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The Actuary The magazine of the Institute & Faculty of Actuaries

The way forward?

he Pensions Commission’s first report, published in 2004, analysed the current state of private and state retirement provision in the UK. It identified several weaknesses:
– the state system, which governments of both hues have described as ‘affordable’, is only so because of the low level of benefits provided;
– private pension savings, which were expected to compensate for the inadequacy of state provision, were unlikely to do so because of the incomplete coverage and dwindling provision provided by the occupational sector.
The commission’s second report concludes that a mixture of the three possible solutions suggested in the first report to work longer, pay more tax, or save more is required:
– state pension should be reformed;
– state pension age should increase; and
– a quasi-compulsory pension savings scheme should be set up by the government.

State pension
There are currently two state pensions: the basic state pension (BSP), which is flat rate, and the state second pension (S2P). Eligibility for both depends on the national insurance contributions a person pays over their working history, although different rules apply to each part. The state also pays means-tested benefits, primarily the pension credit.
The single person’s BSP is £82 per week in 2005/6. To receive this, someone with a state pension age of 65 must have paid, or been credited with, NI contributions for 44 years, or a lesser period if they have been eligible for home responsibility protection (for example, if in receipt of child benefit). However, the guarantee credit part of the means-tested pension credit is £109.45 per week. Everyone aged over 60 is assured an income at least as big as this, so the BSP is no longer the headline state retirement benefit.
Means-testing erodes the value of private saving, making savings decisions very difficult for people on low incomes. Since government policy has been to uprate the BSP in line with prices, and the guarantee credit in line with earnings, saving will become a more difficult decision for people further up the income scale.
S2P was introduced from 2000 to replace the state earnings-related pension (SERPS). For people paid less than the ‘lower earnings threshold’ (£12,100 pa in 2005/6), S2P is effectively flat rate, although above that level of pay it is earnings-related.
The government originally intended that, once stakeholder pension schemes had become established (envisaged to be around the year 2006/7), S2P would become flat rate at all rates of pay. However, stakeholders haven’t inspired the mass pensions market the government anticipated, so S2P has been left untouched. Its design is such that eventually (in about 50 years, depending on rates of inflation) it will evolve into a flat-rate benefit naturally.
Because of these weaknesses in the current regime, the Pensions Commission has proposed that:
– the BSP should be linked to earnings from 2010, which would ensure that the guarantee credit does not grow in importance; and
– S2P should become flat rate by about 2030.
To maximise coverage, the commission also suggests that eligibility for the BSP should be based on a citizenship test, whereas S2P should continue to be based on the contributory principle, albeit with some revision.
The net effect would be that someone with full eligibility would receive a total pension of about £130 per week from the state (split £75 BSP and £55 S2P), which represents 3035% of median earnings (currently approaching £20,000 pa). Means-tested supplements would remain a feature of the system, but held at current levels where less than half of pensioners are affected. Figure 1 shows how different people will be affected.
There has been a lot of discussion about how affordable the commission’s proposals are, since providing a larger pension to those in low-income groups will be more costly than the present arrangement. However, the UK currently has among the lowest expenditure on pensions of all the ‘old’ EU member countries, and it is projected to become the lowest by 2050. In other words, our current system is only ‘affordable’ in the sense that it provides unsustainably low benefits, and it is widely accepted that reform is needed. However, to mitigate the increasing cost, the Pensions Commission proposes that the state pension age would also rise, suggesting that it increases from 65 to 66 by 2030, 67 by 2040, and 68 by 2050.

National Pensions Savings Scheme
The Pensions Commission considers that government has a responsibility to do more than just provide a moderate level of flat-rate retirement benefit. However, rather than mandate a compulsory level of earnings-related benefit, the commission proposes that government should encourage people to make earnings related saving via a National Pension Savings Scheme (NPSS), starting from 2010.
Employees would be automatically enrolled into the NPSS, starting from age 21, paying 4% of their post-tax pay. Employers would contribute an additional 3% pay and the government would add a 1% ‘tax incentive’. The percentages will be based on pay between the primary threshold (the point at which national insurance contributions begin to be paid, which is £4,888 in 2005/6) and the upper earnings limit (£32,760 in 2005/6). These thresholds would be earnings-linked, but subject to review.
Employees and employers will be able to make additional contributions, but there will be a maximum amount permitted each year, equivalent to around £3,000 in 2005/6. The self-employed will also be able to opt in to the NPSS.
The NPSS will make a limited selection of funds available to investors, with a ‘lifestyle’ fund, moving from predominately equities at younger ages to bonds at older ages, as a default. The Pensions Commission believes that, because of economies of scale, the scheme could be managed for a cost of less than 0.3% of the funds under management, making it a very competitive option. Benefits would be in pension form (no lump sum), so higher-rate taxpayers, for whom the tax-free lump sum is particular beneficial, might prefer to stay outside the proposed regime.
Employees will be able to opt out of the NPSS, to allow them some flexibility over their own financial arrangements. However, if opting out means they lose the employer contribution it is likely to be a costly decision. There would also be arrangements for opted-out employees to be automatically opted in again, so that if circumstances change, opted-out employees do not become victims of their own inertia.
There is little in the commission’s report to indicate how people would be helped to decide between investment options, or whether to opt in or out. If these sorts of financial advice were included in the package, it is likely that the 0.3% charge would be harder to achieve.

Contracting-out and opting-out
A consequence of making S2P flat rate would be that contracting-out would become redundant. The Pensions Commission proposes that it should be dropped immediately for defined contribution schemes, but that existing defined benefit schemes should be permitted to continue until there ceases to be anything to contract out from.
However, as the Pensions Commission does not want to undermine existing occupational provision, it proposes that employers will be able to automatically enrol employees into occupational schemes that at least mirror the contributions received by the NPSS or, if they are defined benefit, target benefits at least as great, as an alternative to the NPSS. Thus, an alternative ‘opting-out’ regime could develop, although it is unlikely to be as involved as contracting-out has become.

Just before the commission published its report, John Hutton, the pensions minister, set out five principles against which any pensions reform should be tested:
1 Does it promote personal responsibility?
2 Is it fair?
3 Is it affordable?
4 Is it simple?
5 Is it sustainable?
Most people have asked that any reforms to state pension provision should result in a simpler regime that will not be subject to continual tinkering. Simplicity is obviously desirable, but stability seems an essential aspect for successful retirement planning, because of its long-term nature. The commission’s proposals will not remove complication from the state regime, but since the target benefit that would result from its proposals appears to meet most people’s definition of adequacy, they have an important prerequisite for sustainability.
An increase in state pension age seems inevitable, and what has been proposed seems quite modest. It assumes that the proportion of the average person’s adult life spent in work will remain broadly at its current level, which is 70%. In current market conditions, this requires people to save about one-quarter of their income (whether via tax or private savings) towards retirement if they want to retire with a 50% replacement ratio, which many might continue to find hard to afford. Longer working could it easier to balance finances before and after retirement.
The commission’s proposals are just that and even with government support they are likely to be modified. The irony is that, although the proposals have many welcome features, the goal of encouraging wider voluntary provision does not seem to have been reached. The NPSS can only be considered ‘voluntary’ if employers pay those that opt out the 3% matching contribution but this will then undermine any incentive to remain opted in and so does not seem likely and many employers might find it hard to justify providing alternative occupational provision for some of their staff. Thus occupational provision could become the preserve of more affluent workers, while the lower paid are expected to rely on the state and the NPSS.