I appreciate the opportunity to appear before you today to discuss what we in the United States can learn from the United Kingdom's experience with public pension reform. This is an extremely important subject, and I would like to thank both Chairman McCrery and Representative Levin for scheduling this hearing. Let me begin by noting that while I am a Research Fellow at the Heritage Foundation, the views that I express in this testimony are my own, and should not be construed as representing any official position of the Heritage Foundation. In addition, the Heritage Foundation does not endorse or oppose any legislation.
The crisis faced by the UK public pension system
In 1997, just eight years ago, reforms made to the United Kingdom's pension system under both Conservative Party and Labour Party governments were regarded as a model for avoiding the fiscal problems caused by the imminent retirement of millions of baby boomers. Studies by international organizations and a variety of think tanks showed that rather than the huge increase in retirement-related costs that threaten to engulf most Social Security systems, the UK faced a future where these costs would be relatively stable in terms of the percent of GDP that would be devoted to paying for retirement benefits. The combination of reductions in government paid benefits and generous incentives for workers to finance their own benefits through personal or work-related pension plans looked like a complete success.
This impression did not fade quickly. As recently as four years ago, testimony about the UK system by a leading British insurance executive to this subcommittee was entitled: "Pensions: A British Success Story.[1]" However, the last few years have been hard on the UK pension system. Due to poor planning, constant government tinkering, the closure of many corporate pension plans and other factors, all political parties recognize the need for a comprehensive pensions overhaul. A UK government pensions survey to be issued this week is expected to reveal that only one out of every six private sector employees can expect to have a "decent" pension when they retire[2].
The British pensions system has become a national issue. As a result, a late October 2004 poll showed that UK voters regarded their pension system as the number one issue that needed to be addressed in the May 2005 general election. A total of 54 percent of those polled listed pensions as one of the top four issues, above such usual political concerns as health care, crime and immigration. While in fact, pensions played a small role in the election, public concern remains high, and pension reform is expected to be a major issue in the coming year.
As a partial response, the government of Prime Minister Tony Blair established a blue ribbon Pensions Commission under former Confederation of British Industry head Adair Turner that is charged with issuing two reports. The first, issued in October 2004, paints a gloomy picture of the current system, while the second, scheduled for fall 2005 elections, will propose solutions.
Two nations separated by a common language: the relevance of the UK experience to the US Social Security debate
The British pension experience does have significant lessons for the American Social Security debate. However, those lessons are different from recent claims made by opponents of President Bush's proposed changes to the American Social Security system. Although there are superficial similarities between personal accounts in the UK system and those proposed for the American Social Security system, a closer examination shows major differences.
First, the accounts in the UK mainly invested in either employer-sponsored defined benefits pension plans or to individual investment plans similar to the American IRA. The American proposal, on the other hand, is completely separate from any employer-sponsored pension plans, and would be limited to investment through a centralized, government-managed investment platform similar to the Thrift Savings Plan (TSP), which is only open to US government employees and to military personnel.
Further, the accounts did not cause most of the problems faced by British pension system. Instead, the overall UK situation closely parallels the problems faced by US defined benefit pension plans such as those recently turned over to the Pension Benefit Guarantee Corporation by United Airlines and Bethlehem Steel.
Finally, to the extent that personal accounts are a significant problem in the UK, this is mainly due to design flaws and poor planning that were present from the beginning, misguided short-term fixes that had unforeseen consequences, and the bursting of the late 1990's stock market bubble. While the British experience shows mistakes for Americans to avoid, it does not prove that adding personal retirement accounts (PRAs) to the American Social Security system will be a failure.
The structure of the UK public pension system
The UK pension system is extremely complicated. There are two levels of state pensions, which are supplemented in some cases by two additional programs aimed at increasing the state pensions of lower income retirees. In addition, there are a variety of employer-related and personal pension plans. To make matters more confusing, workers have the ability to shift a portion of the taxes that fund the second state pension into either their employer-provided pension plan or a personal account. Finally, different governments over the past twenty years have revised and re-named various parts of the state pension system, changing benefit levels, tax treatment of pension contributions, and even account structures seemingly at random. The result is a constantly changing array of programs that are confusing to the British and can bewilder foreign observers.
