Plan is to raise state pension age and encourage saving
The Pensions Commission is courting controversy with the recommendations on UK pensions contained in its recent report. A new National Pension Savings Scheme looks most likely to see the light of day, but the proposal to raise the state pension age will be unpopular with the general public, and the plan to link state pension increases to national average earnings may be opposed by Gordon Brown. Here, we examine the proposals in detail.
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Summary of key points The Pensions Commission has published its report setting out proposed reforms to the UK pension system. Its main recommendations are that the government should:
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The Pensions Commission is proposing a gradual move to a more generous state pension payable from a later state pension age and a new National Pension Savings Scheme (NPSS) that would entail the state collecting work-based contributions and passing these over to approved fund managers to be invested in an employee's chosen fund. Employees without access to good pension arrangements supported by their employer would be enrolled in the new NPSS automatically, though they would have the right to opt out, and employers would be required to contribute. These are the principal recommendations made in the commission's recent report1.
The Pensions Commission, led by Lord Turner, has been operating for three years. It was established by the government (OP, February 2003) to "assess trends in occupational and private pensions and long-term saving, and to advise on whether there is a case for moving beyond the current voluntarist approach", although it seems to have been encouraged to interpret these terms of reference very widely indeed. The three commissioners (Lord Turner along with Jeannie Drake of the Communication Workers' Union and Professor John Hills of the London School of Economics) published a detailed background paper examining the issues (OP, November 2004) and have taken a mass of evidence (OP, April 2005).
Although there is speculation that Chancellor of the Exchequer Gordon Brown is not enamoured of the proposals, the new Secretary of State for Work and Pensions, John Hutton, has welcomed the report. He said that the government is now working towards the publication of a white paper in the spring. Initial reactions to the report are covered in Pensions Commission's report starts new debate.
STATE PENSION REFORM
The Pensions Commission identified three main objectives for reforms to the state pension system - and such reforms are seen to be as vital as underpinning private pension provision. These objectives are to:
- focus constrained tax and national insurance (NI) resources on ensuring that flat-rate state pension provision is not means-tested and is as generous as possible, given the commission's recommendation to create the NPSS in order to provide earnings-related provision;
- improve the treatment of individuals with interrupted paid-work records and caring responsibilities; and
- face the reality of a trade-off between increased long-term public expenditure on pensions and a higher state pension age (as depicted in box 1).
Preferred way forward
The report recognises that not only are there various means of achieving the objectives set out above for state pension reform, but there are also difficult issues concerning timing and affordability - and all these must be debated. Nevertheless, the commissioners set out their preferred way forward. Their report considers that public expenditure on state pensions and pensioner benefits should rise from 6.2% of gross domestic product (GDP) today to between 7.5% and 8% by 2045, depending on what rate of increase is set for the state pension age.
The commissioners considered what Lord Turner termed "the big bang approach" of moving rapidly to a single, unified, higher-value "citizen's pension" and merging the basic state pension and the additional pension from the state second pension (S2P), formerly SERPS. They decided instead to take an evolutionary approach whereby the existing two tiers continue to coexist for some time.itself.
- Freezing the UEL
The report proposes accelerating the evolution of S2P to a flat-rate pension by freezing the upper earnings limit (UEL) at its cash level at the date of the change for the purposes of the accrual of state additional pension. The earnings-related element of S2P depends on an employee's earnings between the low earnings threshold (LET) - £12,100 pa in 2005/06 - and the UEL, which was £32,760 in 2005/06. Since the LET is uprated in line with earnings, freezing the UEL would mean that this band of earnings would eventually dwindle to zero. This would leave the flat-rate pension provided by S2P, which is currently payable to those earning between the earnings threshold - currently £4,888 - and the LET, since for S2P purposes all such employees are treated as actually earning at the level of the LET itself.
- Average earnings indexation
Increases to the basic state pension would be indexed in line with average earnings, ideally from 2010 or 2011 as this is when the public expenditure saving from the rise in women's state pension age begins to flow through. In explaining this particular measure, Lord Turner noted that "clearly having to reflect issues of affordability within the context of overall public finances" would affect the timing of its introduction.
- Raising state pension age
State pension age (SPA) would be raised gradually, broadly in proportion to the increase in life expectancy, and one possibility would be an SPA of 65 for those reaching that age in 2020, 66 for those at that age in 2030, 67 for those becoming that age in 2040 and 68 for those reaching that age in 2050. (Initially it might also be possible to have a later pension age for additional pension than for the basic state pension.)
