Select Committee on Work and Pensions Minutes of Evidence

Memorandum submitted by the Institute for Public Policy Research (IPPR) (PC 27)


  1.1  Since the 1997 election, Labour has devoted much time and effort to pensions and long-term care reform. Both areas have generated significant legislation and the commitment of new public resources. The Government has characterised its reforms as a new contract for retirement: a settlement for the long term.

  1.2  IPPR has great sympathy with the government's central objective of eliminating pensioner poverty. However, we have been concerned about many aspects of the Government's reform package, and retirement policy has not proved to be a source of political capital for Labour. It has been difficult for Labour to win public support for its complex mix of pensions policies, despite significant increases in public spending on pensioners.

  1.3  There are several different objectives that pensions and long-term care policies need to address. These include: securing adequacy, maintaining affordability, delivering clarity and simplicity, protecting incentives, and promoting equity. We do not regard changing the balance between public and private funding as a first order goal of policy. Not all the objectives can be satisfied at the same time, and trade-offs between them are inevitable. By exploring alternative policy options, we have investigated whether the Government's current settlement should continue to be pursued or whether a change of direction is necessary.


  1.4  The Government has made significant reforms to the pensions environment since 1997. The transition from SERPS to the new State Second Pension will begin in April 2002 and Stakeholder Pensions have been on sale since April 2001. The introduction of the Minimum Income Guarantee (MIG), effectively a big increase in Income Support for pensioners, was a good short-term mechanism for directing help to the poorest pensioners.

  1.5  The Pension Credit, which is now set to subsume the MIG, also has many positive features: it represents significant new public funding for lower income pensioners and it was designed to stop penalising people with small pensions savings. However, it will require an increase of over 1 per cent of GDP in pensions spending by 2050, will quickly extend means testing to the majority of the pensioner population, involves numerous incentive problems, and represents a further increase in complexity in an already bewildering pensions environment. It is very hard to argue that the Pension Credit has been designed to generate incentives for current workers to save. Rather, it has been designed to ameliorate the penalties imposed by the MIG on current pensioners with small second pensions. The only way in which the Pension Credit represents an incentive to save is the degree to which it reduces the penalties for future savers relative to the previous regime.

    —  With low take-up of the MIG, and take-up certain to be an issue for the Pension Credit, pensioner poverty is still a key problem.

    —  Incentive problems remain acute. The Pension Credit does not resolve the incentive problems of the MIG: instead it spreads them out over a much larger group. In 2003 around half of all pensioners are expected, according to government estimates, to be eligible for means-tested support. By 2050 up to 70 per cent of pensioners will be eligible.

    —  The long-term purpose of the State Second Pension is unclear. By 2050 anyone with income only from the Basic State Pension and the State Second Pension will retire with an income, which is already below the MIG at 65. Someone who works all their life and makes contributions to the State Second Pension will not have a non-means tested income in retirement that will lift them above the poverty line.

    —  Planning is very difficult for individuals. The pensions environment has become much more complicated since 1997, and the new policy instruments such as the Pension Credit both increase the need for good quality advice and make such advice more difficult to provide.

    —  Public support for the pensions settlement is low. Many individuals feel that means testing retirement benefits is unfair: the settlement is not seen by the public to be equitable.


  1.6  We have compared four sets of pension reform options:

    —  The Government's current strategy.

    —  Making the State Second Pension more generous.

    —  Raising the Basic State Pension to the level of the MIG, and indexing it in line with earnings, for those aged over 75.

    —  Raising the Basic State Pension to the level of the MIG, and indexing it in line with earnings, for everyone.

  1.7  Raising the Basic State Pension to the level of the MIG, and indexing it in line with earnings—together with the phasing out of state second pension provision and a modest raising of the official retirement age to 67 by 2030—best satisfies the key objectives we have set. This option would obviate the need for the Pension Credit.

  1.8  Setting the Basic State Pension at £100 in 2003-04 prices will (along with the Winter Fuel Payments and other supplements to the Basic Pension) give all those with a full contributions record a non-means tested income at around the "low cost but acceptable" benchmark for the incomes of the elderly. It will be just above the quasi-official poverty line of 60 per cent of median household income after housing costs. It will satisfy the objective of securing adequacy, albeit at a level of income few will regard as overly generous. With nearly everyone automatically receiving a full non-means tested minimum pension at the age of retirement, we get round the problem of the inadequate take-up of the MIG and thus deliver a significant boost in income to the very poorest pensioners.

