Social Security Reforms in Britain: The Principles of Effective Privatization

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Social Security Reforms in Britain: The Principles of Effective Privatization

March 2, 1999

There are only two ways to finance pensions. The first is to tax those who work to pay for the pensions of those already retired. Most European countries rely largely on this method. Almost all their pensions are financed on a pay-as-you-go basis. This year's taxes are used to pay the pensions of people already retired. Nothing is saved or invested for the future. So as the number of pensioners rises and the number of workers falls, they face an increasingly crippling burden of tax. That is the nightmare facing most finance ministers in Europe and elsewhere.

The second approach to financing pensions is to encourage people to save and invest during their working life to pay for their future pensions. We in the United Kingdom have relied on this approach. We have persuaded the bulk of people to build up pension funds for retirement. We allow and encourage them to opt out of the central government's State Earnings Related Pension Scheme (SERPS) into company or personal funds (like American Individual Retirement Accounts). Around 60 per cent of those eligible do opt out. Over eight million people are now in occupational funds, and over five million (ten times the number expected when such funds were introduced) have
Personal Pensions.

Those who opt out of the state system receive a rebate from their payroll tax sufficient to finance a private pension at least equivalent to that which they would have been entitled to in SERPS. That rebate is paid directly into their private pension fund, so their money is genuinely saved and invested. It goes into industry to earn the profits which will pay their pensions when they retire--without imposing a burden of tax on the economy and meanwhile strengthening it through a massive build-up of investment.

The Value of Britain's Pension Fund

Significantly, the total value of British-owned pension funds is now some $1.3 trillion. That is not just more than any other country in Europe. It is more than all the other countries in Europe put together have saved and invested for their own pension needs. As a result, the International Monetary Fund has calculated that if countries maintain their present systems, then by 2050 France and Germany would have accumulated government debts nearly twice their national income. By contrast, the United Kingdom would have paid off its entire national debt and accumulated a surplus.

THE UNITED KINGDOM'S
TWO-TIER PENSION SYSTEM

The United Kingdom's social security system provides for a two-tier pension. The first tier is a flat rate Basic Pension. Every employee earning above the minimal threshold at which payroll taxes (known as National Insurance Contributions) become payable earns entitlement to this Basic Pension. It is currently worth £64.70² per week for a single person and £103.40 for a married couple, and is uprated each year in line with inflation.

On top of that, employees also earn entitlement to a State Earnings Related Pension. As its name suggests, the pension entitlement is proportionate to earnings.

SERPS pension rights accruing each year are proportionate to eligible earnings. Eligible earnings are those between the so-called Lower and Upper Earnings Limits. The Lower Earnings Limit is currently £64 per week, while the Upper Earnings Limit is £485 per week. (People pay a National Insurance Contribution on their earnings between those limits.) Employees with earnings between those limits for 40 or more years will receive a State Earnings Related Pension (on top of the Basic State Pension) equivalent to some 20 per cent of their average eligible earnings.

Since SERPS was established (in 1978), provision has been made for some employees to be opted out of this arrangement. Employees who are opted out are entitled to a rebate of their payroll taxes. This rebate is payable only into an approved pension plan. It is paid direct into the plan and cannot be spent on anything else by the employee.

The rebate is set at a level that is calculated to be sufficient to ensure that fund mangers can invest to provide for an at least comparable pension. The rebate is currently set at 4.6 per cent of eligible earnings. The Government Actuary calculates that this will be sufficient to generate a fund sufficient to buy an annuity on retirement equal to the SERPS pension. The Actuary assumes investments will yield 4.25 percent per annum in real terms.

Initially, the possibility of opting out existed only for members of occupational pensions provided by employers. Employers would make the decision as to whether their plan and all its members should opt out of the state scheme. Most did choose to opt out.

Typically, employers running such plans paid contributions into them and usually required employees to do so as well (on top of the rebate from payroll taxes/National Insurance Contributions).

In 1986, the Conservative government gave employees who were not opted out of SERPS through membership in an occupational plan the right to opt out of SERPS into an approved Personal Pension plan. These were something like Individual Retirement Accounts in the United States. Anyone opting for a Personal Pension is entitled to a rebate from their National Insurance Contributions. This is payable directly into their Personal Pension, so it can only be used to fund a pension, not spent on personal consumption.

Five and a half million people have taken out approved Personal Pensions. These are in addition to more than eight million who are members of opted out occupational pension funds. People are, of course, free to put more into their private pensions than just the rebate.

Problems Encountered Along the Way

Britain's pension system has faced two significant problems: "misselling" and missing Maxwell funds.

