Solving Britain's pensions crisis
Not very long ago, Britain’s pension system was the envy of Europe, if not the world. Other European countries faced the prospect of ever higher government spending and budget deficits as their populations aged: their high state pension promises were beginning to look rather reckless. Britain, meanwhile, had funded schemes that could call on pools of capital assets so that the transition from a relatively young population to a relatively old population would be that bit smoother. Few people talk about the superiority of Britain’s pension system today. By and large, the funded schemes are still there, although many are creaking. And the problems of other EU countries have not been addressed: they still loom large. So what has gone wrong in Britain?
In Britain many people talk about ‘under-provision’ for old age – private schemes are not making up the difference between the state retirement pension and a reasonable income. The Association of British Insurers has suggested a shortfall of £27bn (e40.5bn) between the amount people need to save for their pensions and the amount they are saving. Not all commentators agree with that figure. Professor Tim Congdon, for example, has suggested that British people are saving enough – but they are not saving through pensions vehicles (Economic Affairs, March 2005). But even so, this raises the question “Why are the British shy of using pension schemes for saving?”
Other figures are alarming too. Today, 50% of people over pension age are claiming state means-tested benefits in the UK. This figure is likely to rise to two-thirds of the pensioner population by 2050, assuming present policies continue. Occupational defined benefit (DB) schemes, which provide the best pension benefits, are closing at an alarming rate.
A new study, co-authored by this author with Mercer’s actuary Deborah Cooper, The Way Out of the Pensions Quagmire, published by the Institute of Economic Affairs, in London, discusses and illustrates these problems facing the UK pensions system, and proposes solutions. We argue that policymakers have focused on the macro-economic aspects of pensions. Issues such as the proportion of benefits that are privately funded and the burden on taxpayers have been stressed in policymaking, while the micro-economic foundations of pension schemes have steadily been eroded.
There is an analogy to this process in much of the EU eurozone. The euro has been a well-managed currency, but many continental European countries have very slow growth because the micro-economics of their labour markets are undermined by regulation and high taxes. While the macro-economic background is important, politicians should not interfere in the operation of markets to such an extent that markets cease to perform their proper function.
The UK government actuary, Chris Daykin, sums up the situation in a foreword to the study in which he states: “The true nature of many of the quirks of UK pensions that have arisen as the result of political favours to woo groups of voters are laid bare by the_authors.” In other words, successive governments have interfered, sometimes with good intentions, offering special payments or concessions to groups of voters, or regulations to protect particular types of pension scheme member, with the result that it is no longer worthwhile many people saving using pensions vehicles.
Consider some of the following characteristics of the UK pensions scene. There have been so many special benefits created to assist pensioners, in order to attract votes from different interest groups, that somebody who is in receipt of just £9,000 annually in retirement is likely to receive that income from eight or nine different sources – nearly all of them from the government. There is a very complex system of means-tested benefits.
As has been noted above, these are now paid to most pensioners. They are withdrawn, of course, as people get richer so that, when the system of means-tested benefit withdrawal is superimposed on the tax system, there are 12 different rates of tax and benefit withdrawal before people are receiving £30,000 annually. Eight of those withdrawal rates apply before people are receiving £10,000 annually. There are rates of tax and benefit withdrawal so high that an individual saving to provide himself with an extra 100 pence of gross income will sometimes only keep nine pence. These figures can be represented a different way – then they look even more alarming. If we take a person on low earnings who saves £20 per month to provide himself with extra retirement income and assume that the person’s savings earn a return of 4% above inflation, the return after allowing for tax and the loss of means-tested benefits is -1%.
In addition to the introduction of a whole host of new benefits and the extension of means-tested benefits, minimum incomes for those who do not save at all have been increased dramatically in recent years. The government has also increased the tax burden on pension schemes by over £5bn annually and has dramatically increased the regulatory burden on occupational DB schemes.
Incentives matter. There is an underlying current in many commentaries on UK pensions that pensions are too complex for individuals to handle themselves. Indeed, Adair Turner, chairman of the Pensions Commission argues this explicitly in its recent report. However, the evidence is that people are behaving extremely rationally. The response to all these recent reforms of the UK pensions system - the closing down of occupational DB schemes and a significant reduction in pensions saving - has been entirely rational.
How do we address the problems in the UK pensions system that have built up over the last few decades?
Many commentators in the UK suggest introducing a “citizen’s state pension” (a pension given to all citizens, as of right, not based on contributions), increasing compulsory pension provision and abolishing individuals’ ability to contract out of the state scheme. The authors reject this approach absolutely. This would throw away those aspects of the UK pensions environment that do actually work and that have prevented the build up of high levels of state pension debt.
Instead, the authors suggest stripping the system to its foundations, but keeping those foundations. There should be one contributory state pension – the second earnings related state pension would go. Individuals and schemes would be allowed to contract out of that state pension leaving people with no state pension at all if they choose. If they did, they would receive a rebate of national insurance contributions to invest in private schemes. Private pensions would be deregulated – returning them roughly to the position they enjoyed before the 1995 Pensions Act.
The tax system surrounding pensions in Britain is incoherent. Private pensions enjoy a tax-free lump sum – money that is never taxed. Some investments within pension schemes are taxed but not others – a result of the 1997 tax changes. The authors suggest abolishing the tax-free lump sum and returning to the pre-1997 tax regime for investment returns. There are also complex rules requiring pensioners to use private pension money to buy an annuity – even when there can be no possible benefit to anybody from them doing so. These rules should be scrapped. Pensioners would not be able to receive any government benefits if they had not used their pension fund to buy an annuity, but no other rules are needed. Finally, a whole range of state benefits could be abolished and the special favours granted to pensioners in the tax system would be removed. This last reform alone would save several pages of the standard income tax calculation form in the UK.
The results of these reforms would be to restore incentives and an underlying rationality to the UK pensions system. It would rebuild the model that made UK pensions once the envy of the Europe.