Memorandum submitted by the Institute
for Public Policy Research (IPPR) (PC 27) (continued)
THE GOVERNMENT'S
BASE CASE
3.13 We start by establishing the overall
cost of the Government's pension settlement. The modelling by
Hawksworth (2002) suggests that the net cost of the Pension Credit
will rise to 1.2 per cent of GDP by 2050. Overall, the Government's
pension settlement will involve direct expenditure costs of 6
per cent of GDP by 2050, compared with 5 per cent of GDP in 2000-01,
even if the BSP remains indexed in line with prices. We have discussed
earlier how far these costings are compatible with those set out
by the Government (DWP, 2002) and this is discussed further in
Hawksworth (2002), with the conclusion that they are broadly comparable.
These represent of course only the direct expenditure costs: there
will in addition be the costs of the "true" tax expenditures
and subsidies. These cannot be modelled but in this analysis they
are assumed to remain at around the current level of 1.3 per cent
of GDP.
3.14 The key punchline here is that the
objective set out in the Prime Minister's forward to the 1998
Green Paper that public spending on pensions as a proportion of
GDP would fall, will now not be realised. This change to one key
feature of the Government's pensions settlement opens up a very
obvious question: had it been known in 1998 that such an increase
in spending was possible would we have chosen a different means
of delivering the other objectives for the pensions system?
3.15 There are other key questions that
the modelling helps to clarify. The Pension Credit combined with
a BSP indexed in line with prices will draw an increasing proportion
of pensioners into means-testing with all the consequences for
the incentives faced by people and their perceptions of the equity
of the system that were discussed above. Even 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 for the means-tested pension
credit (Hawksworth, 2002). Falkingham et al (2002) look
at an individual on average earnings of around £20,000 a
year and with no employment breaks, saving the minimum in a stakeholder
pension implied by the level of the contracted out rebate, with
a generous 3.5 per cent annual real rate of return, and buying
a non-indexed annuity. They would be eligible for the means-tested
savings element of the Pension Credit after only three years of
retirement. If they purchased an indexed annuity with their retirement
savings pot in 2050, they would be immediately eligible for the
means-tested savings element of the Pension Credit. If they lived
to beyond 80 they would become entitled to the MIG as well.
3.16 Of much greater concern is that by
2050 anyone with income only from the BSP and the State Second
Pension will automatically fall below the MIG threshold on retirement
at 65. As Falkingham et al (2002) point out this raises
real questions about the purpose of the State Second Pension.
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. It is not
clear that this fulfils the objectives for the State Second Pension
that were outlined in the 1998 Green Paper.
THE GOLD
PLATED BASE
CASE
3.17 The option of raising the BSP to the
level of the MIG and then indexing it in line with earnings would
silence most of the Government's critics on the centre-left in
one fell swoop as it is what they have been campaigning for over
many years. It would be generally very popular in the country
as a whole. The option has been dismissed in the past by Whitehall
on two grounds: firstly, affordability and, secondly, that it
would deliver windfall gains to better off pensioners who do not
strictly "need" a higher income from the BSP.
3.18 Our modelling allows us to confirm
the cost of this option. Without offsetting measures, raising
the BSP to the level of the MIG by 2010-11 would add around 0.9
per cent of GDP to direct spending on pensions by this date when
compared with the Government's base case. This estimate takes
into account the savings by not having to introduce the Pension
Credit and by fewer people having to claim the MIG top-up. It
slightly overstates the extra costs, however, in that the BSP
is taxable and 22 per cent and 40 per cent of the extra cost would
be clawed back from better off pensioners. This is one way in
which the option can be seen to be both more affordable and that
the windfall gains to better off pensioners can be mitigated.
3.19 By 2050 this option would raise direct
spending on pensions by about 2.6 per cent of GDP when compared
with the Government's base case. Again this does not take into
account the lower net costs that would result from some flow of
income tax revenue back to the exchequer. Overall direct expenditure
on pensions would total 8.6 per cent of GDP in 2050. This is significantly
higher than in the Government's base case of 6 per cent of GDP,
but is in no sense completely unaffordable. A glance back at the
table in chapter 2 shows that it would still leave public spending
on pensions in the UK lower than in all other EU countries based
on current projections. Simply indexing all taxes in line with
price rises and thereby allowing the phenomenon of "real
fiscal drag" to increase tax revenue would increase the tax
take as a proportion of GDP by 2.3 per cent in just one decade
(IFS, 2001). Nevertheless this significant increase in direct
spending on pensions by definition carries with it an opportunity
cost. The revenues devoted to increasing the BSP would not be
available to tackle child poverty, increase spending on health
care, education or public transport, or any other of the many
priorities faced by Government.
