Social Security Reform Lessons Learned in other Countries

- Thursday, 11th February 1999

 

There are only two ways to finance the pensions of future generations of retired people. The first is to rely on taxing those who will be in work to pay the pensions of those in retirement. The second is to encourage people to save and invest during their working life to pay for their future pensions.

Most European countries rely largely on the first method.

Almost all their pensions are paid out of taxes and charges on those in work. This year?s taxes are used to pay the pensions of people already retired. Nothing is saved or invested for the future. It is pay as you go.

So as the number of retired people rises and the number of people of working age falls they face an increasingly onerous burden of tax on their economies. That is the nightmare facing most finance ministers in Europe and elsewhere.

By contrast the UK has persuaded the bulk of people to build up pension funds for retirement. It allows and encourages them to opt out of the State Earnings Related Pension Scheme. Over 60 per cent of those eligible do opt out. They receive a rebate of their payroll tax which is payable into an occupational or personal pension. So their money is genuinely saved. It is invested. It goes into industry to earn the dividends which will pay their pensions in ten, twenty, thirty years time when they retire - without imposing a burden of tax on the economy and meanwhile strengthening it through a massive build up of investment.

Over eight million employees are now in occupational funds. When we extended the right to personal pensions the Government expected 500,000 to opt out. The top forecast was 1,750,000. In fact, 5,500,000 employees now have personal pensions.

Significantly, the total value of British owned pension funds is now some ?830 billion. That is $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 IMF calculated that if countries maintain their present systems - by 2050 France and Germany would have accumulated government debts nearly twice their national income. By contrast the UK would have paid off its entire national debt and accumulated a surplus.

Let me explain how the UK system works to bring this about.

The 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 tax (known as National Insurance Contributions) becomes 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 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 the scheme. Employees who are opted out are entitled to a rebate of their payroll taxes (which we call National Insurance Contributions). This rebate is payable only into an approved pension scheme. It is paid direct into the pension scheme 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 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. He assumes investments will yield 4.25 per cent per annum in real terms

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

Typically employers running such schemes paid contributions into their scheme 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 of an occupational scheme the right to opt out of SERPS into an approved Personal Pension scheme. These were something like Individual Retirement Accounts in the USA.

Anyone opting for a Personal Pension is entitled to a rebate from his or her National Insurance Contributions. This is payable direct 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 8 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. I imagine the Committee will be at least as interested in the problems we have had to tackle as in the success of this approach.

The first problem was the problem of ?misselling?: pension salesmen selling personal pensions to people who had a better alternative. This was not the result of giving people freedom to opt out of the State Scheme into personal pensions. The initial rebate was set at a level sufficient to ensure that it could fund a personal pension that was better than the State scheme.

The problem arose from a separate change introduced at the same time. This was the decision to give employees the right to opt out of company pension schemes. Prior to 1986, employers who ran occupational pension schemes could make membership of their scheme a condition of employment and deduct from employees? pay at source a premium payable into the fund. Most employers with such schemes did make membership obligatory for those eligible to join. Typically, they made employees pay pension contributions of up to 10 per cent of salary and many added a similar sum themselves.

From 1986 employers could no longer force employees to join their scheme. If employees wished they could leave the company scheme and take out a personal pension. If they did, their rebate of National Insurance would be automatically transferred to the personal pension fund. They could also pay into their personal pension the premium previously deducted from their own salary. But most employers would not pay into the personal pension the matching amount they had been paying into a company scheme.

So anyone foolish enough to move from a generous company scheme to a personal pension fund was almost bound to lose out. Nonetheless, many were persuaded by unscrupulous salesmen, paid on commission, to make this change.

Many employees were allegedly confused by government advertising extolling the virtues of opting out of the State scheme into personal pensions. They assumed that the government was also recommending them to opt out of company pension funds into private pensions.

In fact, the original legislation required salesmen to make sure their product was appropriate to their customer?s circumstances. Consequently it was invariably illegal to missell in this way. The Regulator has therefore required companies to go through their files and reimburse any customer who was missold a pension in this way.

This is a massive exercise. However, the Regulator has given an assurance that no one who was missold will lose out at the end of the day. They will either be reinstated in their original scheme or compensated.