  1.9  Importantly, it will do this without the complexities of the existing policy regime. With the Basic State Pension raised to a level that would be somewhat higher than the government's planned level for the combined Basic State Pension and State Second Pension, the opportunity would arise of simply phasing out the latter altogether. The need for the Pension Credit would disappear. The overall pensions system will be significantly simpler, assuring adequacy without involving significant means-testing or a complex and ill-understood state second pension. The proposed increase in the state retirement age to 67 would occur in the decade after the official retirement age for women has increased from 60 to 65, which should make the reform easier for people to comprehend. It thus scores highly in terms of the clarity and transparency of the overall pension settlement. The proposed new settlement would significantly reduce the need for potentially costly pensions advice.

  1.10  The overall reform package favoured here passes the affordability test as well as the Government's pensions settlement, as we have tried to make the package broadly revenue neutral. Raising the retirement age to 67 combined with ending state second pension provision and with it the system of National Insurance rebates achieves this goal. The overall costs to the exchequer rise to around 6 per cent of GDP by 2050, but this is the same as the projected costs of the Government's settlement including the Pension Credit. Under that settlement the Government is confident that "Over the longer term, the forecast spending on pensions remains affordable and sustainable" (DWP, November 2001). The reform package suggested here is likewise affordable and sustainable.

  1.11  Raising the official retirement age needs to be justified on more than just the grounds of improving the affordability of the state pensions system. Average life expectancy has been rising for many years, and for those who will reach 65 in 2030 is now in the middle to late 80s for both men and women. So retiring at 67 would still leave an average of around 20 years of retirement for most men and women. There is evidence that raising the official retirement age has a positive impact on labour force participation rates, achieving one of the goals that everyone recognises as desirable.

  1.12  Our favoured reform package might raise concerns about the "windfall" gains that will go to many of today's better off pensioners that do not strictly "need" the extra income from the enhanced BSP. The distributional consequences of these reforms could be offset through changes to the current tax treatment of pensions and other forms of saving. The tax system could be made more progressive by abolishing equity ISAs that will from 2004 only be benefiting higher rate taxpayers and by scaling back the age related income tax allowances.

  1.13  In terms of the impact of the proposed reform package on incentives, the greater clarity and transparency of the system and the reduction in the prevalence of means-testing should give clearer incentives for people to save for their own retirement. However, offsetting this, the more generous BSP might result in some people saving less given the extra income guaranteed to them by the state. As the BSP would still be set at a very modest level and most people would want to retire on a significantly higher income, those with the means would still face a clear incentive to save in a second tier pension vehicle. The proposed pensions settlement may work without additional compulsion, though it is likely that policy makers would want to keep this issue under review.


  1.14  IPPR has investigated whether the Government's current pensions settlement should continue to be pursued or whether a change of direction is necessary. We have firmly concluded the latter. Although we are supportive of the Government's aims and its primary focus on tackling pensioner poverty, we part company on how best to achieve those aims. If a means-tested approach was working for poor pensioners and working for people planning for retirement, then we would be in accord with the Government. But it is not working, and people perceive means testing in retirement to be different from means testing benefits during working life. Even if a reinvigorated campaign saw take-up of the MIG/Pension Credit improve, many pensioners would still be reliant solely on the Basic State Pension, which if price indexed will fall further and further below the poverty line. The introduction of the Pension Credit, complexity aside, creates incentive problems that cannot be resolved. In theory, the government's strategy has merit. In practice, it falls short of eliminating pensioner poverty and providing an environment whereby people can understand their entitlements, save and be rewarded for doing so.

  1.15  The centrepiece of our suggested reforms—to increase the Basic State Pension to the level of the MIG and ensure it retains its value in relation to earnings in the future—is the only way to guarantee all pensioners escape poverty. Moreover, it allows a radical simplification of the system—the Pension Credit becomes redundant and SERPS/ State Second Pension can be closed—creating a framework which people can understand. This policy reform delivers for both current pensioners and people currently planning for retirement. It delivers for people in poverty and it delivers for the working poor who will no longer be penalised for their thrift. We also believe it delivers for government: with the closing of SERPS/State Second Pension and a modest increase in the official retirement age to 67 it is affordable, and the political rewards of what would be a highly popular reform would be significant.

  1.16  Ensuring the security of all citizens in retirement is a key element of social justice. If the elderly in our society are in poverty or receiving inadequate care, we are failing to make progress. We hope our recommendations describe a contract, which will ensure better provision of pensions for millions of older people, both now and in the long term future.


The Minimum Income Guarantee

  2.1  In April 1999 MIG replaced Income Support for people who are over 60. Like Income Support, MIG is a means tested entitlement. People qualify on the basis of having low income and small savings, but the value of their home is not taken into account. In the 1998 Green Paper the Government stated its long-term ambition, but made no commitment, to raise the MIG in line with earnings (DSS, 1998).