3.20 This reform option would score highly
against the objective of securing an adequate retirement income
for all and the objective of maintaining people's incentive to
save for their own retirement. 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. The MIG would retreat to being a residual
means tested benefit for those without a full entitlement to the
BSP, a section of the population that we expect to see decline
sharply over time.
3.21 In terms of incentives, the existence
of a non-means tested pension in retirement at the level of the
MIG would mean that individuals faced a much clearer incentive
to accumulate their own savings through pensions or other vehicles.
They would know that they were not going to be faced by an ill-understood
system of means testing in retirement that might significantly
reduce the return to their own savings. However, individuals facing
significant housing costs in retirement might still face the high
marginal tax rates implied in the housing and council tax benefit
regimes, and this is the one significant incentives problem that
the gold plated base case does not surmount. The answer here would
lie in a fundamental reform of the housing and council tax benefit
regimes.
3.22 It is highly unlikely that any government
would simply raise the BSP to the level of the MIG and not take
the opportunity to make other changes to the pensions settlement
designed to achieve the other main objective of reform: a simplification
of the system. From 2007 it is planned that the State Second Pension
will become flat rate to be added to the value of the BSP for
those who are contracted in. However, with the BSP raised to a
level that would be somewhat higher than the Government's planned
level for the combined BSP and State Second Pension, the opportunity
would arise of simply phasing out the latter altogether. For those
on low incomes the BSP would be generous enough in its own right
to provide people with a minimum retirement income.
3.23 Taking the opportunity to phase out
the State Second Pension would not only significantly simplify
the system, it would temper the "affordability problem"
that Whitehall in particular will be concerned about. We can model
the effect of phasing out the State Second Pension in the context
of raising the value of the BSP. In itself over the short term
this would make little difference. By 2010 the revised gold plated
option shaves only 0.1 per cent of GDP from the overall cost of
the pension reform package. However, by 2050 when the State Second
Pension would have matured, its phasing out would lower direct
public spending on pensions by 1 per cent of GDP when compared
with the full gold plated option. This would leave the option
costing overall 7.6 per cent of GDP in terms of direct public
spending compared with the 6 per cent of GDP that is the cost
of the Government's base case.
3.24 However, the analysis does not stop
there. If the State Second Pension was phased out (perhaps from
2007) there would by definition be no need to retain the expensive
system of offering rebates or lower contribution rates to people
contracting out of state second pension provision. These rebates
cost 0.9 per cent of GDP in 2000-01. We cannot model the cost
of these rebates out into the future, but we can use the working
assumption that the cost remains the same as a proportion of GDP.
In this case abolition of the rebates means that in 2010-11 the
total cost of the gold plated reform package as a proportion of
GDP would be 5.5 per cent, almost exactly the same as the Government's
base case. The reform is basically revenue neutral over the first
decade. By 2050 the total cost of the gold plated option would
be 6.7 per cent of GDP including the savings on the rebates compared
with the 6 per cent cost of the Government's base case not including
the rebates. The gold-plated reform option along with the phasing
out of the State Second Pension is barely less affordable in the
round.
3.25 It is important to clarify what is
going on here and in particular the distributional consequences
of what is being proposed. The initial cost of raising the value
of the BSP to the MIG by 2010-11 is paid for by closing state
second pension provision. In addition we abolish the rebates paid
to those opting out of this provision and effectively everyone
moves to the contracted-in rate of NICs. The main distributional
impact here is to transfer resources between the current generation
of workers who would have benefited from having the rebates paid
into their pension pots or paying the lower contracted out rates
and the current generation of pensioners who will benefit from
the higher BSP. It is a transfer from the current workforce to
their parents and/or grandparents. Over the long run it is a transfer
across the lifetimes of individuals who give up their entitlement
to state second pension provision in return for a more generous
BSP.
3.26 Nevertheless some people—and
especially those in Whitehall—are going to worry 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. These pensioners are unlikely to
complain about the extra income, but their sons and daughters
may complain about losing their rebates or paying higher contribution
rates.
