Annex
Institute/Faculty of Actuaries Response
to: The Pension Credit: a Consultation Paper (CM 4900)
PREAMBLE
The actuarial profession welcomes the opportunity
to respond to the Government's consultation document on the Pension
Credit. The profession supports the aims of widening the opportunity
to achieve a decent income in retirement and of providing security
for those who cannot save (DSS 2000a).
We begin by setting out our interpretation of
the Pension Credit document. We assume that:
1. From 2003 the Minimum Income Guarantee
(MIG) will be £100 per week
2. For every pound of private income above
the level of the basic state pension (BSP), pensioners will receive
the Pension Credit.
BACKGROUND
Fellows of the Institute of Actuaries and the
Faculty of Actuaries provide advice to companies about occupational
pension schemes and other employee benefits, as well as to Trustees
of occupational pension schemes. Fellows are less likely to provide
advice to individual savers who fall into lower income brackets,
but this area is also a concern since occupational pension schemes
often have a wide membership.
Since the 1980s, the extent to which the state
has been involved in providing retirement income "as of right"
(that is, in return for National Insurance contributions) has
been eroded, whilst means tested benefits available to those over
state pension age have increased in value. The recent promise
to increase the MIG to £100 per week means that a single
person who received median earnings whilst in work would have
to have paid nearly 40 years' National Insurance contributions
in order to have a state retirement pension (that is, from BSP
and State Earnings Related Pension or State Second Pension) equal
to the MIG.
The average time spent unemployed is approximately
17 per cent of a working lifetime (this estimate is based on data
in Labour Market Trends, 1998, Vol 106 No 9 and Labour Market
Trends, 1999, Vol 107, No 1), or 8½ years in a working lifetime
of 49 years. Some periods away from paid employment carry full
credit towards the BSP, but even so pensioners receive, on average,
only 80 per cent of the BSP.
We would like to respond to the consultation
in the following areas:
II. Abolishing the capital limits.
III. Integrating the tax and benefit systems.
I. The Pension Credit
STATEMENT OF
PROBLEM
We noted above that someone on median earnings
would have to have a nearly complete record of National Insurance
contributions in order for their state retirement pensions to
exceed the MIG. Single people with shorter contribution histories,
or who have been paid less than median earnings, could get no
benefit from the first tranche of any private income they had
managed to save.
People on low incomes wanting to save for retirement
thus have to make a difficult choice. By making such provision,
whether by joining an employer's occupational pension plan or
by making private saving, employees could become worse off:
1. Because income employees might otherwise
have received during their working lifetimes has been deferred
until retirement, when it just reduces entitlement to means tested
benefits.
2. Because loss of the MIG can mean loss
of other means tested benefits that are, potentially, quite valuable.
Couples are in a slightly different position
since, although entitlement to state retirement pensions is based
increasingly on individual National Insurance contributions, eligibility
for means tested benefits is based on household income. Together
with the increasing incidence of family breakdown, this makes
estimates of the financial position of couples in retirement quite
unreliable. For this reason, and because the majority of pensioners
in receipt of means tested benefits are single, we concentrate
on the position for single pensioners. However, the points we
make are relevant to couples as well.
Whilst the MIG has been the "headline"
figure on which means tested income has been publicised, those
on low incomes could also be eligible for other means tested benefits.
The most financially significant of these are Housing Benefit
(HB) and Council Tax Benefit (CTB), which the DSS estimates could
amount to approximately £3.4 billion in 2001-02 (compared
to £3.9 billion for income support) (DSS, 2000b).
HB and CTB have tapers of 65p in the pound and
20p in the pound respectively, so that private income is not lost
pound for pound for those only entitled to these benefits. However,
together the tapers result in the high marginal tax rate of 85
per cent. Currently the tapers start to apply once income is above
the MIG (otherwise individuals could experience marginal tax rates
of over 100 per cent). Depending on the amount of rent and council
tax a pensioner has to pay, those with incomes of up to £15,000
per annum could be in receipt of means tested benefits. That is,
marginal tax rates of 85 per cent will apply to most tenants on
low incomes.
Because of the taper, it might appear that this
group of people does indeed benefit from their savings. Clearly
they are better off in retirement than had they not saved. But
in order to get to this position they have been worse off during
their working lifetimes. If they saved in a pension scheme then
they will have done so without incurring much tax, but in payment
their savings are taxed at 85 per cent. If the savings accumulated
in a building society they will have been taxed at the individual's
marginal rate, say 23 per cent, and in retirement they will be
taxed at a further 85 per cent. In either case, the individual's
lifetime wealth would be higher if no savings had been made.