  The full weekly MIG rate in 2001 is £92.15 for a single person and £140.55 for a couple, equivalent to just under 20 per cent of average male full time earnings or just under 30 per cent for a couple. The income and savings of a couple are added together for the means test. Most income is fully set off against any entitlement, so a single person with a full BSP of £72.50 and no other income or savings would be entitled to £19.65 from the MIG, bringing their total income up to £92.15 per week. Savings of up to £6,000 are not taken into account in the means test. People with savings of between £6,000 and £12,000 receive less help the more savings they have, and individuals or couples with over £12,000 of savings do not qualify for any MIG payment.

  2.2  The MIG is currently at the level which the BSP would have attained if the earnings link had not been broken in 1981. The MIG will be raised to £100 a week for a single person by April 2003 (HMT 2000), and the Chancellor stated that the MIG would rise in line with earnings for the duration of the current Parliament (PBR, 2001). The MIG would thus be just above the quasi-official poverty line[36] from 2003, so effectively abolishing pensioner poverty if there were 100 per cent take-up.

  2.3  The following table details the Department of Social Security's own estimates of take up for Income Support (Minimum Income Guarantee), Housing Benefit and Council Tax Benefit among pensioner households (Department of Social Security, 2001)[37].

Table 2.1


Pensioner households entitled but not receiving benefit
Median weekly amounts unclaimed
Mean weekly amounts unclaimed
Income Support
19-32 per cent
1999-2000 (MIG)
22-36 per cent
Housing Benefit
4-11 per cent
7-15 per cent
Council Tax Benefit
26-32 per cent
30-36 per cent


  Department of Social Security, Income Related Benefits Estimates of Take-up in 1999-2000.

  2.4  As the table indicates, between optimistically one in five and pessimistically one in three pensioner households did not claim the Minimum Income Guarantee payments they were entitled to in 1999-2000[38]. Whilst some of these people would have been missing out on very small amounts, the median and average weekly amounts unclaimed are significant: £12.80 and £20.00 respectively. What makes these take up figures so important is that all those entitled but not receiving this benefit are, by definition, living in poverty.

  2.5  It is notable that pensioner take up of Housing Benefit is much better than take up of the Minimum Income Guarantee. This may be because many pensioners claiming HB were already claiming before they became pensioners: non pensioners and pensioners have similar take up rates for HB, whilst take up of MIG is much worse than take up of Income Support for younger households.


  2.6  IPPR has conducted its own research into people's attitudes towards means testing with a series of focus groups and interviews with a spectrum of age and income groups. The results reveal a complex and sometimes contradictory picture (Edwards, 2001). Firstly, few people instinctively see means testing as a way of targeting help on those who are most in need. Instead, the first reaction of many is to see means testing as a way of penalising those who have been hard working and prudent. There is a great deal of resentment towards a perceived group of the "undeserving poor" who are felt to receive help they do not deserve. The concept of the undeserving poor is also mirrored by a perception of the "deserving rich": those people who have worked hard and deserve their relative wealth.

  2.7  However, when talking about these undeserving poor our interviewees were rarely referring to people they knew. People who "abuse the system" and get "handouts" they don't deserve are most often an unknown quantity and more likely to be shaped by stories in the media than by individual experience. When means-testing is related to known individuals such as friends, family, and neighbours, people are often far more willing to make the arguments in favour and to recognise a genuine need. Our research revealed a real concern for pensioners struggling to get by on very limited resources.

  2.8  In some cases the same people who object to the "undeserving poor" receiving special help, simultaneously object to what they perceive as the stigma attached to means testing, the difficulty of claiming entitlements, and the intrusion of privacy implied by the process. Another area of particularly stark contradiction was the conflict between people's desire for the flat rate benefits and rewards according to contribution. Some responses suggested that this contradiction could be resolved by a decent flat rate pension for all with additional provision being on a contribution related basis. Others expressed the view that people should "get out what they put in", and few recognised that the state should have an essentially redistributive role.

  2.9  People often feel particularly negative towards means-testing when it relates to older people rather than those of working age. At the broadest level there is an argument that older people are more vulnerable, the implication being that older generations are a homogenous group who are collectively in need of support. Other, perhaps more fundamental, arguments are made around the notion that the wealth and assets accrued in retirement have been built up over the course of a life. There is a perception that retirement wealth is the result of years of hard work, saving and good money management. Many therefore resent these assets being "held against" people as it suggests penalising them for the effort they have put in over the years. In general our interviewees found it much more natural to consider as "fair" treating retired people alike than recognising inequalities and responding to them by treating people differently.