THE TAX
TREATMENT OF
PENSIONS
3.27 To what extent could some of the distributional
consequences of the reforms be offset through changes to the current
tax treatment of pensions and other forms of saving? The major
distributional problem that many people might perceive with the
gold plated reform package is that it will give a large windfall
gain over the next decade to existing middle and high income pensioners,
paid for by the current middle and high income workforce who will
lose their rebates. Some of these windfall gains would be automatically
taxed away at the pensioner's current marginal rate. However,
given the existing quite generous tax breaks for the current generation
of pensioners, the question arises of whether this distributional
impact might be partially offset by reducing the value of those
tax breaks. This would achieve some redistribution of the gains
within the pensioner population away from more affluent pensioners
who would otherwise stand to gain. It would also raise some revenue
for the overall reform package.
3.28 Before we explore the options it is
worth setting out the principles that should underlie any changes
to the tax treatment of pensions and other forms of saving.
— a key objective for any centre-left
government is to make the overall tax system significantly more
progressive;
— saving long-term in a pension needs
to remain the most tax favoured form of saving;
— an effort should be made to simplify
the system if possible;
— it would be a bonus if the overall
cost of tax expenditures could be reduced to release resources
for raising the basic state pension and/or to fund a more generous
settlement in long-term care.
3.29 One modest way of reducing the windfall
gains to better off pensioners would be to freeze the age allowances
until they were at the proposed level for the BSP/MIG. This might
satisfy most people's judgement of an equitable tax treatment
in that pensioners reliant solely on the BSP would not be taxed
on it, but pension income above this level would be taxed at the
normal rates. With the minimum income set at £100 a week
from 2003 and then indexed in line with earnings and the age allowances
frozen in nominal terms from 2003, it would take only about four
to five years for convergence to be achieved. This would imply
a clear u-turn in government policy, which is to index the age-related
personal allowances in line with earnings from 2003-04 for the
remainder of the current Parliament. The proposed reform would
generate some additional revenue over the middle of this decade
as the BSP was being increased to the level of the MIG, but this
gain in revenue would be modest.
3.30 The additional married couple's age
allowance for the over 65s could be abolished outright at an appropriate
point. With the BSP being raised in value significantly and an
ever-higher proportion of people establishing entitlement to the
full BSP in their own right, any justification for the continuation
of this allowance would appear to be very weak.
3.31 Getting rid of the tax-free lump sum
is favoured in some quarters, though this would be politically
difficult. It could not be done retrospectively of course and
so would only affect those "cashing in" their pensions
from the date of the reform. Such a change would probably need
to be phased in so as not to create a sense of inequity between
age cohorts. It would not therefore raise much revenue in the
medium term or offset the immediate distributional effects of
the proposed reforms. The maintenance of the tax-free lump sum
would be one way of ensuring that the tax advantages of saving
in a pension vehicle were seen to remain intact.
3.32 The abolition of higher rate tax relief
on pension contributions is attractive on distributional grounds
as is abolition of the upper earnings limit on NICs. However,
both would further impact on the current workforce rather than
existing better off pensioners and so would not solve the perceived
problem of the windfall gains to those current better off pensioners.
The issue of higher rate tax relief on pension contributions raises
important questions about the structure of the tax system that
cannot be resolved here.
3.33 We have already flagged up other reforms
to the tax treatment of pensions and other forms of saving, including
the abolition of tax relief for equity based ISAs after 2004 and
the ending of the loophole that allows grandparents to contribute
to their grandchildren's pensions through the stakeholder vehicle.
Alongside the freezing of the age allowances and the ending of
the married couples' allowance, we have a package of reforms to
the tax treatment of pensions and savings that would satisfy the
principles set out above:
— the tax system would be made more
progressive by abolishing equity ISAs that will from 2004 only
be benefiting higher rate taxpayers anyway and by scaling back
the age allowances;
— the abolition of equity based ISAs
and the continuation of the tax free lump sum would mean that
pensions remained clearly the most tax favoured form of saving;
— the abolition of equity based ISAs
and the married couple's allowance would simplify the system;
— some resources would be released
to finance the increase in the BSP or to fund a more generous
settlement in long-term care.
3.34 Some of the windfall gains to current
better off pensioners would be tempered. However, it is an inevitable
feature of a reform package that relies on increasing a universal
benefit that a significant part of the gain will go the better
off. This has to be traded off against the other objectives that
are secured by the reform package: people receiving an adequate
non-means tested pension in retirement; a clearer set of incentives
for private saving; and a significant simplification of the system.
ANOTHER OPTION:
RAISING THE
OFFICIAL RETIREMENT
AGE
3.35 Several countries have planned for
or are considering raising the official retirement or pensionable
age at which the state pension is paid. The US is raising its
official retirement age to 67 by 2027 and this is also the age
that Sweden has chosen. It is interesting that these two countries
that are often seen to represent the polar models of advanced
market economies are both implementing changes to the official
retirement age similar to the one that is considered here.
