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Select Committee on Economic Affairs Fourth Report



10.1. This chapter reviews the extent and nature of the public pension system in the United Kingdom. This system is extremely complex, and this complexity is seen to act as a significant barrier to public comprehension of pension issues. A major element of complexity relates to the extensive and growing use of means-testing to allocate pensioner income. This is seen as a significant barrier to the further development of voluntary pension savings. An additional impediment to voluntary savings is the uncertainty created by the lack of political consensus about the purpose and structure of the state pension system. We make recommendations to address each of these problems.

Complexity and uncertainty

10.2. The United Kingdom pension system is complex - arguably the most complex of any industrialised economy. The Basic State Pension (BSP) is provided to all persons above state pension age who have an adequate National Insurance (NI) contribution record. There is also a State Second Pension (S2P) which has replaced SERPS as a supplementary pension for low earners. Income from these sources may be inadequate to provide a minimum acceptable income, in which case the income guarantee element of the Pension Credit (PC) acts to top up pensioners' income, as do a range of other means-tested benefits. In addition, workers have the option of "contracting out" of SERPS/S2P, and instead putting their NI rebate into a personal pension (PP) of which there are 12 different types, or a contracted-out occupational pension scheme, of which there are 10 different types which can be either defined benefit (DB) or defined contribution (DC).[110] Employers who do not run occupational pension schemes are now required to offer Stakeholder Pensions to their workers. Pension professionals find this structure complex; non-experts find it impenetrable. In the words of Dr Deborah Cooper (Retirement Research Unit, Mercer Human Resource Consulting Ltd), speaking on behalf of the Actuarial Profession, "a huge obstacle to saving at the moment is not a lack of incentive, it is just the maze that you have to go through in order to make the decisions, and it is just too difficult. It is difficult for us to understand exactly what it all means so I dread to think what the ordinary lay person thinks" (Q962).

10.3. All independent witnesses were of the opinion that the complexity of the state pension system, and the complexity of the way it interacts with private pensions to produce a retirement income, creates a significant barrier to better and more widespread understanding of pensions issues among the United Kingdom population. This viewpoint was expressed by, amongst others, the Engineering Employers' Federation (Q595), the Confederation of British Industry (Q635), the National Association of Pension Funds (Q647), the Association of British Insurers (Q742), Age Concern (Q309), the Fawcett Society (Q408), the Financial Services Authority (Q896) and the Equal Opportunities Commission (Q518). We are extremely concerned to find that the Department for Work and Pensions and the Treasury appear not to recognise or give due attention to these widely and deeply held concerns about the complexity of the state pension system. It is striking that the commitment to a "simpler pensions framework" embodied in the 2002 pensions Green Paper[111] is confined almost wholly to simplifying the tax rules relating to private pensions (Q408).

10.4. We acknowledge the validity of the distinction drawn by the Secretary of State for Work and Pensions between the internal complexity of the rules of a pension system and the ease with which that system can be used by consumers (Q1119). However, we are disappointed to find that he does not seem to recognise the strength of the views of consumers, employers, and the pensions industry that the current pension system in the United Kingdom fails the test of "ease of use". Many of the concerns of users relate to the interaction between private sources of retirement income and the means-tested elements of the state system. We discuss this issue of means-testing in more detail below.

10.5. The problem of complexity which pervades the state pension system is compounded by the problem of uncertainty. Pension outcomes are inherently uncertain because pension provision involves very long run formal or implicit contracts, and long-run economic and political outcomes are subject to a wide variety of risks. However, uncertainty about the outcomes of the public pension system has been exacerbated by a lack of political consensus about pensions, which has led to major reform of the United Kingdom public pensions system at least once a decade since the National Insurance system was inaugurated in 1948.[112] Further uncertainty is generated by the sensitivity of the value of public pensions to technical issues such as indexation, which are not well understood among the general population. Thus, according to Dr Katherine Rake (Director, The Fawcett Society) many people "do not trust the state but they trust private pension providers even less" (Q451).

10.6. We conclude that the state pension system is too complex to function effectively, and that the Government have taken insufficient notice of widespread concern about this complexity in their formulation of pensions policy.


