.
About the author
Doug Brodie is Founder and CEO of Chancery Lane Income Planners. He has specialised in retirement income for over thirty years and is Chartered with both the CISI and CII. This article is general information and not personal advice. Tax rules can change, and the impact of any planning depends on your specific circumstances. Capital is at risk and past performance is not a guide to future returns.