3.36 Such a change needs to be justified
on more than just the grounds of improving the affordability of
the state pensions system. There is one particularly important
argument to make. There is evidence that the official retirement
age impacts on labour force participation rates (Disney and Johnson,
page 10). We could expect an increase in the official retirement
age to drag up labour force participation rates in its wake, thus
helping to achieve one of the goals that everyone recognises as
desirable. Indeed the modelling by Hawksworth (2002) assumes that
raising the official retirement age has this desirable impact
on labour force participation, making the point that such an administrative
change only has the full desired impact if it changes actual behaviour.
3.37 There are other principled arguments
to make. Hawksworth (2002) models the impact of raising the official
retirement age over the period 2020-30. This would be the decade
after the official retirement age would have been raised from
60 to 65 for women to align it with the age for men, which will
occur between 2010 and 2020. This already announced reform would
therefore set a useful precedent for raising the official retirement
age further and sensitise the whole population to the issue. For
the cohort first fully affected—that is those who would
have reached 65 in 2030—average life expectancy 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. Many people could expect to live for most
of that period in a reasonably robust state of health. With an
average of around 20 years of childhood and full-time education
and training, people would spend around 40 years not in the workforce
and around 45 years in it. It is intuitively plausible to think
that you have to work for more years than you can live in "leisure".
3.38 The distributional impact of raising
the official retirement age is easy to perceive. In effect the
same cohort is paying for its own more generous state pension
by being required to work a little longer—a redistribution
across the lifetimes of these individuals. Whether the official
retirement age is raised or not, the Government should engage
the public in a debate about trends towards early retirement in
the context of increased healthy life expectancy.
3.39 There are other practical steps that
should be taken. The Government has already recognised that a
key priority of the new Jobcentre-plus service that will integrate
the Employment Service and Benefits Agency should be to increase
activity rates amongst the over 50s—the employment and pensions
agendas are indeed inter-linked. The suggestion of the Performance
and Innovation Unit (PIU 2000) that people should be able to take
part of their pension while continuing to work part time for their
current employer needs to be taken forward. And the Government
will need to consider carefully the role of future legislation,
which it is required to introduce by 2006 to comply with an EU
directive, to prevent age discrimination and to promote age equality
(Spencer, 2002, forthcoming).
3.40 Currently, the gold plated reform package
that we have proposed would still result in a significant increase
in public spending on pensions over the period 2020-40, when the
bulge in the retired population occurs. They will now be entitled
to a significantly more generous BSP than would otherwise be the
case with the BSP indexed only in line with prices.
3.41 The modelling by Hawksworth (2002)
analyses an increase in the official retirement age to 70 over
the decade from 2020-30. We have made a pro-rata adjustment to
his costings to look at the impact of raising the official retirement
age to 67. This would be sufficient to make the whole gold-plated
reform package broadly revenue neutral. In this case overall expenditure
on the reform package would be around 6 per cent of GDP in 2050,
exactly the same as in the Government's base case. In practice
of course other elements of the reform package such as the phasing
out of the State Second Pension could be traded-off against a
larger increase in the official retirement age than the one suggested
here.
CONCLUSIONS ON
THE GOLD
PLATED BASE
CASE
3.42 It should be clear that we think that
the reform package outlined here with a much greater role for
a more generous universal Basic State Pension satisfies the objectives
for the pensions system better than the Government's current settlement.
The issue of whether adequacy for pensioners is best delivered
through a means-tested or a universal approach is an empirical
one. The current Government has in effect balanced the two approaches.
The MIG has been used to channel resources to the poorest elderly
but at the same time the BSP has been increased in real terms
and Winter Fuel Payments and Free TV licences (for the over-75s)
have been introduced on a universal basis. The 2001 Pre-Budget
Report showed that around two-thirds of the overall gains for
the average pensioner family from these policies had resulted
from increases in universal benefits with the MIG actually playing
the junior role (HM Treasury, 2001, page 89). Government policy
has thus been more pragmatic and more universalist than would
have been expected at the time of the 1998 Green Paper. Rejecting
the gold-plated reform on the grounds that it is too universalist
would seem strangely ideological for a government that prides
itself on implementing what works.
3.43 The Government's strategy has, however,
been essentially ad-hoc, with annual adjustments made to
the pension settlement. The political attractions of this approach
to the Chancellor might seem obvious. However, it means that people
really cannot see how the system is supposed to evolve over the
long-term, which is the necessary background against which they
can make their own plans for retirement.