10.7. Institutional and administrative complexity obscures the purpose of the state pension system. It is not clear whether it is supposed to offer a (semi-contractual) return to insurance contributions; or a system of income support and poverty prevention; or a (minimal) foundation for private pension accumulation. Elements of each of these intentions can be found in the existing public pension system. The requirement of a full National Insurance contribution record for full pension entitlement preserves Beveridge's concept of a contribution-based insurance system. The income guarantee element of the Pension Credit which is used to raise the income of the poorest pensioners to a subsistence level reflects a primary concern with poverty prevention. The facility for individuals to "contract out" of all but the basic state pension, together with the long-run decline in the value of this pension, which is expected to fall from 16 per cent of average earnings to just 6 per cent over the next 50 years, suggests that the state system is designed to do little more than provide a minimal (and increasingly residual) foundation for private long-term saving.[113]

10.8. The lack of clear purpose renders it impossible to determine an unambiguous set of criteria by which the level of the public pension, or the state pension age, or pension eligibility criteria, might be set. It is thus difficult to evaluate the desirability or otherwise of the Government's 1998 aim to shift the balance of public and private sources of income in retirement from 60:40 towards 40:60 (see paragraph 9.10 above).

10.9. It was suggested to us by Steve Webb MP that rather than set targets and evaluate achievements by reference to the broad source of retirement income, a more relevant criterion might be the proportion of people of working age who are likely to achieve an income in retirement that at least equals some agreed percentage of their pre-retirement income (Q1062).

10.10. While we do not wish to endorse any specific criteria for evaluation of the Government's overall pensions policy, we believe that such criteria should give due weight to the performance of the pension system in meeting the welfare needs and goals of individuals, as well as meeting higher level objectives relating to the funding mix.

10.11. This lack of a clear purpose to the state pension system also makes it difficult to impute any clear meaning to the concept of the "fiscal sustainability" of the pension system. According to evidence from the Treasury, a general measure of fiscal sustainability is a stable ratio of debt to GDP over time (Q92). However, the fiscal sustainability of the pension system appears to be interpreted by the Government as meaning a stable or slowly declining ratio of public pension expenditure to GDP, falling from 5 per cent today to 4.4 per cent by 2051 (QQ14-5). It should be noted that this decline in expenditure share is projected to occur over a period in which the proportion of the population above state pension age will rise from 18 per cent to 24 per cent.[114]

10.12. In the absence of clear criteria relating to the purpose of the state pension scheme, we cannot see why an expenditure share that rises in line with the increase in the size of the pensioner population, and the need to raise additional tax or national insurance revenue that this would imply, should be any less "fiscally sustainable" than the course the Government have mapped out. We make this point not because we believe that state pension expenditure necessarily should rise in line with population, but because the Government's use in this context of the term "fiscal sustainability" appears to us to be vacuous.

10.13. We recommend that the Government produce a clear set of pension performance criteria which include indicators of the outputs of the pension system (present and expected future pensioner income) as well as the inputs to the system (the scale and source of pension finance). We further recommend that the Government's success in meeting these objectives be regularly monitored and published.

10.14. Even less clear is the logic behind other age-specific public benefits such as subsidised or free travel on public transport. Baroness Greengross suggested that, as we move towards a society in which competence rather than age determines employability, and need rather than age determines receipt of public resources, age-related benefits such as heating allowances, free television licences for the over-75s and the bus pass seem increasingly anachronistic (Q130).

10.15. We recommend that the Government should provide an explanation of the rationale for the continuation of age-related benefits such as subsidised travel.

Means testing and public pensions

10.16. Many witnesses identified the nature and extent of means-tested benefits for pensioners as a fundamental weakness of the United Kingdom public pension system. The primary means test until October 2003 applied to the Minimum Income Guarantee (MIG), which was the name used for income support for the over 60s. In October 2003 the MIG was replaced by the Guaranteed Income Top-Up of the Pension Credit. At least three separate problems with this system were identified by witnesses:

  • The marginal tax rate faced by pensioners
  • The number of pensioners subjected to this means test
  • The difficulty of giving unambiguous financial advice to persons who may qualify for the Pension Credit