  2.10  Concerns quickly arose that the Minimum Income Guarantee might undermine incentives as people who worked and accumulated pension entitlements found themselves with an income in retirement little higher than the MIG. The MIG effectively operates a 100 per cent rate of benefit withdrawal as original income rises up to its level, and this has been felt most acutely by those with small second pensions. For example, a single pensioner with a full BSP plus a weekly pension of £15 would be no better off than a pensioner with only the BSP and no additional income, assuming both claimed their full MIG allowance. The saved income of £15 would be fully set off against MIG entitlement. This problem was given real bite by the large number of pensioners in this situation: £15 was in fact the average SERPS payment to men aged 65 to 69 in 1998[39], and the figure was just £8 for women in the same age group. Around a third of all pensioner benefit units received less than £5 a week from private sources in 1995-96 (Emmerson and Johnson, 2001).

  2.11  In addition to the incentive problems, the very high withdrawal rate operated by the MIG generated public resentment over the perceived unfairness of the system. It was clear that both the incentive and fairness problems would become progressively more acute if the BSP were to grow in line with prices and the MIG with earnings. The response to this problem was the Pension Credit announced in the autumn of 2000.


  2.12  The Pension Credit has been proposed for introduction in 2003, and will subsume the Minimum Income Guarantee. Those on low or modest incomes will have their income raised to a guaranteed minimum, and will then receive a further "savings credit" on any other income they have in excess of the level of the Basic State Pension up to a ceiling. The savings credit then reduces in value as the individual's original income increases to a second ceiling, above which no credit is payable. The guaranteed minimum can be considered the replacement for the MIG. The savings credit is the element, which is intended to deal with the incentive problem of the MIG and reward those with small retirement incomes additional to the BSP. The guarantee element operates for men and women over the age of 60, and the savings credit for all pensioners over the age of 65. The future uprating of both the guarantee element and the lower savings credit threshold are crucial aspects of the future development of the Pension Credit. Whilst the Government has announced that the guarantee element is set to rise in line with earnings at least until the end of this Parliament, there is no commitment beyond that date (Department for Work and Pensions, 2001b).


  At the time of introduction in 2003 the guaranteed minimum income is expected to be £100 per week for a single pensioner and the Basic State Pension £77 per week. Income excluding any Pension Credit, called original income, between £77 and £100 will attract a credit of 60 pence per £1. Thus an individual with a full BSP plus £10 of second pension would have an original income of £87 and would receive £100 - £87 = £13 in guaranteed income top up plus £10 x 0.60 = £6 as savings credit. The maximum savings credit payable would thus be £23 x 0.60 = £13.80 for someone with an original income of £100. The savings credit is then tapered off at the rate of 40 pence per £1 of additional original income, so an individual with original income of £101 receives £13.40 of savings credit, an individual with original income of £102 receives £13.00 of savings credit, and someone with £135 of original income receives no Pension Credit. Analagous arrangements will operate for couples.

  The Pension Credit will also treat savings more generously than the MIG. As with the MIG, savings of up to £6,000 are not taken into account in the means test for the Pension Credit. However, the upper savings limit of £12,000, above which people are not entitled to the MIG, will not apply for the Pension Credit. Instead, savings above £6,000 will attract notional interest at 10 per cent which will be taken into account as if it were income. This notional interest rate is half that assumed under the MIG.

  An additional improvement to the MIG is that entitlements to Pension Credit payments will be reassessed relatively infrequently: initially at retirement, then at 65, then only once every five years.

  2.13  The most obvious way of considering the Pension Credit is as a straightforward means tested benefit with a long taper. The maximum benefit for an individual with a full state pension is £23 if they have no additional income. For each £1 that their income rises above this level, the £23 is reduced by 40 pence, a taper which runs up to those earning (£77 + £23/0.4) = £134.5. The problem with the MIG was that it had a 100 per cent withdrawal rate up to a ceiling of £100 (in 2003 terms). The problem with the Pension Credit is that it has a withdrawal rate of 40 per cent up to a much higher ceiling of £135, therefore affecting a much greater number of people.


  2.14  The Pension Credit will generate other incentive problems. The first is that those with entitlements to less than the full level of the BSP will face a 100 per cent withdrawal rate on any additional earnings up to the full BSP level. As noted above, over 10 per cent of men were in this position in 1997 (Pension Provision Group, 1998). Individuals in this position will have no incentive to save if the expected weekly income from their saving will not take them over the level of the BSP.

  2.15  The second incentive problem arises because of the gap between entitlement to the guarantee element of the Pension Credit at the age of 60, and entitlement to the savings credit at the age of 65. Women pensioners between the ages of 60 and 65 will thus remain in the same position as under the MIG with respect to benefit withdrawal as a result of small second pension incomes. Poorer female pensioners may see no benefit from saving for small second pensions until they reach the age of 65.