3.44 However, what is being suggested here
as part of the gold plated base case—the indexation of the
BSP in line with earnings—will raise concerns in Whitehall.
Again, however, this cannot be a matter of principle. The 2001
Pre-Budget Report stated explicitly that "The Government
is committed to raising the MIG in line with earnings throughout
this Parliament" (HM Treasury, 2001, page 88). It also stated
that "the age-related personal allowances will be raised
in line with earnings rather than prices from 2003-04 and for
the remainder of the Parliament" (HM Treasury, 2001, page
92). Earnings indexation is therefore firmly on the Government's
agenda. If in principle you can earnings link the MIG and the
age allowances then in principle you can earnings link the BSP.
Which of these you want to do is an empirical matter and depends
upon your view of the affordability constraint. And of course
the effect of the ad-hoc increases in the BSP plus the Winter
Fuel Allowances is that the universal element of pension provision
has broadly been linked with the increase in earnings since 1998
anyway.
3.45 There is another feature of the gold-plated
base case that is not explicit but needs to be addressed. The
withdrawal of the rebates for contracting out would not in itself
alter the relative attractiveness of final salary (defined benefit)
as opposed to money purchase (defined contribution) occupational
pensions. However, the ending of the rebates might bring forward
the decisions of some companies to end final salary schemes. Whether
this is a matter of concern depends on a judgement as to whether
final salary schemes are capable of being saved. If you think
that the actuarial arithmetic that appears to spell the eventual
decline of final salary schemes is remorseless, then a reform
that might give that process an extra push might be seen as regrettable
but unavoidable.
THE SILVER
PLATED BASE
CASE
3.46 One frequent confusion in the debate
over pension or wider welfare reforms is the equating of targeting
solely with means testing. The original universal benefits introduced
by Beveridge were well-targeted on groups that by and large suffered
from low incomes. This included the BSP as in 1945 most pensioners
were poor. The fact that by the 1980s and 1990s this was no longer
universally the case as many of the retired had good private incomes
was one argument advanced for the retreat from the universalism
embodied in a somewhat more generous BSP going to all. However,
if certain groups of pensioners still suffer from higher levels
of poverty, this might justify an increase in the BSP aimed only
at these groups. This would be a form of targeted universalism.
3.47 The easiest way of enabling such targeting
would be to increase the BSP for older pensioners who tend to
have lower incomes.
Table 3.2
PERCENTAGES OF PENSIONERS LIVING IN HOUSEHOLDS
WITH RELATIVE LOW INCOMES BY AGE OF HEAD OF FAMILY, 1999-2000
| | Below 50 per cent of mean
| Below 60 per cent of median
|
| Under 70 | 20
| 20 |
| 71-75 | 25
| 25 |
| 76-80 | 29
| 29 |
| 80+ | 30 |
30 |
Note:
After housing costs.
Source:
Households Below Average Income series.
3.48 This then is the argument for what we have described
as the silver plated base case. This consists of raising the BSP
to the level of the MIG and indexing it in line with earnings
for those pensioners aged over 75. The BSP would remain price
indexed for those aged 65-74 and other features of the current
pensions settlement would remain in place, including the MIG and
the Pension Credit that would still be playing an important role
for the 65-74 age group, and the State Second Pension.
3.49 The available data on the income distribution allowed
Hawksworth (2002) to only model an increase in the BSP for those
over 75. This would raise direct public expenditure on pensions
to 5.8 per cent of GDP in 2010-11 compared with 5.6 per cent in
the Government's base case and 6.5 per cent in the gold plated
base case with the State Second Pension still in place. In 2050
this option would see direct public expenditure on pensions rising
to 7.3 per cent of GDP compared with 6 per cent in the Government's
base case and 8.6 per cent in the gold plated base case. Unsurprisingly
then the silver plated base case is more affordable than the gold
plated base case but costs more than the Government's base case.
3.50 This reform option scores poorly on the goal of
simplifying the system. In fact it adds another layer of complexity
with people having to adjust their behaviour to the prospective
jump in the BSP at age 75 in the context of a pensions system
where all the other features remain intact. This hike in the BSP
at age 75 is quite significant. Expressed in terms of benefit
levels as they were in 2000, the BSP could be worth just £34
at age 65 in 2050 and would then leap to £92 at age 75. Such
a skewed BSP does not seem sustainable.