10.17. In 2003-04 the basic state pension for a single person was £77.45 per week, and the MIG was £102.10 per week. Under the MIG, any pensioners who received a non-state income of up to £24.65 per week saw no net benefit from this private income because their MIG was reduced pound for pound. Thus they faced a marginal tax rate on the first £24.65 of private pension income of 100 per cent. The Pension Credit was designed to remove the 100 per cent marginal tax rate. It does this by providing pensioners with a savings credit which is reduced at the rate of 40 pence per £1 of additional income, up to a total weekly income of £139 for a single person, and £203.80 for a pensioner couple. Thus pensioners with incomes in this range will now face a marginal tax rate of 40 per cent. However, Mr Graham Vidler (Policy Adviser, Association of British Insurers) pointed out to us that this 40 per cent marginal tax rate is a minimum. A pensioner who receives the savings credit but who also pays tax at the basic rate will face a marginal tax rate of 53 per cent, and if their receipt of the savings credit leads to withdrawal of housing benefit and council tax benefit the marginal tax rate could reach 93 per cent (Q743).

10.18. The Pension Credit has removed the absolute penalty of saving that was imposed by the MIG, but it still leaves pensioners who are on an income of barely 30 per cent of national average earnings facing a marginal tax rate that is otherwise reserved for persons earning over £35,000 per annum. The Rt Hon Frank Field, MP, pointed out to us that the impact of these high marginal tax rates on poor pensioners sends out a message that "under the present system it is not safe to save" (Q1055).

10.19. Because the savings credit element of the Pension Credit now extends further up the income scale than did the MIG, it affects more people. At the point of introduction, around 50 per cent of all pensioners became eligible for some means-tested income supplement under the Pension Credit. Because the savings credit element of the Pension Credit is likely to be indexed to earnings, the number of pensioners who will qualify for means-tested savings credit is expected to rise over time. The Government have estimated that 65 per cent of pensioners will qualify by 2050; Mr John Hawksworth (PricewaterhouseCoopers) provided us with an alternative estimate of 70 per cent coverage by that date, and noted that the Institute for Fiscal Studies has produced an estimate as high as 80 per cent. It is clear, therefore, that the means-testing of pensioners in order to provide them with a savings credit income supplement will become the norm.

10.20. Older pensioners are, and will continue to be, particularly prone to means testing, because income in retirement tends not to increase as fast as real earnings - largely because many private pensions, and the basic state pension, are indexed to prices. If a pensioner's income is indexed to prices, then after 20 years in retirement, their income is likely to be around 50 per cent lower than the income of a new retiree. This means many pensioners with incomes above the Pension Credit threshold on retirement will fall into the Pension Credit means-test during retirement (Q914).

10.21. It is very difficult to predict how the Pension Credit will affect any individual who retires in the future, for two reasons. First, there is uncertainty about how the various income and savings thresholds of the Pension Credit will be indexed. Secondly, there is uncertainty about how much pension income an individual's lifetime savings will generate if these are paid into a defined contribution pension, because this income will depend on long-term investment performance and on annuity rates at the point of retirement. This dual uncertainty makes it very difficult to provide unambiguous financial advice for that half to three-quarter of the population who are likely to be eligible for the Pension Credit during their retirement. FSA rules require that individual financial advice should be thorough and appropriate, but it is extremely difficult to provide such advice given the uncertainty of the way in which private savings may interact with the Pension Credit. Mr Peter Tompkins (PricewaterhouseCoopers) told us that "virtually all people in the industry would like to see the state bedrock pension taking people clear of means-testing, so that the advisory process can be simple" (Q248).

10.22. The Government appear to believe that the high marginal tax rate faced by Pension Credit recipients does not necessarily reduce the incentive to save. The Secretary of State for Work and Pensions noted that while the theoretical argument about the savings disincentive is clear, there is no empirical evidence to demonstrate that these tax rates in practice affect people's long-term saving behaviour, and therefore the Government have decided to initiate research on this subject (Q1117).

10.23. We are pleased that the Government are commissioning research in this area, but we believe that the disincentive to save comes not simply through the level of the marginal tax rate. Indeed, given the complexity of the Pension Credit system, we suspect that among current recipients few can calculate for themselves the marginal tax rate imposed on their savings, and among current workers almost none will be able to predict the marginal tax rate they may face in retirement. We concur with evidence from the Association of British Insurers that "the effect of means testing on the incentive to save is slightly more subtle than that, and it is mediated through people's vague awareness of the existence of means testing and in particular the way that that impacts on financial advisers' perceptions and the advice they can give" (Q743).