  2.16  The third incentive problem is that those with original incomes between £77 and £100 face new and conflicting incentives. Their withdrawal rate has fallen from 100 per cent to 40 per cent, improving their incentives to save. On the other hand the effect of this is to increase their total income, which may reduce their need to save. The net effect of these changes is not easily predictable. However, the 100 per cent withdrawal rate in this income band was clearly politically unacceptable, and its removal helps to address the popular concern that the MIG was actually unfair.

  2.17  The fourth incentive problem is that original income in the range £100-£135 now faces an increased withdrawal rate. Under the MIG these individuals suffered 100 per cent withdrawal on income below £100 and zero withdrawal above that level. They would now face 40 per cent withdrawal rates between £77 and £135, reducing their incentive to save into the £100 to £135 bracket. In addition, the Pension Credit will increase their total incomes, reducing the need to save. The Pension Provision Group noted in their response to the consultation paper that "it seems likely that saving which would result in income in this range (£100 to £135) would fall" (Pension Provision Group, 2001a).

  2.18  The fifth incentive problem concerns the interaction of the Pension Credit with Housing Benefit and Council Tax Benefit. All those receiving MIG are currently entitled to the maximum HB and CTB. Income above MIG level reduces entitlement to HB by 65 pence per £1, and entitlement to CTB by 20 pence per £1: a maximum 85 per cent withdrawal rate. Under the Pension Credit income up to the level of the guaranteed minimum plus the maximum savings credit (£113.80) is likely to be disregarded when calculating entitlement to HB and CTB[40]. This would mean that each £1 of additional income above £113.80 would incur 40 pence per £1 withdrawal of Pension Credit plus £0.60 x (0.65+0.20) = 51 pence per £1 withdrawal of HB and CTB. It is hard to identify any treatment of the three benefits, which does not impose very high withdrawal rates at some point in the income distribution. On the other hand it should be remembered that under the existing system people claiming HB and CTB already face 85 per cent benefit withdrawal rates on some of their income above the MIG level.

  2.19  Finally, incentives need to be understood to be effective. The foregoing discussion should make it clear that the Pension Credit is a highly opaque means of generating the right incentives: it is extremely difficult for individuals to know what to expect from it, especially over the long time periods relevant to retirement planning. This problem does not just affect the individual planning for their own retirement: professional advisers are in a similar position in respect of their clients.

  2.20  It would be very hard to argue that the Pension Credit has been designed to generate incentives for current workers to save. Rather, it has been designed to ameliorate the penalties imposed by the MIG on current pensioners with small second pensions. The only way in which the Pension Credit represents an incentive to save is the degree to which it reduces the penalties for future savers relative to the previous regime. The story of the Pension Credit highlights one of the fundamental problems of pensions policy: the requirement to meet the needs of both current and future pensioners.


  2.21  The proposals before Parliament at the beginning of 2002 indicated short term costs of £2 billion for 2004-05, including £460 million for consequent increases in Housing Benefit and Council Tax Benefit payments. It has been independently estimated that the Pension Credit will increase public spending on pensions alone by about 1.2 per cent of GDP by 2050 (Hawksworth, 2002)[41]. The Department for Work and Pensions produced its own long term estimates for the cost of the Pension Credit in late January 2002 and these indicate similar incremental expenditure of 1.3 per cent of GDP by 2050[42] (Department for Work and Pensions, 2002)[43]. On the basis of the independent modelling, total government spending on pensions and related income support is thus set to rise from just under 5 per cent of GDP to 6 per cent by 2050, in contrast to all previous projections which had public spending falling as a proportion of GDP. One of the key aims of the 1998 Green Paper would appear to no longer apply.

  2.22  It has been estimated that the Pension Credit will increase the proportion of people being means tested to approximately 65 per cent of single pensioners and 51 per cent of couples by 2025 (ABI 2001). The Department for Work and Pensions also estimates that coverage will be 65 per cent of pensioner benefit units by 2040 if the guarantee element is uprated in line with average earnings whilst the savings credit threshold rises in line with prices (Department for Work and Pensions, 2002). The significant increase in means testing to cover the majority of the retired population appears to undermine one of the other main aims of the 1998 Green Paper. It is possible that developments in other areas of public policy, particularly in-work family benefits and tax credits will mean that future cohorts may increasingly be used to receiving means tested benefits. However, it remains a challenge to ensure maximum take up and minimum effects on work and saving incentives. However, there are significant differences in which in work benefits are perceived compared to benefits in retirement. New benefits such as the Working Families' Tax Credit are received thorough the pay packet and are effectively seen as a supplement rather as an entitlement. IPPR's qualitative work brings out that the public do see means testing in retirement as different from means testing in-work benefits: whilst those receiving benefits in work may be getting something "extra", those who "fail the means test" in retirement are often seen as being punished for their accumulated work and saving (Edwards et al, 2001).