3.51 Thus increasing the BSP to the level of the MIG
for the over 75s as a more targeted measure to alleviate current
pensioner poverty, does not really resolve one of the critical
structural issues facing the current pension system: the future
of the BSP for everyone. The silver plated base case looks like
another sensible pragmatic short-term solution that does not really
meet the objectives for a sustainable pensions settlement over
the long-term.
MAKING THE
STATE SECOND
PENSION MORE
GENEROUS
3.52 The fact that the Government's pension settlement
now implies an increase in direct public expenditure on pensions
allows a range of options other than increasing the BSP to be
explored. To many the attractions of going down the route of making
the State Second Pension more generous seem obvious. It appears
to be more targeted than a straightforward increase in the BSP,
having been explicitly designed to be more generous to the lower
paid when compared with the SERPS that it is planned to replace.
3.53 Modelling an increase in the State Second Pension
is, however, rather difficult. Hawksworth (2002) assumes that
the savings credit rate in the Pension Credit is reduced steadily
from 60 per cent in 2010 to zero by 2050. The resources saved
are used to increase spending on the State Second Pension so that
it costs twice as much by 2050 (that is 2.4 per cent of GDP as
against 1.2 per cent of GDP in the Government's base case). To
the extent that this extra money is focussed on those poorer pensioners
who opt for the State Second Pension, this would lift them above
the MIG. This reform option appears to turn out cheaper than the
Government's base case, with direct public expenditure running
at just 5 per cent of GDP in 2050 as against 6 per cent of GDP.
Phasing out the Pension Credit saves some resources and the more
generous State Second Pension reduces the cost of the MIG.
3.54 However, a more generous State Second Pension would
need to be accompanied by more generous rebates for opting out
otherwise more people will stay in the State Second Pension inflating
its direct costs. The extra costs of the rebates cannot be modelled.
However, a rule of thumb might be that a doubling of the value
of the State Second Pension would need to be accompanied by a
doubling of the cost of the rebates. These already cost 0.9 per
cent of GDP in 2000-01. This would effectively make the total
cost to the exchequer of this reform package similar to the cost
of the Government's base case (Hawksworth, 2002).
3.55 Falkingham et al (2002) also model an increase
in the State Second Pension paid for by phasing out the Pension
Credit. They point out that any increase in the State Second Pension
would have to be considerable for people to avoid means testing
in retirement. They also note that the more generous the State
Second Pension is the more likely it is that the stakeholder target
group will opt back in, thus increasing the direct expenditure
costs to the state.
3.56 This reform package scores poorly against the objective
of increasing the clarity of the system, though it does allow
the Pension Credit to be phased out eventually. Moreover, the
history of SERPS is salutary. It might be relatively easy for
a future government to once again reduce the generosity of the
State Second Pension safe in the knowledge that few might object
because so few understand the system.
BOX 3.1 SUMMARY
ASSESSMENT OF
ALTERNATIVE STATE
PENSIONS POLICY
OPTIONS
Hawksworth (2002) explicitly scores the four different models
against the four key objectives we have identified for the pensions
system. The Government base case scores poorly in terms of certainty
and transparency when compared with the gold plated case. The
gold plated case is nevertheless as affordable as the government's
model when combined with the phasing out of the State Second Pension
and the associated rebates and the increase in the retirement
age to 67 by 2030.
| Options1 | Affordability
(cost as per cent
of GDP in 2050)
| Adequacy
(minimum income
levels)
| Incentives to save
for own retirement
| Certainty and
transparency
Index (best =
6,Worst =1)1
|
| Government's base case: | 6.0
| Moderate/High | PC better for low earners/worse for moderate earners
| 1 |
| —without PC | 4.8
| Moderate | Poor for low earners
| 2 |
| Gold plated base case (BSP=MIG for all): |
8.6 | Very high
| No means-testing but income effect could be negative
| 4 |
| —with no S2P | 6.72
| High | Similar to above
| 6 |
| —retire at 67 from 2030 and no S2P |
6.02 | High for 67+/low for 65-66s
| Similar to above | 5
|
| Silver plated base case (BSP=MIG at 75) |
7.3 | Very high for 75+, high for others
| Means-testing retained for under-75s
| 3 |
| Higher S2P and no PC | 5.03
| High | Less means testing should boost incentives
| 3 |
1 PwC Index: Maximum score set at 6 for option 2b as this
has no means-testing and no complex second state pension arrangements.
For other options, up to three points deducted for the degree
of means-testing and 2 points for options where the State Second
Pension is retained. An additional 1 point deduction is made where
the state retirement age is increased (due to the disruption to
pensions planning).