- Limiting means-testing
The pension credit would be maintained but the spread of means-testing would be limited by freezing the maximum level of the savings credit element (£21.51 per week for a couple in 2005/06) in real terms (ie it would rise in line with prices). This implies that the savings credit threshold (£131.20 per week for a couple in 2004/05) would have to increase faster than average earnings.
- Residency rather than contributory test
Future accrual of the basic state pension would be based on the individual (rather than using rights derived from a spouse or civil partner) and on a residency test, rather than the current system that is based on NI records, credits and home responsibility protection.
- Carers' credits in S2P
The current S2P protection would be enhanced to bring it into line with that applying to the basic state pension so that, for example, it is available to carers of children aged up to 15 (currently it is limited to children under six).
- Full basic state pension for all pensioners aged 75 or over
Ideally, a universal, residence-based, full basic state pension would be introduced for all pensioners aged 75 or over from 2010.
NATIONAL PENSION SAVINGS SCHEME
The rationale for the introduction of a NPSS largely arises from the current high cost of private pension provision for many middle and lower-income employees. The report points out that new stakeholder pension schemes have a maximum charge cap of 1.5% pa of the fund during the first 10 years and 1% pa thereafter. Many group personal pension arrangements currently have annual management charges of around 1.3%.
In contrast, the negotiating advantage presented by the NPSS could mean that the average charge would be as low as 0.3% pa. Any charge can be translated into a reduction in yield on the investment return achieved by the employee's pension fund, and an annual management charge at 0.3% over 40 years would give rise to a pension some 30% higher than if the employee had saved in a group personal pension arrangement with a 1.5% annual management charge.
Similar levels of charges can also occur in insured occupational pension schemes, although those of the very largest self-administered occupational pension schemes can be much lower.
The benefits of scale that would lead to such a competitively low charge would arise through two main factors:
- the contributions would be collected via the employer's payroll and passed to the NPSS in much the same way as NI contributions are passed to HM Revenue & Customs (HMRC) - this would entail a lower unit administrative cost than that incurred by a personal pension provider; and
- the NPSS would then be able to bulk-buy fund-management services at a lower cost.
This proposal provoked a strong reaction from the life assurance firms. Stephen Haddrill, director-general of the Association of British Insurers (ABI) argues: "We should use the expertise and infrastructure of our existing private sector to put this vision into effect. Adair Turner questions whether the private sector can do this at an acceptable cost. Provided that we are asked to deliver the same service under similar conditions, we believe that we can. As Lord Turner notes, we are already doing so for larger company schemes."
In an immediate response2, pensions minister Stephen Timms challenged the ABI to come up with a plan to achieve such a radical reduction in costs, adding: "If you can design a detailed, workable model that meets these criteria and can match the Turner version for a broadly comparable level of charging, then that will be very attractive to us in government. The decision when we make it will be a pragmatic one. We are serious about building consensus, and we are in no doubt as to the potential attraction of an industry-led model."
Auto-enrolment and contribution levels
The model proposed by the report is that employees will be enrolled into the NPSS automatically if they are aged 21 or over, but they would have the right to opt out.
Contributions would be based on the employee's earnings in the band lying between the earnings threshold and the UEL (as noted above, currently £4,888 per annum and £32,760 per annum respectively). For the purposes of the NPSS, these two limits would then be increased annually in line with national average earnings. (It is interesting to note that the UEL, under the overall proposals, would be increased in line with earnings for the purposes of the NPSS but frozen in cash terms for the purposes of the calculation of S2P. This begs the question of what happens to the UEL for the purposes of the calculation of NI contributions.)
The default contribution for employees would be 5% of their gross pay in this earnings band but the effect of tax relief is that this can be viewed as approximately equal to a 4% employee contribution plus a 1% contribution by the state. Also, provided that the employee did not exercise his or her right to opt out, the employer would be required to pay a 3% contribution based on earnings in this band.
The Pensions Commission settled on an employer default contribution of 3%, rather than a higher amount, because it reasoned that the higher the amount, the greater the risk that employers would seek to persuade employees to opt out of the NPSS, perhaps by offering them a lower-cost, but immediate, cash payment in return.
Under the proposals, employers and employees would be able to pay higher contributions up to a cap set at twice the combined default contribution from the employee (including tax relief) and the employer in the case of an employee on median earnings. Given that the total default contribution is around 8% of earnings between the earnings threshold and the UEL, and that median full-time earnings are about £23,000 pa, the current monetary amount of the cap would be around £2,900 pa.
