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The naked truth about pensions, by Peter Robinson

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09 December 2005

So finally the Pensions Commission report is out. But has it found the answer to the funding crisis and, if so, will the government take its recommendations on board? Peter Robinson investigates

It is hard to think of any government-commissioned report in the past that has been as eagerly awaited, as extensively debated and as contentious as the findings of the Pensions Commission headed by Adair Turner.

The commission's final report, published on November 30 after three years of deliberation, made two important statements about the current pensions system. First, there is no immediate crisis, in terms of the problems faced by the current generation of retirees. Second, the system is not 'fit for purpose' for the current workforce. By 2050, three-quarters of these will be drawing means-tested benefits to supplement the inadequate pension they will then be receiving from the state, at a time when many (private sector) employer pension schemes will be dying on their feet.

The two main recommendations in the report are:

  • A new National Pension Savings Scheme (NPSS) should be established. This would require employees to make contributions of 4% of post-tax pay (above the primary threshold in the national insurance system, currently £94 per week, and below the upper earnings limit of £630 per week), unless they explicitly opt out. But if they stay in, employers would also be compelled to make 'modest' matching contributions of 3%, and an additional 1% would come from tax relief. These contributions would be collected through the Pay As You Earn system and invested in funds with low charges. Employers already offering a better pension scheme could opt out.

    This is described as a system of 'soft compulsion'. From the employees' point of view, it would look like increased 'voluntary' national insurance contributions – voluntary because you can opt out, but only within one month of joining an employer.

  • The basic state pension would be indexed in line with earnings rather than prices from 2010/11. This would help maintain it as a foundation for the rest of the pensions system. But the quid pro quo is that the state pension age would rise to about 66 by 2030, 67 by 2040 and 68 by 2050. The state second pension would remain but go flat rate by about 2030.

To think through the implications of the Pensions Commission's proposals, it is helpful to divide the retired population into three groups of broadly equal size.

The poorest third currently have to rely on means-tested benefits, of which the most important is Pension Credit. Under the commission's proposals, this will continue. It is widely recognised that only the state can provide a minimum retirement income for those with poor lifetime earnings. It can do this either through a decent universal pension that almost everyone gets or through means-tested benefits. The commission chose the latter route for the poorest, which is also favoured by the government.

The richest third of the population will be okay, whatever the state pensions system offers. They include high earners and those who still have generous employer-provided salary-related pensions, including of course a large proportion of better-paid public sector workers.

The commission report is primarily aimed at the middle third. This is the group that currently can rely on a reasonably generous state pension system allied to private employer-provided salary-related pensions. On current trends, they, too, would become reliant on means-tested benefits in the future. Thanks to the NPSS and a more generous basic state pension, they would be assured of a more comfortable non-means tested retirement, but with the trade-off of increased 'voluntary' national insurance contributions and a higher state pension age.

The obvious question to ask is how the government, or perhaps more accurately, different parts of the government, will react to these proposals? A formal response is promised next spring. However, on November 24, Work and Pensions Secretary John Hutton outlined five tests that the government would apply. It is worth going through these tests to gauge the likely nature of the government's response.

Does it promote personal responsibility, giving everyone the opportunity to build a decent retirement income? Overall, the answer is likely to be yes. A more generous non-means-tested state pension and the proposed NPSS should allow the median worker the opportunity to build a decent income. Number 10 and the Department for Work and Pensions are very worried about the prospect that three-quarters of all pensioners could be relying on the means-tested Pension Credit by 2050. The commission's proposals will peg this proportion to about one-third.

Is it fair to women and carers and to those who have saved, and does it protect the poorest? The answer to this is more complex. The poorest remain protected by the existing means-tested Pension Credit, but almost a fifth of the very poorest do not take it up. The commission proposes that future entitlement to the basic state pension should be based on residency rather than contributions, and this would be more generous to women and carers. Reducing the growth in means testing should help middle-income savers. But the weakness is that some of the very poorest will continue to fall through the net because of incomplete take-up of means-tested benefits. The report also does nothing additional for existing pensioner poverty (unless the government takes up the idea of paying the basic state pension on a residency basis to the over-75s, at a net cost of around 0.15% of gross domestic product).

Is it affordable to taxpayers and the economy as a whole? This is the biggest test of all. It is, of course, the one that most worries the Treasury, and the affordability or otherwise of the commission's proposals were dominating the debate before the report was even published. Under those proposals, public spending on pensions (and therefore taxes) will rise as a proportion of GDP from 6.2% today to about 6.4% of GDP in 2020 and to between 7.5% and 8.0% of GDP by 2045. After that, if we are prepared to accept a higher state pension age, it need not rise further.

The Treasury has already challenged the affordability of these proposals. The key issue of disagreement is over what is expected to happen to public spending on pensions if current policy continues. The commission argues that any savings from equalising the state pension age for men and women between 2010 and 2020 should be used to help pay for a better basic state pension. The Treasury disagrees.

The commission also quite understandably assumes that the Pension Credit will continue to be indexed in line with earnings over the long run. If it weren't, relative pensioner poverty would rise, unravelling the main achievement of government policy since 1997.

However, the commission is also relatively pessimistic about what will happen to private pension savings under the current system. The more private provision declines, the more costly will be the Pension Credit, as more and more people will have to claim it.

Thus the commission, and many other observers, believe that state spending on pensions will have to increase as a proportion of GDP no matter what. This will remain the main battleground in the coming months, with the Treasury denying this and maintaining that the commission's proposals are unaffordable.

Is it simple, clearly setting out what the state will do and what is expected of citizens themselves? The answer to this question is a straightforward no, and this is the report's main weakness. Almost all of the existing features of the current system will remain. There will be two state pensions with different entitlement rules, including possibly different eligible ages. The Pension Credit will retain a significant role.

No major reforms to the overall system of tax relief were recommended, although everyone agrees that the current system is opaque, ineffective, regressive and very costly. Effectively then, we are left with essentially the current very complex pensions system with the NPSS on top.

Is it sustainable, with the reform package forming the basis of an enduring national consensus? That, of course, is the big unanswered question. The Conservatives are at the moment happy to exploit the obvious signs of division within the government, but, taking their cue from the opposition of many employers, they have big reservations about the 'soft compulsion' of the NPSS. The pensioners' lobbies will be displeased that there is so little for existing pensioners, as by definition that is their constituency. A lot of stakeholders will be disappointed that there is no overall simplification, which is the main feature they wanted.

The commission fought shy of more radical proposals to increase the value of the basic state pension to the level of the Pension (Guarantee) Credit. This would have reduced means testing to an even smaller role and pensioner poverty could be almost eliminated. They rejected this on the grounds of cost.

A final word is needed about the future of public sector pensions, following the controversial deal that was agreed in October to keep the normal pension age at 60 for most existing staff. The cost of public sector pensions will rise from 1.5% to 2.3% of GDP over the next 30 years. This raises the obvious question of why, if the Treasury deems this affordable, a more generous basic state pension that would benefit the whole of the workforce, including the majority who are in the private sector, is also not affordable?

There is an even more troubling consequence of the October deal. The signals sent out will make it very difficult, if not impossible, for the government to sell a higher state pension age for the rest of us. The current government has said firmly that it will not revisit the deal. However, it looks like one of the least sustainable features of the current pensions settlement. If the current government does not revisit it, the next one will.

It was always going to be difficult to get a consensus on pensions reform, within government, across the political parties and involving all the stakeholders. Selling any settlement to a sceptical, if not hostile, public will be even more difficult.

Peter Robinson is senior economist and associate director of public services at the Institute for Public Policy Research

PFdec2005

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