In the past the value of income support was
lower and, relatively, the value of the BSP was higher. This meant
that most employees with occupational pensions could expect to
receive incomes in retirement greater than means tested benefits.
With the increase in the MIG and the decrease in state pensions
this position is likely to deteriorate significantly and, under
current policies, it will continue to do so. For example, if real
earnings growth is 1.5 per cent per annum, the MIG will increase
from the estimated £100 per week in 2003 to approximately
£150 per week in constant price terms 27 years later, nearly
double the level of the BSP.
For people to be able to plan effectively for
retirement, the foundation on which savings are built needs to
be made more stable. Ideally, this means that the BSP should be
the headline benefit. It might need to be underpinned by a MIG,
but this should be a safety net for those unable to find employment
for a large part of their working lifetime.
Clearly, since the BSP is paid to all eligible
employees regardless of their income there would be cost implications
in increasing its value to take the place of the MIG as the target
minimum income. We consider this later in our response. However,
if the Government genuinely wishes to "reward the thrift"
of those on low incomes, it cannot do so by imposing high marginal
rates of tax on their savings.
ANALYSIS
The consultation paper describes the Pension
Credit as a "reward" for pensioners on low and middle
incomes. In fact, the Pension Credit is a benefit taper of 40p
in the pound, similar to that applied to HB and CTB. It will result
in a smaller penalty being applied to some savings than is the
case presently.
Chart 1 of this response shows the marginal
tax rates that are applied to the savings of an individual in
receipt of a BSP of £62 per week (80 per cent of the full
BSP in 2003), under three scenarios:
(i) Under the current means testing regime;
(ii) Under the regime that will be applied
if our interpretation of the consultation document goes ahead;
and
(iii) The regime that would apply if the
values of the BSP and the MIG were exchanged.
The calculations ignore the effect of HB and
CTB, which will complicate the picture.
We can see the following:
— Under the current system, pensioners
with incomes lower than the MIG experience marginal tax rates
of 100 per cent. Those with incomes above the MIG experience the
appropriate marginal tax rate for their level of income (for example
0 per cent for those whose income is less than the single person's
tax allowance plus the age allowance).
— Introducing a Pension Credit only
on income in excess of the full BSP means that pensioners with
incomes lower than the BSP will still experience marginal tax
rates of 100 per cent.
— Those pensioners with incomes greater
than the BSP will experience marginal tax rates of 40 per cent.
Since pensioners with incomes just above the income tax threshold
could still be entitled to the Pension Credit, they could experience
a marginal tax rate higher than 40 per cent. However, this group
can expect to be better off under the proposed Pension Credit
regime than they currently are, or than they would be if the current
regime continued.
— The effect of reducing the benefit
taper applied to the MIG from 100 per cent to 40 per cent is to
extend the income range over which means testing applies. As the
taper falls, the marginal tax rates of those already subject to
means testing falls, but those brought within the net will experience
higher marginal tax rates. Ironically, reducing the taper (and
so reducing the savings penalty) will increase the number of people
who experience poor net rates of return on their saving.
— By increasing the BSP to £100
per week whilst keeping the MIG at £77, pensioners will experience
the appropriate marginal tax rates for their level of income.
Individuals within a couple who each accrue
the average entitlement to BSP and remain together are less likely
to experience marginal tax rates of 100 per cent, provided their
entitlement to Pension Credit starts at the level of the married
person's BSP.
If their entitlement to Pension Credit starts
at the single person's BSP, they would receive Pension Credit
in respect of some of their income from the BSP, which seems contrary
to the intention of the consultation document.
The position of a person who is over 60, and
thus entitled to MIG, but under state pension age and thus not
eligible for state pension is not clear. The position would appear
to be even more complicated for couples, given the possible permutations
of ages above and below 60 and state pension age. The Government
should also consider whether their proposals will be sustainable,
once the State Pension Age for women begins to increase in 2010.
The effect is more complicated when HB and CTB
are taken into account, and will depend on how the MIG and Pension
Credit tapers are integrated with HB and CTB tapers. There must
be some change to the basis for integration, otherwise individuals
could be subject to marginal tax rates greater than 100 per cent.
In any case, it is likely that marginal tax rates will remain
higher, and more people will be subject to these high marginal
tax rates.
We support the principle of encouraging more
people to save for their retirement. However, there is evidence
that many people find it difficult to save and that there are
significant costs to saving in approved pension vehicles. To overcome
these obstacles, the Government must provide a savings environment
where the low paid genuinely benefit from their savings, rather
than not being penalised quite so extensively as they are at present.
Reducing the effect of the taper from 100p to 40p in the pound
will clearly make some people better off. However, any taper will
act as a disincentive to saving.