  2.23  The Pension Credit raises other questions. Its introduction into an already complex system of provision will add to the lack of transparency, making it harder still for individuals to understand that system. In the long-term, it is not clear that the Pension Credit and the State Second Pension will work together. The ostensible aim of the State Second Pension added to the Basic State Pension is to provide a non-means tested retirement income for those on low lifetime incomes that is clear of the means-tested MIG level. There were already concerns before the introduction of the Pension Credit that the State Second Pension would not achieve this aim without being made significantly more generous (Rake, Falkingham and Evans, 1999). With the introduction of the Pension Credit, the State Second Pension and all other forms of second pension provision will have to work much harder to give people a non-means tested retirement (Pension Provision Group 2001).

  2.24  Not withstanding what has just been said, it is still important to recognise that the Pension Credit represents an improvement on the Minimum Income Guarantee. It undeniably represents significant new public funding for lower income pensioners, and it softens some of the benefit withdrawal problems of the system it replaces. However, it is clear that it is far from a perfect solution, and that we must ask the question whether the very significant resources it will require could be better deployed.


  2.25  Direct public spending on pensions in 2000-01 totalled five per cent of GDP. This included spending on the Basic State Pension, SERPS and means tested benefits including income support or the MIG and housing and council tax benefit. However, the Government also contributes resources to people's pensions through its treatment of pensions through the tax system and its system of National Insurance rebates for those who contract out of state second pension provision.

Table 2.2


Percentage of GDP
Direct spending items
Basic State Pension
Income Support/MIG
Other (Winter fuel allowances etc.[44])
"Expenditure" on "real" tax concessions
Contracted out NI rebates
Age-related allowances
Tax free lump sum
Total expenditure on "state" support
Other items
Income tax relief for approved pension schemes
(Of which: higher rate tax relief
Income tax relief on PEPs/ISAs/TESSAs
Upper earnings limit on NICs


  HM Treasury 2001, IFS

  2.26  The system of NI rebates is especially costly—a sum equivalent to 0.9 per cent of GDP was paid into people's pension pots in 2000-01 in return for their giving up their claims to state second pension provision. This was almost twice as much as was paid out in SERPS itself in that year. This system of NI rebates is almost unique to the UK, with only Japan also allowing people to contract out of the state pension system but on a much smaller scale (Disney and Johnson, 2001, p25). The introduction of rebates for personal pensions in the late 1980s cost the government substantial revenues that it will never recoup from lower SERPS payments.

  2.27  Individual contributions into pension schemes attract income tax relief at an individual's marginal rate. There are limits on the proportion of annual income that can be saved in a pension and these are age-related in the case of personal pensions. Income and capital gains accrued in pension funds are tax-relieved. Pension income is then taxed when it is paid out. This approximates the treatment that would exist under what economists call an expenditure tax regime—income is tax-free on the way in but taxed on the way out (Emmerson and Johnson, 2001).

  2.28  However, other features of the tax treatment of pensions make them especially tax-favoured. Two features stand out that benefit existing pensioners. Firstly, income tax allowances are higher for pensioners. In 2001-02 the personal allowance for those aged under 65 was £4,535. It was £5,990 for those aged between 65-74 and £6,260 for those aged 75 and over. Pensioner couples still benefit from a married couple's allowance when this has been abolished for all those under 65. Secondly, a quarter of an individual's pensions pot or 1.5 times final salary in the case of a salary related defined benefit scheme can be taken as a tax-free lump sum[45]. Together these two forms of "tax expenditure" currently cost the Exchequer about two-fifths of 1 per cent of GDP. In addition employer contributions to pensions are exempt from NICs and no NICs are paid by individuals when the pension is drawn.

  2.29  Although the whole cost of the income tax relief allowed for pension contributions should not be counted as an "expenditure" in that people will be paying tax on their pension income, some pensioners will be better off in that they may get tax relief at the 40 per cent tax rate while in work but attract only the basic rate of tax in retirement. This has made higher rate tax relief a target for revenue raising. Overall the system of tax relief for pensions is highly regressive.

