Government’s pension White Paper not good enough
by Dr. Ros Altmann
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PENSION REFORM – MORE RADICAL CHANGE ESSENTIAL
A few years ago, we thought the UK had successfully addressed its long-term pension challenges. With more retirement savings in this country than in the rest of Europe put together, rising company or private pensions were expected to supplement falling state pensions, allowing Government pension spending to remain around 5% of GDP (despite the huge rise in numbers of older people). This complacency has been replaced by a growing realization that pensioners’ incomes are far too low and on current trends, both state and private pensions will fall further. As the population ages, this will mean long-term economic decline and we are facing a crisis, unless older people’s long-term income prospects are improved.
How did this situation arise?
In order to understand these problems, we need to go back to some basics. Essentially, pensions have two distinct functions: Firstly, they provide social insurance – the original idea was to ensure people who were genuinely too old to keep working could still survive. This would typically be considered a state responsibility. Secondly, the word ‘pension’ has come to refer to a private long-term savings vehicle – which would normally be an individual’s own responsibility. When it comes to pensions, however, the role of employers has caused muddled thinking. Paternalistic 20th century employers offered pensions to ‘reward’ loyal lifelong workers, but over time Governments asked employers to take on far greater social welfare burdens than originally intended, for example providing spouse cover, protection for job leavers, revaluation of leavers’ pension rights and even inflation- linking. Government also decided to encourage personal pensions for those without an employer scheme and private pensions were expected to grow over time.
Expectations of good private pensions became embedded in state pension policy.
UK pension policy, for many decades, has been predicated on offloading state pension costs and risks onto the private sector. Governments have continuously reduced state pensions, relying on generous employer final salary pension schemes and private pension funds – invested in equities – to provide increasing private pensions. The requirement for annuitisation of personal pension funds aimed to ensure pension savings would also deliver reliable pensions, thus offsetting falling state pensions. Until the late 1990’s, unusually high equity returns and relatively high interest rates seemed to validate this model, but this appears to have been an illusion. As asset prices and interest rates fell, it became clear that the costs and risks of private pensions are much higher than previously believed. In fact, they cannot be relied upon to deliver adequate pensions.
The problems have been compounded by the unique UK system of encouraging people to ‘contract out’ of the state pension system, effectively swapping their state pension rights for private pension promises. These ‘contracted out’ pensions are really privatised social welfare benefits. Unfortunately, however, many of those who contracted out of the state system have found that they are receiving far less from their private pension than they would have had from the state.
Transferring pension risk away from the state does not make that risk disappear. If the private sector does not deliver good pensions, or cannot afford the costs, the risk ultimately falls back onto the state anyway. This encapsulates much of our pensions problem. Neither state, nor private pensions are working effectively and an over-reliance on means tested benefits to supplement the inadequate state pension is undermining incentives to save just as employers are struggling with pension costs as longevity rises.
Problems of private pensions:
Employers are retreating rapidly from offering generous final salary pensions. As lifelong employment disappears, average job tenure declines, global competitive pressures intensify and corporate ownership changes frequently, companies cannot justify continuously trying to ‘run up the down escalator’ in an attempt to provide long-term welfare benefits that are provided by the state elsewhere. When moving to money purchase schemes, or relying on private personal pensions, employers and individuals are generally not contributing enough to provide the level of pensions that were expected from final salary schemes. The reduced expectations for future private pension income have thrown the inadequacy of our state pension system into stark relief.
Problems of state pension:
We have just about the lowest and most complex state pension in the developed world. The Basic State Pension (BSP) and earnings-related state second pension (S2P) each have different rules and qualification criteria. Since 1980, BSP has been uprated in line with prices, rather than earnings and has fallen significantly behind average earnings, thus becoming wholly inadequate for preventing poverty. In addition, many pensioners (especially women) do not even receive the full BSP, so millions ended up poverty. The Government recognized that state payments had to rise, but rather than increasing the BSP, the Government introduced the means-tested pension credit, designed to ‘target’ spending on the poorest. However, anyone claiming pension credit (close to half of all pensioners are eligible) loses at least 40% of their private pension income and many lose all of it. This has left a substantial proportion of the pensioner population being penalized for privately saving in a pension. Furthermore, there are still well over a million pensioners in poverty, due to imperfect take-up.
As mass-means-testing discourages the private savings needed to top up very low state pensions, our whole pension system has become unstable.
The recent White Paper proposals will stabilize the system
The Government claims that its proposals will make the state pension fairer and more generous and encourage a new retirement savings culture in which people will take personal responsibility for their pensions. This is expected to create a pension system that is ‘coherent, comprehensive and will stand the test of time’. I do not believe these aims will be achieved without far more radical changes than currently proposed.