The lessons from this are clear. Either don?t give people the right to leave company plans or don?t do that the same time as enabling them to opt out of the state retirement plan. It is essential that clear rules against misselling be included in the legislation and that they are toughly enforced after enactment.

The second problem was a massive theft from a company scheme. In 1991 Robert Maxwell (a former Labour MP and head of a complex business empire) was found dead leaving up to ?450 million missing from the pension funds of his companies. The pensions of 30,000 people seemed to be at risk. In the event, sufficient monies were recovered to ensure all pension entitlements would be paid in full. Nonetheless the theft revealed apparent weaknesses in pension fund security. A new framework was therefore 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 UK the Labour Party has traditionally favored state funded, pay-as-you-go pension provision. It was grudgingly prepared to allow company schemes to opt out of the State Earnings Related Pension scheme. But it was critical both of 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 private funded pension provision. 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. Labour now plans to encourage more people to build up private funded pensions.

Private pension provision proved so popular and its beneficial effect on public finances became so clear that there is now more of a political consensus in Britain that where possible more people should be enabled to opt out of the state system. The new Labour Government even proposes forcing everyone earning more than ?18,000 to leave SERPS and take out a private ?stakeholder? pension.

Proposals to Extend Private Provision of Pensions. Before the last election Conservatives were seeking ways to extend private pension provision.

In the late 1980s we gave members of company schemes 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 tax free.

The then government also consulted on the idea of closing the State Earnings Related Pension Scheme. That would have meant everyone would in future be opted out and pay obligatory premiums (rebated from National Insurance Contributions) into personal or company schemes.

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

Because the SERPS scheme is earnings related, anyone on 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 ?485 per pension. The government therefore kept the State Earnings Related Scheme 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 scheme.

The government therefore encouraged transparency - 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 schemes. And new and small companies who are typically reluctant to set up company schemes (which have low costs) 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 Labour government is essentially 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 attractions of opting out of SERPS a little wider. Many low paid would continue to find their rebates too small to set up a personal pension.

Basic Pension Plus. Before the May 1997 General Election, 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 provision to cover the basic state pension as well as the earnings related pension.

This would have mandated that all new entrants to the labor market should be given tax rebates sufficient to fund both their basic pension and their earnings related pension. Over a generation, the entire burden of financing pension provision would be transferred from taxation to investment. It would also bring about the largest extension of personal ownership of wealth since the spread of home ownership, enable future retirees to share in economic growth, give a massive boost to investment and strengthen the economy.

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

Such a flat rate rebate would enable everyone - even low earners - to cover the fixed costs of setting up a pension fund. So 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 come in gradually with the new generation of young people entering the labor market. We therefore proposed a scheme called Basic Pension Plus.

It had three key elements.

First, the personal fund. Everyone in the new generation would have 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.

Second, 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 third element was the Basic Pension Guarantee. The State would guarantee that everyone would receive a pension at least equal to his or her basic state pension (increased at least in line with inflation). We called the scheme 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 provides. 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 scheme.

And everyone would stand to do better, if as we hoped, the economy and their investments did well. If returns are one per cent higher than assumed they would get a pension nearly 30 per cent above the basic pension. If the yield is 2 per cent higher, the pension could be over 70 per cent better.

So 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. That is based on making the 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 their fund.

We would phase in the new system of funded pensions gradually over a generation. Existing pensioners would not be affected by the new scheme 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 initially 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 forty 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 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 PEP style 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, it would produce massive savings in public expenditure reaching ?40 billion a year. At its peak the net revenue forgone would be less than the peak cost of SERPS rebates, which we had already taken in our stride. It would be a fraction of the savings resulting from the UK?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 scheme boosted economic growth by just a twentieth of one per cent the scheme would be entirely self-financing - though we did not take account of this in costing the scheme.

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 five per cent 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 one per cent investment yield would generate a pension 30 per cent 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 - British people would have been able to look forward to secure pensions, higher investment and low tax.

Conclusion: Social Security reform is about much more than saving money. It should be about spreading wealth, independence and security to everyone. Britain has shown this can be done in a mature economy.

 

 

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