Mechanics of the NPSS
Employers would deduct their employees' contributions at source automatically and add their own contributions. The employer would then pass these NPSS contributions to HMRC either via the PAYE system, in much the same way as NI contributions are currently collected, or via a separate and newly created pension payment system. The individual employee's NI number would serve as the employee's unique account identifier.
The NPSS would then invest the money in funds as selected by each individual from a range of funds bulk-bought from the fund management industry. The report envisages that each member would be permitted to change these choices a limited number of times in any one year. If individuals fail to make an investment choice, their contributions would be invested in a lifestyle default fund.
The NPSS would undertake all the administration and communication tasks so it would administer the accounts and send out annual benefit statements, combining these with information on the individual's state pension entitlement. An overview of the mechanics of how the NPSS would operate is given in the flowchart reproduced in box 2.
Self-employed and economically inactive
The Pensions Commission points out that self-employed people could also be free to contribute to the NPSS and benefit from the low annual management charges. In their case, of course, there is no employer so no employer contributions would be paid and it would be difficult to apply the principles of auto-enrolment. Yet it would be relatively easy for them to contribute directly to the NPSS and their contributions could be collected alongside their monthly class 2 NI contributions.
Similarly, voluntary membership of the NPSS would be open to those who are currently not in paid work, including those with caring responsibilities.
Impact on employer costs
The possible effect of the NPSS on private sector labour costs has been modelled by the Pensions Commission. It shows that the impact on larger employers is relatively small, because most already offer pension schemes, but that, for the very smallest employers, it increases the total labour costs by around 1%. The results of this modelling are summarised in a chart reproduced in box 3.
The report cites the economic theory that the actual long-term cost to employers may in fact be considerably less than the figures in box 3 suggest, and in the very long term may even be close to zero. This is because the impact of requiring employers to provide some remuneration in a deferred non-cash form will over time be offset by a lower rate of increase in cash remuneration. The commissioners are opposed to suggestions that the very smallest employers should be exempt from the requirements since it would amount to denying the advantages of the NPSS to employees in precisely the segment of the workforce where pension scheme provision is most deficient.
Possible scheme-specific tax regime
The Pensions Commission explored the issue of whether benefits from the NPSS should be subject to a scheme-specific tax regime with the following three features:
- no tax-free lump sum;
- additional up-front tax relief for a basic rate taxpayer, implying an additional 37.2% on the employee's contribution and 7% on the employer's contribution, so that, if a default level contributor contributes £100 out of post-tax earnings, the net effect is that the employer contributes £75 and the government contributes £42; and
- annuity income taxed at the individual's marginal rate.
The commission explains that it has not reached a clear conclusion on the desirability of such a scheme-specific tax regime for the NPSS, but hopes that it will be the subject of further consultation.
Alternative work-based provision
The report emphasises that it is not intended that the NPSS should replace existing good pension provision and that it is important that the introduction of the scheme allows companies and individuals who currently have good arrangements in place to continue with them.
The commissioners therefore put forward proposed conditions which, if met, would permit an employer to be exempt from the requirement of auto-enrolling its employees into the NPSS. These conditions are that:
- employees aged 21 or over must be auto-enrolled into the employer's own alternative work-based pension provision (but if this work-based provision has restricted access, any employees aged 21 or over who are not eligible for the work-based provision must instead be auto-enrolled into the NPSS);
- benefits accrued in an alternative defined-benefit occupational pension scheme by most members must exceed the default level of benefits that are estimated to be provided by the NPSS; and
- in the case of alternative defined-contribution work-based provision, the employer contribution must at least match that required from the employer by the NPSS and the total employee and employer contributions, net of all costs and fees, must at least equal the level of default contributions to the NPSS, again net of all costs.
Consideration would have to be given to whether transfers from alternative work-based pension provision would be permitted into the NPSS (but not transfers in the opposite direction!) and, if so, whether the value of such transfers should be limited in the same way as it is planned that contributions payable into the NPSS would be capped.
ADDITIONAL RECOMMENDATIONS
Apart from the two main recommendations concerning the state retirement pension and the introduction of the NPSS, the report makes a number of other important suggestions for change.