  2.30  Overall expenditure on the "real" tax concessions and subsidies in the pensions system totalled about 1.3 per cent of GDP in 2000-01. This needs to be added to the cost of direct public spending on pensions. In total the state devoted 6.3 per cent of GDP to pensions in 2000-01. In looking at the scope for reforms this is the total pot that one would look at if an attempt was being made to make any set of reforms revenue neutral, that is to ensure that the overall costs to the state were similar to those envisaged under the Government's pensions settlement.

  2.31  There are other features of the tax system relevant to the debates on pensions and long-term care. One anomaly in the tax system that has been the subject of much debate is the upper earnings limit on national insurance contributions. Employees in 2001-02 paid NICs at 10 per cent on income between £87 and £575 per week, but not above this upper limit, producing a dip in the marginal direct tax rate from 32 per cent to 22 per cent until the higher rate of income tax at 40 per cent clicked in at £33, 935. Eliminating this limit entirely would have raised revenue equal to about 0.6 per cent of GDP in 2000-01 and aligning it to the higher income tax rate would have raised 0.1 per cent of GDP.

  2.32  Pensions are not the only form of saving that is currently tax-favoured. In 2000-01 the tax reliefs attached to PEPs, ISAs and TESSAs cost the Exchequer about 0.2 per cent of GDP. There is a very real question as to why the state feels it should encourage saving through these kinds of vehicles. In the 2001 Budget, the Government outlined three reasons for helping people to save: for independence throughout their lives; for security if things go wrong; and for comfort in old age. Private pensions help secure the first and third of these objectives. Very liquid assets such as cash ISAs are appropriate for security. The proposed asset based welfare vehicles are designed to secure the first objective. What objectives do equity based ISAs meet?

  2.33  Equity based ISAs also create real incentive problems for people thinking about locking away income for up to 40 years in their pension. Why should one do so when putting income into an ISA attracts somewhat similar tax treatment as saving in a pension, albeit on the basis of income not being tax-free on the way in but tax-free on the way out?

  2.34  From 2004 the advantages of investing in an equity-based ISA will be zero for a basic rate taxpayer due to the little noticed abolition of the 10 per cent tax credit on dividend income: it will become a vehicle solely of benefit for higher rate taxpayers. This will make the continuation of equity-based ISAs very difficult for a Labour government to justify. The problem of investment in ISAs competing with investment in pensions would be partially removed if equity-based ISAs were simply abolished and cash-based ISAs retained with a modest limit on total savings to help people shelter some of their "rainy-day" savings in a tax favoured manner.


  3.1  Is it possible to design an alternative settlement that would better meet the key objectives that we think any pensions system should be measured against? These objectives are:

    —  Ensuring that all receive an income in retirement that is at least adequate to lift them clear of the poverty line.

    —  Constructing a system that is clear enough for people to understand its main features so they can plan with some confidence for their retirement needs.

    —  Adequately rewarding and incentivising people to save for themselves.

    —  not setting up future costs for the state that are unaffordable in the sense that they imply a sharp and ongoing rise in spending as a proportion of GDP.

  3.2  We believe that a pensions settlement that could meet these objectives would be more likely to generate widespread popular support and be more politically robust. We do not believe that the current settlement is sustainable. We also believe that the clarity and transparency of any settlement needs to become a first order goal of any reform.

  3.3  Any discussion of the options for pension reform has to start with a full understanding of how the pensions settlement proposed by the Government will look once the system, with its many separate features, is fully in place. This will then provide us with a benchmark against which to assess other reform options.

  3.4  Our discussion of reform options draws extensively on two pieces of modelling work that have been done in collaboration with IPPR. The first modelling exercise has been undertaken by John Hawksworth at PricewaterhouseCoopers (Hawksworth, 2002). This has attempted to cost out different pension reform options, projecting the costs as a proportion of GDP for each decade to 2050, and assessing the options against the four objectives outlined above. The second modelling exercise has been undertaken by a team at the ESRC SAGE Research Group (Falkingham, Rake and Paxton, 2002). This has attempted to assess different pension reform options according to how well they deliver to individual women and men at the point of retirement and through later life. It should be noted that IPPR's policy conclusions are not the responsibility of these external partners.

  3.5  These modelling exercises have looked at four possible sets of reforms. However, here we concentrate heavily on a comparison of the Government's base case with what we describe as the gold plated base case.

  3.6  The Government's base case The starting point is the Government's own pensions settlement, what we have called the Government's base case. This involves a price-indexed Basic State Pension, an earning-indexed MIG and the introduction of the State Second Pension and the Pension Credit. One can explore variations on this base case including for example not introducing the Pension Credit.