Problems of proposed state reforms
Under the proposals, both BSP and S2P will remain, as will pension credit and the complexities of contracting out. Between 2012 and 2015 the Government will restore the uprating of BSP in line with earnings instead of prices and by 2030 S2P will become flat-rate, rather than earnings-related. New contribution tests will be fairer to women. The aim is to increase state pension income to the equivalent of £135 a week in today’s terms by 2050 (30% of median earnings). However, if the earnings link had been maintained since 1980, BSP would now be worth over £136.75 a week and we would not need pension credit! Thus, even by 2050, these complex reforms will only return us to where we could have been today, by just keeping BSP linked to average earnings. Not only that, but by 2012 the weekly BSP currently at £84.25 will be worth around £70 and by 2015 just £67, so the proposed reforms will not help pensioners immediately and things will get worse, before they even begin to improve. Furthermore, the level of means testing will still be around today’s 40% by 2050, thus continuing to undermine private pensioner incomes.
Why private pension reforms could prove dangerous
As for private pension reform, the Government plans to introduce new ‘low cost’ personal pension accounts into which employees will be automatically enrolled, with compulsory employer contributions of 3% of salary, a further 1% from tax relief and employees contributing at least 4%.
The key criteria for these accounts are to minimise cost and maximize competition, but low cost does not ensure good pensions and these personal pension accounts could actually result in deteriorating private pensions over time. Those who are not saving in a pension are the ones most likely to opt out of the auto-enrolment and people with an existing employer scheme will probably end up with lower contributions. Almost all employers offering pensions are contributing well over 3%, but by recommending just 3% compulsory contributions, employers will be tempted to cut back to this minimum level, thus dumbing-down employer pension provision.
Possibly worse than this, these personal pension accounts will not actually be ‘suitable investments’ for most people with low incomes (or high debts) because around 40% of pensioners will remain eligible for means-testing in future. So people will be auto-enrolled into a product they should not be buying, but they may not realize this until it is too late. The Government believes these problems will be minimized because the employer is contributing too. However, employer contributions are not ‘free money’ and are a part of the wage package. Effectively, personal accounts will encourage people to save 7% of earnings in return for a 1% addition in tax relief. If their savings are eventually penalised by 40% when they qualify for the Pension Credit, this will not be a good deal. And if the investments go wrong, they could end up with no pension from the scheme at all, causing further loss of confidence.
So what is a better solution?
A universal residency-based pension – at least at the £115 weekly pension credit level – provide a sustainable underpin to retirement income, be fair to women and anything on top of that must come from private sources. This would provide a clear division between what the state pays (the social welfare underpin) and what people must do themselves, either from private saving or working more. Once private income is no longer penalized by the state pension means test, financial services providers could safely sell pensions to the mass market with a clear message: Government will provide enough to live on, but only just. To have a better lifestyle later, you will need more – and whatever you save won’t be penalized. Government says this is unaffordable but that is not true.
The myth of ‘affordability’
We are wasting billions of pounds on pension-related spending which could be redeployed to provide decent state pensions for all citizens. For example, pension tax relief costs £21bn a year – over half of which goes to top-rate taxpayers (mostly men) – and higher rate tax relief does not even go into pensions, but is a ‘cashback’ off the tax bill. Winter fuel allowances, free television licences and other universal pensioner giveaways are politically popular, but cost over £3bn a year. This spending is not ‘targeted’ at all – even if you spend the winter in Spain, you still get winter fuel allowance! We could save about £10bn a year by abolishing contracting-out completely – and meaningfully simplify our pension system at the same time. Indeed, ending contracting-out for final salary schemes should also reduce their long-term liabilities, thus actually improving their funding position. In the longer term, the upper earnings cap to National Insurance offers another potential source of income. National Insurance is extremely regressive. NI contributions take 9.2% of salary from someone earning £30,000 a year, but just 3.7% if earning £100,000 and only 1.3% from someone earning £1m. Anyone earning £1m from property or investments pays nothing.
So, there are many ways to find extra money to fund a decent, fair state pension, giving a sound basis upon which individuals can plan their later life finances. This may require slaying some sacred cows and entail measures that will be unpopular with certain groups, but the money is there. However, as long as the Treasury is wedded to the concept of credits and means-testing, we are not likely to get these much-need reforms.
The bottom line is that the Government’s pension reform proposals seem more concerned with short-term headlines than with ensuring sustainable, long-term changes that we urgently need. It is time for a radical overhaul of our pension system, to provide a minimum state social welfare pension to prevent poverty, and leave the private sector free to provide additional income to supplement this, either from lifetime savings, employer-funded savings, or part-time earnings in later life.
The Government says a decent universal state pension, which lifts the elderly out of poverty and recognises women in their own right, would be too expensive, however, by exploding the ‘myth’ of affordability and redirecting the current pension-related spending in a more socially just fashion, we could well-afford to finance such much-needed reform.