2 Including the savings from abolition of NIC rebates assumed
to be 0.9 per cent of GDP each year.
3 Excluding the cost of NIC rebates for those opting out
of the State Second Pension, which could be significantly higher
under this option.
Source:
Hawksworth, 2002.
4. CONCLUSIONS
4.1 The results from the modelling exercises discussed
here lead to the conclusion that it is possible to design an alternative
pensions settlement that would better meet the key objectives
against which any system should be measured.
4.2 The current pensions settlement ensures an adequate
income for those who claim the MIG and will claim the Pension
Credit, but with the drawback of considerable complexity and a
very large role for means-testing with the associated problems
in terms of take-up, incentives and people's sense of the equity
of the system.
4.3 The gold plated base case, including 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. 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.
4.4 Importantly, it will do this without the complexities
of the existing policy regime. 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 will 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.
4.5 This can be illustrated by showing how far the proposed
new settlement would significantly lower the need for potentially
costly advice. Referring back to the simple framework outlined
earlier for thinking about the different forms of advice needed
by individuals:
— the question of whether to save should at least
be significantly simplified by people having clearer expectations
about what the state will provide in a non-means tested manner;
— the question of how much to save would be unresolved
and is discussed further below in the context of questions in
relation to the issue of compulsion;
— the question of where to save would be significantly
simplified by the phasing out of the State Second Pension and
equity based ISAs leaving funded pensions vehicles as the only
form of tax-favoured equity based saving;
— the question of whether to contract out of the
State Second Pension or not would become redundant as the state
would withdraw from second pension provision.
4.6 In these circumstances the questions of who should
provide and who should pay for advice would become much less important.
Overall the costs of providing advice should decline significantly—a
major additional benefit of introducing a clearer and more transparent
system.
4.7 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.
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" (page 7, DWP Nov. 2001). The reform package
suggested here is likewise affordable and sustainable.
4.8 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 Basic State Pension
might have what economists would term a negative income effect,
that is some people might save less given the extra income guaranteed
to them by the state. As the Basic State Pension 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.
5. APPENDIX: COMPULSION
AND INCENTIVES
Compulsion to save
5.1 The reform package would of course remove the option
of paying into the state second pension and the associated rebates
to those contracting out. The second tier vehicles that people
could save into would be the various private funded options: occupational,
personal and stakeholder pensions. Personal and stakeholder pensions
could no longer rely on being fed by the rebates. A key question
left unresolved is whether there should be compulsion to contribute
to a private funded pension.
5.2 The reform package suggested by the Pensions Reform
Group (Field et al, 2001) gave a clear answer to the question
of compulsion. This group advanced a similar analysis of the problems
with the current pensions settlement as presented here and suggested
that Government policy, with its heavy reliance on means-testing,
could be summed up as telling people "don't save, but don't
be too sure about relying on us either" (page 38, Field et
al 2001). Their proposal for a Universal Protected Pension
represented a hybrid of the pay-as-you-go Basic State Pension
and a new, state administered (at arms length), strongly redistributive,
funded, defined benefit scheme. The overall pension paid out would
be much more generous than the enhanced Basic State Pension suggested
here. However, this would be paid for by a significant increase
in national insurance contribution rates, with these contributions
diverted into the funded part of the scheme. This would represent
a clear increase in compulsion.
5.3 In the gold plated reform package outlined here there
could effectively be less compulsion, unless individuals were
compelled to make minimum payments into some form of private funded
pension. People would continue to pay the current contracted-in
contribution rates but would lose their rebates for contracting
out. Those personal pension pots fed solely by the rebates would
now require people to add their own private savings on a voluntary
basis if they were not to be effectively frozen in terms of new
contributions. This could worry many of the providers of personal
and stakeholder pensions, though they now feel obliged not to
persuade most people to opt-out and fund their pension pots through
the rebates. Some providers would advocate some level of compulsion,
in terms of minimum individual contributions into funded pensions,
doubting that the greater clarity and transparency of the proposed
reforms would in itself allow providers to more effectively market
their products. These providers also make the point that where
employers make a contribution this can be just the incentive necessary
for individuals to take up, say a Stakeholder, and contribute
as well.