  3.7  The gold plated base case This is one of the most generous settlements that we might envisage. It involves raising the Basic State Pension gradually to the level of the MIG between 2002-03 and 2010-11 and then indexing it in line with earnings. In this option it is assumed that the Pension Credit is not introduced (though it is also compatible with the Pension Credit only being introduced as an interim measure and then phased out by 2010-11). In this case the MIG retreats to being a residual means tested benefit for those with incomplete entitlements to the Basic State Pension. One can also explore variations on this option such as ending state second pension provision or increasing the official retirement age.

  3.8  The silver plated base case This option involves raising the Basic State Pension to the level of the MIG at age 75 reflecting the higher levels of poverty faced especially by older single pensioners. This can be modelled with a price indexed Basic State Pension and the Pension Credit continuing for younger pensioners or with an earnings indexed BSP and no Pension Credit for younger pensioners.

  3.9  Making the state second pension more generous This option involves putting significant extra resources into the State Second Pension, which would allow the Pension Credit to be phased out over the very long-run and reduce the need for the MIG to top-up incomes. This can also be modelled with different assumptions, particularly about the level of the BSP.

  3.10  These four options are of course not exhaustive. Even more generous than what we have called the gold-plated base case would be the introduction of a citizen's pension, where everyone would receive something equivalent to the BSP as a right without having to establish a contributions record. If it is correct that by 2020 most women and men will have achieved full entitlement to the BSP in their own right, then the current system will look more like a citizen's pension. However, the current system where people receive a benefit based on some record of contributions appears to be well understood and well supported. Given this our objective of promoting clarity and transparency would seem to suggest not overturning this feature of the current settlement.

  3.11  The least generous option would be for the state not only to withdraw from second tier pension provision but to withdraw from first tier provision as well and retain only a means tested system to help the poorest in retirement, an option modelled by Falkingham et al (2002). A less drastic option would be to incentivise individuals to opt out of the BSP in the same way that they were encouraged to opt out of SERPS into personal pensions in the 1980s. In some discussion this option is based on an argument about the inherent superiority of funding over pay-as-you-go, an argument we do not find compelling. The impact on the state's finances would, if the system were actuarially fair, be neutral in the long run: the state would lose income in the short run as it paid out rebates and gain in the long run as fewer people had entitlement to the BSP. If the incentives to opt-out were made too generous the settlement would prove less affordable for the state in the same way as the reforms in the late 1980s generated net losses for the exchequer. It would introduce another element of complexity into the pensions system and would not reduce either existing or future pensioner poverty. It therefore fails to meet any of the objectives we have set for pension reform.

  3.12  The four pension settlements we explore here encompass the likely range of options that most people on the centre-left and probably the centre-right would be comfortable with. They allow us to probe in more detail the trade-offs inherent in the objectives we are trying to meet for the pensions system. We think the analysis leads us to choose a variation on the second option—the gold plated base case—as the best outcome, but exploring the other options enables us to clarify the case for the option we have chosen.

Table 3.1


Government's Base Case:
—with PC
—without PC
Gold Plated Base Case:
—BSP=MIG for all, no PC
—& close SERPS/S2P
—& abolish rebates
—& raise ret. age to 67
Silver Plated Base Case:
—BSP=MIG at 75
Higher State Second Pension:
—without PC (not including
increased costs of rebates)


  Hawksworth 2002. Authors calculations on impact of abolishing rebates.

36   That is 60 per cent of median household income after housing costs. Back

37   The estimates are constructed by comparing benefit claims with responses to the Family resources Survey. Ranges represent 95 per cent confidence intervals. Back

38   The figures in the table above should not be interpreted as showing a statistically significant worsening of take-up rates between 1998-99 and 1999-2000. Take up rates are estimates given as 95 per cent confidence intervals, and in all cases shown the confidence intervals for 1998-99 overlap with those for 1999-2000. Back

39   This is the average for those with SERPS entitlements, who comprised 91 per cent of men in this age category in 1998. Back

40   These details have not yet been finalised by DWP. However, setting the disregard at the guaranteed minimum level of £100 would mean that income between £100 and £135 would attract a withdrawal rate of 40 pence per £1 for the Pension Credit and then an additional £1 x (0.65+ 0.20) = 85 pence per £1 for HB and CTB. This would result in a potential withdrawal rate of 125 per cent between these income limits: clearly unacceptable. Back

41   This does not include knock-on effects to Housing Benefit or Council Tax Benefit. Back

42   On the assumption that the guarantee element of the Pension Credit is uprated in line with average earnings in all years after 2003 and the savings credit threshold in line with prices. Back

43   The two exercises use somewhat different modelling techniques and assumptions which are discussed in Hawksworth, 2002. Back

44   Also includes free TV licences for the over 75s, widow's pensions, war pensions and the Christmas bonus. Back

45   On the condition that the member has at least 10 years of service. Back

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