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
£64.70 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.