The Basic State Pension: The most basic level of public pension benefits in the UK is the Basic State Pension, which pays a flat-rate pension to all workers who have both worked and paid taxes for at least a minimum period. Currently, women are allowed to retire at age 60, while men are only allowed to retire at age 65. The retirement age for women will increase to 65 between 2010 and 2020 starting with women born in April 1950. Approximately one in eight retirees receives only the Basic State Pension.
Currently, the Basic State Pension pays single people GBP 82.05 ($148.50) per week and couples GBP 131.20 ($237.50) per week. This equals $7,722.50 per year for single people and $12,348.50 annually for couples. As a comparison, the US Social Security system paid individual retirees an average of $11,460 annually as of December 2004. Benefits are indexed to the change in prices, and are adjusted every April.
In order to qualify for the Basic State Pension, men must work and pay taxes for at least 44 years, and women must work and pay taxes for at least 39 years. However, workers who are unemployed, unable to work due to illness, or who stay home to care for a family member may receive credits that can replace some of the required earnings years. US Social Security benefits are based on the worker's highest 35 years of employment, and do not give any form of credit for these situations.
The State Second Pension (formerly SERPS): Since 1978, the UK has also had a second level of public pension that is based - at least in part - on past earnings. Starting in 2007, this pension level will also pay a flat rate benefit. Prior to 2002, the State Second Pension (S2P) was known as the State Earnings-Related Pension Scheme (SERPS), and paid benefits that are much more directly linked to earnings than the new S2P is to be.
Workers receive credit towards their S2P benefits for income earned between 15 percent and 110 percent of national average earnings. Overall, they pay National Insurance Contributions (NIC) (which help to fund several different benefits including the Basic State Pension) equal to 11 percent on income between about GBP95 per week ($172 per week or about $8,941 annually) and GBP 625 per week ($1,131 per week or $58,825 annually) and 1 percent on incomes above that level. In addition, employers pay 12.8 percent on all income above GBP 94 per week. Both the income levels and tax rate are subject to change annually, and if the employee has contracted out of the S2P, taxes rates are different.
Workers have the ability to "contract out" of this pension level and re-direct a portion of their taxes into either their employers' pension plan or a personal plan. In the case of an employer pension, the tax level is reduced, while for an individual pension plan, the government pays a portion of taxes directly into the plan. If a worker contracts out, he or she receives credit for those benefits only on a prospective basis; benefits already earned are not affected.
Since 1978, the UK has changed benefits payable under both SERPS and S2P several times. These changes are more fully reviewed below, but the mixture of changes combined with the ability of workers to jump in and out of this pension level have resulted in some workers gaming the system, and make it very hard to determine benefits. The S2P is intended to improve benefits to low and moderate income workers, and gives workers who earned under GBP 12,100 annually (about $21,900) credit for earning that level.
Means tested benefits: In addition to these two public pension levels, low income workers can qualify for additional means tested benefits. The Pension Credit is intended to ensure a minimum retirement income of at least 30 percent above that paid by the Basic State Pension. These benefits are reduced by 40 pence for every pound that an individual receives above the Basic State Pension level, and must be applied for. In addition, low income retirees are eligible for non-cash benefits that mainly rebate some or all of the local ("council") taxes they pay and a portion of their rent payments.
Employer and personal pension plans: As mentioned above, UK workers have the ability to re-direct a portion of their NIC into either their employers' pension plan or a personal pension plan. The UK had a highly developed defined benefit (DB) pension system, but it has been hit with a series of reverses similar to those that have hit DB plans in the US. As a result, the majority of these private sector plans have been closed to new entrants and replaced with less favorable defined contribution plans.
Stakeholder Pensions: Since October 2001, employers (including small businesses with more than 4 employees) that do not offer workers another pension plan have been required to offer their employees a "Stakeholder Pension" plan. Designed by the government, and intended to be a simple and low cost pension system that would especially appeal to moderate income workers. Fees for these plans were initially capped at one percent of assets under management, and plans were required to accept an opening deposit as low as GBP 20 ($36). After initial enthusiasm, this plan has widely been regarded as a failure, and in an effort to revive it, the UK Department of Work and Pensions increased the allowable fee to 1.5 percent of assets under management for the first ten years an account is open in December 2004. At the same time, it also reduced the regulatory burden (in the form of a required level of investment counseling) for certain types of simple investment products.