Tax relief
Many of the submissions made to the Pensions Commission had dealt with the use of tax relief as an incentive for individual pension saving, including the observation that more than 50% of all such tax relief is received by the 12% of employees who pay tax at the higher rate. The commission, however, was forced to conclude that, while in principle there might be good arguments for redesigning the current system of pension tax relief to redistribute the benefit to basic- and lower-rate taxpayers, there was no practicable way to do this in the foreseeable future given the particular problem of quantifying the relief in the case of defined-benefit schemes.
Nevertheless, as noted above, the commissioners suggest the option of creating a scheme-specific tax regime for the NPSS, with a government matching contribution of equal percentage value to all members.
Contracting out
The commission recommends that contracting out should be phased out gradually, even if, as explained above, the "two-tier" approach is adopted whereby the basic state pension and S2P remain, for the present, separate systems.
Contracting out by means of the protected rights test, either using an appropriate personal pension or a contracted-out money-purchase (COMP) scheme, should, says the report, be abolished in the near future (eg from 6 April 2010). Members currently contracted out under the protected rights test would become members of S2P for the purposes of future accrual.
Contracting out by means of the reference scheme test, however, would be maintained over the medium term. Eventually it would be phased out so that contracted-out benefits in a contracted-out salary-related scheme would cease to accrue at the latest by around 2030, which is the date at which, under the report's proposals, accruals of S2P will become entirely flat rate.
Following the model for the future evolution of S2P, the Pensions Commission's approach involves freezing the UEL in cash terms for contracting-out purposes while continuing to uprate the LET in line with national average earnings. This will result in earnings-related accruals (ie accruals on earnings above the LET) ceasing by around 2030. Over the intervening period the importance of the contracted-out rebate would automatically and gradually decline. By around 2030 the residual element of contracting out, relating to relevant earnings below the LET, could be phased out with minimum impact.
The recommendation to abolish the protected rights test much sooner than the reference scheme test reflects the commission's desire to achieve a simpler system as soon as possible. This is coupled with the fact that the number of employees accruing benefits in COMP schemes has been falling and that many insurance companies are already advising policyholders with appropriate personal pensions to contract back into S2P. The report says that the improved government cashflow resulting from abolition of the rebate should not be used to fund current expenditure, but for measures that directly or indirectly increase national savings.
Annuity market
The report discusses issues relating to meeting the increasing demand for annuities, making five specific recommendations. It says the government should:
- over time, raise the youngest age for purchasing an immediate annuity (currently 50, rising to 55 in 2010) and the oldest age (currently 75) in line with life expectancy;
- consider the case for a cash limit on the amount that individuals are required to annuitise (but allowing the benefits of the tax relief to be recovered by the appropriate tax treatment of income withdrawals and balances remaining at the time of death);
- investigate ways of encouraging a wider market for income withdrawal products;
- consider issuing longevity bonds which absorb the risks relating to uncertain future mortality rates among those over age 90 if these liabilities can be reduced by raising pension ages (but it should not become a general issuer of longevity bonds given its liabilities to fund both state retirement pension and public sector pension obligations); and
- ensure that there are no artificial constraints on the supply of long-dated and index-linked gilts.
Flexible retirement
The report makes the point that the proposal to increase state pension age will not be an effective solution to public expenditure pressures unless there is an accompanying increase in the average age of retirement. If both state pension age and the average age of retirement rise, state pension expenditure as a percentage of GDP is reduced not only by the reduction in pension expenditure but also by a rise in GDP. On the other hand, if state pension age rises but average retirement ages do not, even the reduction in pension expenditure may be offset by other non-pension expenditure such as incapacity benefit or jobseeker's allowance.
The commission makes a number of recommendations to facilitate later working and flexible retirement including:
- having no default retirement age beyond which the provisions of the age discrimination legislation do not apply;
- consideration being given to having two state pension ages: a higher one for S2P and a lower one for the basic state pension;
- modifying the rules governing deferral of state retirement pension to allow claimants to take a proportion of their pension while deferring receipt of the rest; and
- reducing the employer's NI liability in relation to employees who are over state pension age.
1 "A New Pension Settlement for the Twenty-first Century: The Second Report of the Pensions Commission", ISBN 0 11 703602 1, available from the Pensions Commission's website ( www.pensionscommission.org.uk), or from The Stationery Office, PO Box 29, Norwich NR3 1GN, tel: 0870 600 5522, email: book.orders@tso.co.uk, price £35 for the main report, or £49.50 with appendices, in each case plus £4.71 p&p.
2 Department for Work and Pensions press release issued on 5 December 2005.
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Our research This feature draws primarily on the Pensions Commission's report and on attendance at its press conference called to launch the report. |