Both were major scandals, but it is important to recognize that neither scandal had anything directly to do with the right to opt out of the state system. Moreover, in both cases none of the potential victims will actually lose a penny.

The misselling scandal involved unscrupulous pension salesmen persuading gullible investors to switch--not out of the state system, but from one form of private investment (company funds) into another kind of private investment (Personal Pensions). It usually would be better to remain in a company fund, because employers usually pay in an extra contribution on top of the employee's contribution. Companies which missold pensions in this way broke the rules that require salesmen to give the best advice, so they are required to reinstate members back into their company fund.

Significantly, this misselling became possible only when the government stopped companies from making membership in their company pension fund a condition of employment.

The Maxwell scandal had even less to do with opting out of the state system. In 1991, Robert Maxwell, a former Labor Member of Parliament and head of a complex business empire, was found dead, and up to £450 million was missing from the pension funds of his companies. The pensions of 30,000 people seemed to be at risk. In the end, sufficient money was recovered to ensure that all pension entitlements will be paid in full. Nonetheless, the theft revealed apparent weaknesses in pension fund security. A new framework therefore was established to ensure that adequate funds are in place and that they would be safe in future. In the last resort, a compensation fund would make good any shortfall due to fraud.

Public Acceptability

In the United Kingdom, the Labor Party traditionally has favored government-funded, pay-as-you-go pension provisions. It was grudgingly prepared to allow company plans to opt out of the State Earnings Related Pension Scheme, but it was critical of both the principle and the practice of allowing individuals to opt out of the state scheme into Personal Pensions.

The emergence of the misselling problem and the Maxwell scandal gave them ammunition to fire at the provision of private funded pensions. Despite that, the growing public popularity of private pension provision, coupled with increasing awareness of its long-term benefit to the public finances, brought a gradual change of heart. The Labor Party now plans to encourage more people to build up private funded pensions.

Consequently, there now is more of a political consensus in Britain that private pension provision is a success and that, wherever possible, more people should be enabled to opt out of the state
system.

PROPOSALS TO EXTEND
PRIVATE PROVISION OF PENSIONS

Before the last election, the Conservatives, then in power, were seeking ways to extend private pension provision.

In the late 1980s, Parliament gave members of company plans the right to save more than the standard amounts required by the company. Employees could make additional voluntary contributions into their fund, up to a certain amount, out of income free of tax.

The government at the time also considered closing down SERPS. That would have meant that everyone in the future would be opted out and would pay obligatory premiums (rebated from National Insurance Contributions) into personal or company plans.

The government, however, was persuaded that this would damage the position of low-paid workers and those with variable patterns of employment (as well as put an increased burden on businesses).

Because SERPS only is earnings related, anyone with low earnings who opted out would receive a small rebate. This would be inadequate to cover the fixed costs of setting up and running a Personal Pension. The government therefore kept SERPS for people on low and intermittent earnings.

Within that framework, the only way to enable more people to benefit from opting out is to reduce the costs and charges of running a Personal Pension system.

The government decided to encourage "transparency" by requiring companies to publish their charges and costs in a standardized form. This would enable competition to drive down costs. In addition, regulations were streamlined, especially for simple standard pension plans. And new and small companies that are typically reluctant to set up company plans were encouraged to set up Group Personal Pensions. These are a form of Personal Pension, but the company can negotiate low charges for its employees by arranging Personal Pensions for them.

The Labor government essentially is going down the same route with what it calls Stakeholder Pensions. These will have fairly standardized terms and a ceiling on costs. However, there is a limit to how far costs can be reduced, so such developments, welcome though they are, can only extend the attractiveness of opting out of SERPS so far. Many low-paid people would continue to find their rebates too small to set up a Personal Pension.

Basic Pension Plus

Before the May 1997 general election, as the Secretary of State for Social Security, I published a proposal which involved a radical step forward to enable all new entrants to the labor market to opt out of SERPS.

This would involve extending funded pension provision to cover the Basic State Pension as well as the earnings related pension.

Our Basic State Pension is a flat amount for everyone. So if people are allowed to opt out of it and enabled to save for an equivalent private pension, they must be given a fixed rebate.

Such a flat rate rebate would enable everyone--even low earners--to cover the fixed costs of setting up a pension fund. Even low earners could then also opt out of SERPS and put their earnings related rebate, however small, into the same fund.

This could only be implemented gradually with the new generation of young people entering the labor market. We therefore proposed an approach called Basic Pension Plus.

