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The Actuary The magazine of the Institute & Faculty of Actuaries

Pensions green paper sidesteps SPA issue, says Towers Watson

In a response to yesterday’s green paper from the DWP on changes to UK state pensions, consultants Towers Watson say that the Government has failed to address the most fundamental questions regarding linking the State Pension Age to life expectancy. The firm also points out that the green paper is likely to lead to employers with defined benefit pension schemes revisiting the benefits they offer to employees.

The green paper says the Government will seek "a more automatic mechanism" for increasing the State Pension Age in future. Towers Watson say this could involve following a formula (though the pensions minister Steve Webb said "it is possible to have too formulaic or automatic an approach") or conducting regular reviews. However, the green paper does not confirm the outcome this would be designed to achieve.

John Ball, head of UK Pensions at Towers Watson, said: "There are three principal questions which will determine how quickly the State Pension Age goes up. First, what is the benchmark? When the Government announced plans to increase the State Pension Age to 66 by 2020, it thought men retiring in that year could on average expect to live for a further 21.6 years and women for 24.1 years. Will this be the starting point for younger generations? Or does the Government think retirements of this length are unaffordable and that the State Pension Age needs to rise further to catch up with the increases in life expectancy that we’ve already seen?

"Second, the green paper recognises that there will have to be a principle against which proposed changes would be measured. It suggests this might be to maintain the average proportion of adult life spent in retirement. In that case, extra years would be shared between work and retirement - for example, the State Pension Age might rise by roughly two years for every three years that life expectancy increases. However, other principles are not ruled out. If the Government instead chose to preserve the average number of years for which people can expect to receive State Pensions, the State Pension Age would rise by a year for every extra year of life expectancy.

"Finally, how long people receive State Pensions for depends partly on how quickly mortality rates improve after they have been notified of their State Pension Age. The independent reviewers can’t simply assume that the very fast improvement rates seen recently will continue without looking at what has driven them, whether this progress can be sustained, and what else might pick up the slack. For example, deaths from heart disease almost halved for men aged 65-74 between 2001 and 2009. Heart disease deaths for this group would have to fall almost to zero to make the same contribution to overall mortality improvements between 2010 and 2017. If that happened, later improvements would have to come from other causes. The more notice the Government tries to give people of their State Pension Age, the more heavily it will rely on inherently uncertain assumptions about the future rather than experience of what has happened already."

If the Government sought to maintain the average number of years spent in receipt of State Pensions at projected 2020 levels, and if current ONS projections remained unchanged, the State Pension Age might rise to 67 by about 2030 and 68 by about 2040, the firm says. Faster increases would be possible if the Government sought to respond to more of the improvements already seen or if future projections involve bigger anticipated improvements in life expectancy.

Towers Watson believes that a single-tier flat-rate pension would signal the end of contracting out for defined benefit schemes, forcing employers to choose between accepting higher costs, redesigning their schemes or closing them. The green paper proposes a second option, under which contracting out could be preserved because there would still be two tiers to the State Pension. However, under this option the gradual reduction in rebates that would take place by around 2030 under existing legislation would instead be fully phased in by 2020.

John Ball said: "Although this may look like a reprieve for contracting out, it would still accelerate the reduction in rebates that employers are expecting. The impact would vary from scheme to scheme, but many could see the value of rebates fall by half or more compared with what they are now. This may concentrate employers’ minds when it comes to reviewing the benefits they offer employees."

The central idea behind State Pension reforms is that if people have a clear idea of what they will get from the state, the firm says, so they can decide what they need to save on top.

John Ball added: "The theory is fine but in practice we know that every generation of politicians likes to leave its fingerprints on the State Pension system. Today’s twentysomethings can’t be too sure that a £140-a-week payment will be around when they retire, especially if there are questions about affordability."

Under the single-tier State Pension option proposed in the green paper, individuals would be entitled to a full State Pension after 30 years of contributions through work or other activities like looking after young children or sick relatives.

John Ball said: "People leaving school today have 50 years or more before they reach State Pension Age. Saying a full pension can be earned in 30 years, even though activities outside paid employment are properly credited, flies in the face of the Government’s central message about longer working lives. It also means that older workers could frequently get no boost to their State Pension entitlement as a result of paying tax and national insurance. The Government has probably calculated that State Pension rules have less effect on decisions about whether to work than they do on decisions about whether to save whilst in work."