5.4 This discussion raises the issue of whether the state
should compel employers to make contributions to their employee's
pensions, whether they are occupational, personal or stakeholder
pensions. Such compulsion does not exist in the current system,
though many employers do of course contribute voluntarily. We
have, however, seen that the manner and scale of those voluntary
employer contributions appears to be changing significantly, with
the decline of traditional defined benefit or final salary schemes
and a switch to defined contribution schemes often with lower
employer contributions. It was emphasised that it was not the
switch itself which was the cause of lower employer contributions,
rather a range of pressures were causing firms to lower their
contribution rates and a switch to a defined contribution scheme
was the means to achieve this. It was also emphasised that the
true incidence of employer contributions should in an efficient
labour market fall on employees in the form of lower gross wages.
5.5 Nevertheless there may be significant attractions
in terms of presentation of there being a new contract between
the employer and the employee to match the new contract being
suggested here between the state and the individual, with employers
and employees both paying into a funded pension. The question
is whether this new contract between the employer and the employee
should be underpinned by compulsion, as by definition would be
the contract between the state and the individual with its more
generous taxpayer financed pay-as-you-go Basic State Pension.
5.6 One problem with compulsory minimum employer and
employee contributions into a funded pension is that this can
become the norm for contributions rather than the floor, with
the potential that current contributions above the minimum could
fall towards it. Another objection is that over the lifecycle
it is not necessarily optimal for an individual to be making compulsory
contributions to a funded pension year-in and year-out, rather
than reducing their debts or saving in some other way. One objection
in principle to such compulsion is that the State has no right
to tell any individual how much and in what ways to save, in the
absence of external costs being imposed on the rest of society.
One reason why some people advocate greater compulsion in the
first place is so individuals do not rely on receiving means-tested
benefits in retirement. However, in a pension settlement where
the role of means testing is residualised, the need to avoid such
"moral hazard" is also minimised.
5.7 A key argument in relation to compulsion must be
that many employers will continue to provide a pensions contribution
to their employees as part of the employment contract, albeit
inevitably at a lower level of contributions than today. Providers
should be able to convince individuals to make contributions,
pointing out that although the enhanced Basic State Pension will
remove the perceived penalty to saving, it will itself only provide
a bare minimum income. The income effect of a higher Basic State
Pension in reducing saving is likely to be modest precisely because
the Basic State Pension will itself remain quite modest. It is
not possible to say whether total private savings will go up or
not under this reform package without further compulsion, but
then that is not a first order goal for any pensions reform. On
balance the proposed pensions settlement may work without additional
compulsion, though it is likely that this would be an issue that
policy makers would want to come back to at some point in the
medium term.
Incentives to save
5.8 The debate on compulsion is perhaps jumping the gun.
Clearly, the alternative strategy to compulsion is to make the
existing emphasis on incentives work better for more people. It
has been recognised that the current reliance on tax relief as
the sole saving incentive does not work for many people, particularly
those on low incomes. In their broader savings strategy, the government
is pursuing this approach and developing new means of incentivising
people to save. We have already referred to the Savings Gateway
and the Child Trust Fund, which include the notion of "matched"
contributions and kick-start capital endowments respectively.
These policies are still being consulted upon so it is early days
on how public policy can be more creative in the incentives it
offers to get people to save. In the pensions arena, we need to
learn form this wider debate and perhaps think more imaginatively
about new or reformed incentives, before considering compulsion.
A framework of coherent incentives might fit better with British
culture and the evolution of our welfare state, and would also
avoid some of the problems with compulsion identified above.
5.9 Assessed against our objectives for pensions reform
the proposals of the Pension Reform Group (Field et al,
2001) score highly in terms of adequacy for future pensioners.
However, in itself the proposed Universal Protected Pension does
not do anything for current poor pensioners. This is why in addition
Field et al (2001) suggested that there are significant increases
in the Basic State Pension for the over 75s and over 80s—that
is a variation of our silver plated base case. Their proposals
score highly in terms of the improvement in incentives to save,
in so far as the incidence of means testing is reduced, but there
is in addition of course the greater compulsion to save anyway.
The proposals are clearly affordable in that the reforms are fully
funded and the proposed variation on the silver plated base case
would not be too costly. However, the proposals do not meet the
objective of introducing greater clarity and transparency into
the system, as they—intentionally—involve a significant
departure from the system as it has evolved over the post-war
period and with which people are familiar. A more generous Basic
State Pension by its very simplicity would seem more likely to
generate sustained popular support than a more wholesale reform
that might be hard to explain.
5.10 Indeed it is the fact that the gold-plated base
case builds on the existing settlement and its most widely recognised
feature—the Basic State Pension—that may be its strongest
point.
Richard Brooks
Sue Regan
Peter Robinson
February 2002
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