What Americans should learn from the UK public pension system
Simplicity in program design and administration is essential: The UK system is overly complex both in its design and in its administration. To some extent, this is the unintentional consequence of program changes intended to correct specific problems, but the end result is a system that is extremely difficult for even professionals to understand.
As a result, a December 2004 survey found that only 6 percent of felt that they understood the pension system very well, while 29 percent did not know about key tax benefits. Not surprisingly, only 5 percent of those polled felt that they were "very confident that they would have enough to live on in retirement, and only 3 percent thought that state benefits would provide a comfortable income.
Unfortunately, this complexity also applies to the administration of certain benefits. The Pension Credit, a means tested benefit intended to improve the retirement incomes of lower income retirees, must be applied for, and is not automatic. Retirees are required to answer a complex survey in order to qualify, and despite the fact that individuals could answer the questions over the phone, many have not bothered to apply for the benefits. As of September 2004, 40 percent of those eligible had not claimed their benefits. Experts believe that most of those who have not claimed the credit are those who need it the most - the lowest income retirees. Interestingly, the government had assumed that 30 percent would not claim benefits in its planning.
Programs can have unintended motivational consequences: A side effect of the Pension Credit has been to reduce pension savings by low and moderate income workers. While the 40 pence per pound of income above Basic State Pension levels reduction in this benefit is actually significantly lower than the program that it replaced, the net result has been a sharp drop in pension savings. A June 2005 study found that almost 20 million workers earning between GBP 9,000 and GBP 25,000 annually ($16,200 to $45,000) are not saving for retirement because they fear that a means tested system would penalize them for their savings. In the aggregate, the means tested program is estimated to reduce annual pension savings by about GBP 3.7 billion a year ($6.7 billion).
Constant change increases confusion: Change has been a constant feature of the UK public pension system since the 1980's. Programs and new benefit levels have been created, revised, and re-named many times. A side effect of this has been to increase confusion among UK workers.
Looking at SERPS alone, the program was created in 1978 and promised to pay benefits based on the 20 best years of a worker's earnings. In 1986, SERPS benefits were changed to being based on all earnings between the age of 16 and retirement, and in 1995, changes to the pension formula further reduced benefits. In 2001, SERPS was replaced with the S2P, while the benefit formula was made more generous to lower income workers, and after 2007, the S2P will become another flat-rate pension. In 2002, thousands of workers who had contracted out of SERPS and its successor received letters from their financial services companies advising them to contract back in, as the amount they were savings was unlikely to be enough to equal what the government was likely to pay. Even though most benefit credits earned prior to these various changes were grandfathered in, workers can be excused if they feel completely confused and unsure what their benefits will be.
The availability of individual accounts does not alone solve problems: Despite massive publicity and fanfare when they were first offered in April 2001, Stakeholder pensions have largely been a failure. Even though about 305,000 employers started these pension plans for their employees, and that number grew to about 350,000 by the end of 2003, 82 per cent of those remained as "empty boxes" with no members, while only 13 per cent of employer-based pensions have contributions from employers. To make matters worse, only about 1.5 million plans were sold by the end of 2003, and sales have steadily dropped annually since then. Even these poor numbers do not indicate new savings, for about half of all Stakeholder plans were funded with money transferred from another existing plan. In addition, a significant number were estimated to be set up by wealthier individuals in order to claim the tax benefits of opening such an account.
Merely designing an "ideal" account structure and making it available does not guarantee that industry will aggressively sell it - especially if there is an unrealistic cap on fees. In the UK case, one key error seems to have been including marketing charges in the fee cap rather that limiting it to fees directly associated with the individual's account. Faced with such a limited profit potential, companies were unwilling to spend the amount necessary to continue to promote Stakeholder accounts. While the December 2004 fee increase may help, these plans have been labeled a failure, and are unlikely to revive as a significant retirement investment vehicle.
Price indexing can reduce benefits below poverty: Since 1980, the Basic State Pension has been calculated using price indexing rather than growth in wages. As a result, the flat rate pension amount has dropped to only about 17 percent of average wages (GBP 82.05 ($148.50) per week and couples GBP 131.20 ($237.50) per week or $7,722.50 per year for single people and $12,348.50 annually for couples). The roughly 12 percent of retirees who only receive this pension have incomes that are below poverty level. If the wage indexing had been retained, the benefit levels would equal GBP 109 a week ($197.29 week - $10,259 year) for individuals and GBP 174 a week ($314.94 week - $16,377 year) for couples.