Currently the low paid face far more disincentives
to save than the high paid and they save (proportionately) far
less. If they are to be expected to save more it must be made
rational for them to do so. This could happen if, as suggested,
means testing resumed its role as provider of last resort, and
the BSP became a minimum income.
II. Abolishing the capital limits
We welcome the decision to remove the current
onerous means test and replace it with a less intrusive test.
However, total removal of a means test on capital could encourage
the development of financial products designed to convert income
into capital. In particular, it could place a further obstacle
in the way of pension savings, where the majority of the savings
must be converted to income at retirement.
It seems absurd that someone with a large amount
of capital but no income flowing from it should be entitled to
claim means tested benefits. The Government might like to consider
a high level cap or other anti avoidance provisions.
III. Integrating the tax and benefit systems
Many people are aware of the tax allowances
for people aged over 65, which help to raise many of those on
low incomes out of the income tax system. However, the fact that
the allowance tapers from £1,385 (£1,645 if aged 75
or over) to £0 for those on incomes over £16,800 (1999-2000
tax year) is less well known. The effect of the taper is to impose
a marginal tax rate of 33 per cent on those with incomes of between
£16,800 per annum and £19,570 per annum (£20,090
if aged 75 or over).
The Government is concerned that by increasing
the BSP, those with higher incomes will benefit to the same extent
as those with lower incomes. Indeed, as the DSS have pointed out,
because of the effect of means testing, in absolute (but not proportional)
terms, the better off will benefit more.
To a limited extent, removal of the age allowance
"claws back" a proportion of the BSP. This principle
could be extended. For example, the 33 per cent marginal tax rate
could be extended up to the higher rate tax bracket. After all,
those in work have to pay National Insurance contributions on
their incomes above the Lower Earnings Limit so effectively pay
tax at 33 per cent on all their income above the single person's
allowance.
Extending the tax coverage of the better off
elderly can be justified in many ways:
1. Concentrating the cost of retirement
over the time whilst people are in paid work, means that some
people could experience poor working lifetimes and relatively
better off retirements. If the cost were spread over all those
with the ability to pay, whether in work or in retirement, people's
net lifetime incomes could become more stable.
2. If the state pension age remains at 65,
the elderly will spend an increasing proportion of their adult
life in retirement. The extra marginal tax rate could be designed
to ensure that the cost of ageing is shared equitably between
those in work and those in retirement.
3. Those who are better off are likely to
have received a tax free lump sum from their pension schemes at
retirement. There is little economic rationale for this benefit
and it is regressive in the sense that it is more valuable to
those on higher marginal tax rates.
CONCLUSION
The Pension Credit document notes that the gap
between rich and poor pensioners has grown dramatically over the
past 20 years. This is partly due to the success of occupational
pension schemes. By introducing stakeholder pensions the Government
hopes to extend the benefit of retirement saving to the low paid.
However, those on above average earnings have a clear playing
field on which to plan their savings, since the likelihood that
they will be eligible for means tested benefits is small. The
lower paid need to have similar clarity in order to plan effectively
for retirement.
The current benefit and tax system neither provides
clarity, nor acts equitably across different income groups. Extending
the reach of means testing, whilst applying tapers at different
rates for different benefits will result in an even more incoherent
system. Whilst the Pension Credit will improve the position of
those with small amounts of income in addition to the BSP, if
it is introduced without significant adjustment, it will become
impossible to provide savings advice to those on low to medium
incomes (or to their agents). No one who thinks they might fall
within the means testing system can be expected to plan rationally
in these circumstances.
The tradition in the UK has been for the state
to encourage individuals to save for themselves, whilst recognising
that the private sector cannot meet everybody's needs. This is
why Beveridge kept means tested benefits to underpin the BSP and
private savings. Attempting to underpin private savings through
means testing ensures that the private sector will fail the most
vulnerable groups. Effectively, means testing institutionalises
mis-selling, since certain groups will receive a negative return
on their savings, regardless of the private provider's efforts.
If people on low incomes are to be expected
to save for retirement, then the Government has a responsibility
to ensure that, in most circumstances, they are able to get a
positive return on those savings. It can do this by providing
a BSP that is both comfortably in excess of means tested minimum
incomes, for those with nearly full working histories, and a reasonable
proportion of earnings.
There will always be circumstances in which
people are unable to accrue a full entitlement to BSP, in which
case there must be a means tested safety net. But the need for
this should only arise in a small minority of cases. In these
circumstances we could return to our work with confidence that
we are not actually doing our clients and their employees a grave
disservice by encouraging the provision of occupational pension
schemes.
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