Basic Pension Plus had three key elements:

The Personal Fund. Every worker in the new generation would start their own pension fund to finance their Basic Pension and more. They would choose an approved firm to manage it. They would own their fund. And any amount not used to pay for their pension could be passed on to their heirs.
The Rebate. They would receive a rebate from their National Insurance Contributions. Over their working lives, it would be sufficient to build up a fund big enough to pay their basic pension. The Government Actuary calculated that £9 a week would be needed, so people would receive a rebate of £9 a week (rising in line with inflation) paid into their fund.
The Basic Pension Guarantee. The government would guarantee that everyone would receive a pension at least equal to their Basic State Pension (increased at least in line with inflation). We called the plan Basic Pension Plus because it would have been the Basic Pension, plus a fund, plus a rebate, plus a State Guarantee. Each fund should grow to provide the basic pension. If, for any reason, a person's fund was insufficient, the state would top up the pension it provided. So they would still get their basic pension. Everyone would be protected by the Basic Pension guarantee. No one would do less well than under the present state program.

And everyone would stand to do better if, as we hoped, the economy and their investments did well. If returns turned out to be 1 percent higher than assumed, they would get a pension nearly 30 percent above the Basic Pension. If the yield were 2 percent higher, the pension could be over 70 percent better.

Thus, a person on average wages would build up a fund which should be worth £130,000 when they retire. That would be sufficient to provide a pension of £175 a week at today's prices, based on making minimum contributions over most of a working life. But once everyone in work has their own fund, they and their employers would be able and encouraged to save more in those funds.

We would phase in the new system of funded pensions gradually over a generation. Existing retirees would not be affected by the new arrangement and would continue to receive their state pensions (rising at least with inflation). Likewise, the current working generation would continue to build entitlements to the Basic State Pension and be free to remain in or opt out of SERPS during the rest of their working lives.

The new Basic Pension Plus system would apply to the rising generation--all young people newly entering work plus those aged up to their early twenties. They would receive rebates to build up their pension funds over their working lives, so it would take a generation to replace the present system. That means the impact on public revenues of the rebates needed to fund investment would grow very gradually over 40 years.

In addition, we could halve that impact by reversing the timing of tax relief on pensions for the new generation. Under the current system, contributions to pension funds attract tax relief, but pension income is taxable. That system would have continued for the present generation. For the new generation covered by Basic Pension Plus, I proposed that pension contributions (including voluntary pension savings) be paid from net income and that all pension income be entirely tax free. As far as the saver is concerned, the new tax treatment was equivalent to the old one (except for the lump sum) if the saver's tax rate was the same in work and retirement. For the pension providers, it should have been possible to make the new tax treatment far simpler and less onerous than the current regime.

This proposed change in tax timing, combined with the gradual phasing in of the new system, would make the impact on public finances quite manageable. The net value of extra investment would mount at only about £160 million a year and eventually would produce massive savings in public expenditures reaching £40 billion a year. At its peak, the net revenue forgone would be less than the peak cost of SERPS rebates, which we already had taken in our stride. It would be a fraction of the savings resulting from the United Kingdom's recent Pension Act, which will ease the burden of state pensions by some £13 billion a year. And the extra rebates would be small relative to normal growth of tax revenues.

Moreover, if the huge extra funds available for investment, which would be generated by the arrangement, boosted economic growth by just one-twentieth of 1 percent, the system would be entirely self-financing--though we did not take account of this in costing it.

To summarize:

Basic Pension Plus would come in gradually over a generation.
Everyone covered by the new system would have their own pension fund.
They would receive a rebate of £9 a week to fund their basic pension.
They would be guaranteed to receive at least their Basic State Pension (protected against inflation).
Employees would be opted out of SERPS and get a second rebate worth 5 percent of their earnings to fund their second earnings related pension. Because everyone would have a fund, they would be able and encouraged to save more on top.
Anyone on average earnings paying in just the minimum contributions should accumulate a fund worth £130,000 by retirement, paying a pension of £175 a week in today's money.
Everyone would stand to benefit from good economic and investment growth. An extra 1 percent investment yield would generate a pension 30 percent higher. The economy would be strengthened by a massive increase in long-term investment funds.

Ultimately, the taxpayer and the economy would be relieved of the largest single item of public spending--some £40 billion a year. In short, under this proposal, the British people would have been able to look forward to secure pensions, higher investment, and low tax.

The Rt. Hon. Peter Lilley, M.P., served as Secretary of State for Social Security in the United Kingdom from 1992 to 1997.

1. This paper is based on testimony given by before the Committee on Ways and Means, U.S. House of Representatives, 106th Cong., 1st Sess., February 11, 1999.

2. £1 is worth approximately US$1.60.

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