10.24. We also believe that people who are among the poorest in our society should not face marginal tax rates on their very modest private income in retirement that are at least as high, and in some cases considerably higher, than the tax rates faced by persons earning over £35,115 (the current threshold for the 40 per cent income tax band).

10.25. We therefore conclude that the Government's heavy and growing reliance on means-testing the pensioner population is regrettable because it:

  • unduly penalises current pensioners who have struggled hard to provide a small private income for themselves in retirement
  • sends a clear signal to many current workers that it is not in their interests to save for their own old age
  • is unfair to tax some of the poorest members of our society at marginal rates as high as or higher than those imposed on the rich

10.26. Many witnesses suggested that the extensive means testing of the pensioner population should be avoided, and that this might best be achieved through the payment of a non-means tested state pension at a level around, or slightly above, that of the MIG (roughly 20-22 per cent of national average earnings). Age Concern (Q303), the TUC (Q353), the National Association of Pension Funds (Q675) and the Pensions Policy Institute (Q909) all supported some variant of this idea on the grounds that it would provide a simple, stable, and comprehensible foundation for additional private pension saving.

10.27. We find the arguments for a basic pension paid at or marginally above a minimum subsistence level compelling. Such a pension would permit the removal of the complex and costly apparatus of means-testing for pensioners, and would send a clear signal to workers that any saving they make during their working years will be theirs to keep and use during retirement. We believe that it will not be possible for the Government significantly to increase the scale of voluntary retirement saving unless and until it can make a credible commitment that it will not claw back this saving at a later date via a means test. We believe, however, that the state pension should continue to be treated as taxable income.

10.28. We therefore recommend that as a top priority the Government should consider introducing a non-means-tested state pension paid on the basis of citizenship to all persons of pension age. We believe that the provision of this baseline state pension is a necessary element for the development of a more extensive system of voluntary pension saving in the United Kingdom.

10.29. In addition to providing an adequate, simple and comprehensible pension for retirees, a non means-tested universal pension would enable the extremely complex system of "contracting out" to be abolished, thereby enormously simplifying the administration and regulation of occupational pension schemes.

10.30. We recognise that such a pension would have significant costs, and may have to be phased in over a number of years. There are many ways in which the costs of such a pension might be spread across current and future cohorts of workers, and it is not our place to determine a preferred path. We note, however, that in the short run it would be possible to remove some of the poorest and most vulnerable pensioners from means-testing by paying the basic pension at the level of the income guarantee to all pensioners aged 80 and above. The Rt Hon Frank Field, MP, Mr Steve Webb, MP and Mr David Willetts, MP, all persuasively argued the case for using age, rather than income, as the targeting mechanism (Q1055). The Pensions Policy Institute informed us that the cost of this would be in the region of 0.2 per cent of GDP (Q916). Though this is a non-trivial sum, if it is correct, it is small enough for this policy change to be introduced in the short run.

10.31. We therefore recommend that the Government should expeditiously develop a fully costed proposal for the payment of the basic state pension at the level of the minimum income guarantee for all pensioners aged 80 and above.

The concept of a "pensions crisis"

10.32. The concept of a "pensions crisis" has recently received a good deal of media attention, and it was explicitly analysed earlier this year by the Work and Pensions Committee of the House of Commons.[115] We believe that the concept of a general pensions crisis is too loose to have clear analytical meaning.

10.33. As noted in paragraph 3.7 above, we conclude that there is no general economic crisis of ageing in the United Kingdom now or in the foreseeable future. If there is a pensions crisis, it must relate not to the aggregate economic impact of population ageing, but instead to the specific institutional characteristics of the United Kingdom pension system.

10.34. It is clear that there is no crisis of affordability in the current United Kingdom public pension system. State spending on pensions in the United Kingdom is projected to remain at roughly its current level of 5 per cent of GDP to 2050, whereas the average across EU countries is projected to rise from 10 per cent to 13 per cent (QQ58, 918). However, the large size (relative to EU countries) of the private pension sector in the United Kingdom means that total United Kingdom expenditure on pensions is currently around 11.5 per cent of GDP, compared to 12.5 per cent for the EU average (QQ58-9).