This is not to say that changing the method of indexing is a mistake, but that policy makers must be aware that doing so could result in unacceptably low benefit levels. As a result, such a move should be accompanied with a benefit floor that guarantees an adequate minimum retirement income level.
Poor planning increases costs: When SERPS was created 1978, the UK government failed to conduct accurate longer-term studies of the cost that these benefits would impose on their government. Its failure to estimate benefit payments after 2007, despite the fact that most younger 1978 workers would only be retiring then was a key reason why benefits had to be revised in both 1986 and 1995.
This was also seen after the 1998 SERPS changes that were intended to encourage workers to contract out of SERPS and into either an occupational or personal pension plan. The government estimated that only between 500,000 and 1.75 million workers would take advantage of this option, while by 1993, almost 5 million workers (about 85 percent of those most likely to benefit from contracting out) actually did.
A 1990 government study showed that while about GBP 9.3 billion (about $17 billion) would be paid by the government in the form of rebates and special bonuses into accounts, the cost of paying SERPS benefits in the future would only decline by about GBP 3.4 billion (about $6.2 billion). Pensions expert Edward Whitehouse has an even higher estimate of GBP 12 billion (about $22 billion) revenue lost in return for the same level of reduction in future benefit payments.
A retail-based account system requires close monitoring: The most famous problem with the UK system, the so-called "mis-selling" scandal, is widely misunderstood in the US. When individuals were allowed to move out of SERPS into personal accounts in 1988, many were poorly advised by ill-trained insurance agents, and either moved out of employer-based plans that included an employer contribution and into personal plans that did not include that employer contribution, or failed to make an appropriate level of additional voluntary contributions that would be necessary to reach their retirement goals.
The mis-selling scandal resulted more from a sales force that was used to selling conventional insurance products and did not themselves understand the products they were selling than from other reasons. The fact that the agents' compensation was also tied to commissions exacerbated the situation.
As a result, however, a thorough investigation was conducted, and companies where mis-selling had occurred were required to compensate their customers. In addition, a new financial regulator, the Financial Services Authority, was created from several smaller and weaker regulators, and it has, if anything, overly compensated by requiring levels of disclosures to individual customers far in excess of those required in the US.
For Americans, this problem is interesting, but does not apply to Social Security reform proposals. For one thing, the SEC and other financial regulators have long monitored sales to individuals and require significant consumer disclosures. More importantly, the proposed US Social Security reforms are based on a government-managed centralized investment system, and neither individual companies nor agents and brokers will not be allowed to participate.
Conclusion
It would be a mistake to assume that the UK pensions experience has only been one of failure. The opposite is actually true. The country still has a higher level of pension investments, about 70 percent of GDP, than any other country in Europe, and the cost of public pension benefits is substantially lower than most countries in the world. In addition, roughly 50 percent of the workforce is covered by some level of private pension.
While the current UK government is responsible for some of the problems in their current system, most notably the Pension Credit that has destroyed the incentive to save for many of their workers, others have resulted from the collapse of the defined benefit pension system and problems caused by mistakes by earlier governments. The current government is also responsible for the Pensions Commission, whose recommendations are expected to result in an overall reform of their system.
However, their experience teaches Americans that even well intentioned individual changes can only make matters worse. In addition, it is important to consider the overall structure of the complete pension system. The UK has well learned this lesson, and the expected October 2005 final report of the Pension Commission is expected to give a full picture of proposed changes in light of the complete pension system.
It is important for Americans to remember that much of the UK experience results from special circumstances unique to that country, and that they do not apply to the United States. In addition, it would be a serious error for Americans to assume that the lesson of the UK experience is to discourage individual accounts, whether as part of Social Security or as part of 401k or other retirement savings options. The opposite is rather the case.
Personal accounts are a source of strength, both in the UK pension system and in their economy, and the current government has been actively seeking ways to increase the number of workers who have them. It would be both ironic and sad for Americans to draw the opposite conclusion from their experience at the same time that the UK is working to build individual pension savings.
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Members of The Heritage Foundation staff testify as individuals discussing their own independent research. The views expressed are their own, and do not reflect an institutional position for The Heritage Foundation or its board of trustees. [1] Statement by Keith Bedell-Pearce, Executive Director of Prudential, plc to the Subcommittee on Social Security, Committee on Ways and Means, July 31, 2001.