10.35. Mr David Willetts, MP, questioned the reliability of the Government's projection that state expenditure on pensions in the United Kingdom will remain at or around 5 per cent of GDP for the next 50 years. We are not in a position to evaluate these different claims, but it is clearly important to establish reliable and consistent projections which are open to independent scrutiny.

10.36. We believe that there may be a crisis of adequacy with respect to pensions. The pensioner population is expected to rise substantially over next 50 years, and thus average state pension payments per pensioner must decline relative to per capita GDP if state pension expenditure remains at 5 per cent of GDP (paragraph 10.11). For pensioners to maintain their living standard relative to workers, private pension saving as a proportion of GDP must rise substantially (paragraph 9.10). However, short-run trends indicate that private pension saving is declining rather than rising (paragraph 9.24).

10.37. We believe that there may be a crisis of confidence about pensions. Mis-selling of financial products, the collapse of Equitable Life, the fall in stock market values and in annuity rates, and employer withdrawal from defined benefit occupational pensions has created massive loss of public trust in the financial services sector (paragraphs 9.36, 9.37). Frequent Government meddling with public pension arrangements has undermined confidence that public pension promises made today will be honoured in the future (paragraph 10.5).

10.38. We believe that there may be a crisis of incentives. The extension of means-testing to a majority of pensioners (via the Pension Credit) reduces the incentive to forego current consumption and make private provision for old age (paragraph 10.23).

10.39. As noted in paragraphs 8.10, 9.32 and 10.28 above, we believe that the best way to respond to the problems of adequacy and incentives is to develop an adequate, universal and simple basic pension, based on citizenship rather than contribution record, which will act as a foundation for an expansion of voluntary pension saving. However, we believe that the problem of a lack of public confidence in the United Kingdom pensions regime requires additional intervention. A number of witnesses, including Age Concern, the CBI, the Fawcett Society, the National Association of Pension Funds and the Association of British Insurers lamented the way in which, over the last 30 years, pensions have repeatedly become a political football, and have suffered from an excess of short-run political opportunism rather than coherent and stable long-run cross-party agreement (QQ 310, 448, 637, 708, 747).

10.40. We have been dismayed to see, in the latter stages of our enquiry, considerable differences emerging between political parties over the future direction of pension policy in the United Kingdom. With such evident disagreement between (and sometimes within) political parties over such crucial issues as the level of the basic state pension, the role of means-tested benefits for pensioners, and the desirability or otherwise of compulsory pension contributions, it is hardly surprising that many people appear to have deferred committing themselves to any long-term saving strategy. People accumulate pension assets and entitlements over 40 or more years of paid and unpaid work, and can expect to draw pension benefits for 20 or more years in retirement. A stable institutional environment is necessary for individuals to make coherent savings plans over such a long time period.

10.41. We believe that stability could be enormously enhanced by distancing state involvement in pensions from the immediacy of the political process. A number of witnesses suggested that an independent authority should be established to monitor and report on pensions policy, in a manner similar to that in which the Monetary Policy Committee of the Bank of England monitors and reports on the Government's economic policy with respect to inflation and interest rate targets (QQ273, 897, 924, 1076).

10.42. We recommend that, in order to increase the level of consensus associated with long-run pension planning, the Government should establish an independent authority to monitor, undertake research and make recommendations on pensions policy.

10.43. For an independent authority of this sort to operate effectively, it would be necessary to establish a clear set of criteria by which the performance of the pension system could be evaluated (hence our recommendation at paragraph 10.13 above). It would also be necessary to establish a much simpler state pension system in which the level of benefit is set relative to some clear criteria, rather than being subject to political interference and the complex workings of a means test (hence our recommendation at paragraph 10.28 above).

110   Consumers' Association, volume II, p 163 Back

111   DWP, Simplicity, security and choice, pp 37-9 Back

112   National Association of Pension Funds, volume II, p 233; PricewaterhouseCoopers, volume II, p 83 Back

113   ABI, volume II, p 249 Back

114   GAD, National Population Projections, 2000-based, pp 56-7 Back

115  Work and Pensions Committee, 3rd Report (2002-03): The Future of UK Pensions (HC 92-I), pp 8-10 Back

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