UK pensions – fantasy vs reality
The ongoing disintegration of the entire British pensions system has reached the point at which it is clear that a root and branch restructuring is now unavoidable. This conclusion is being resisted by all the main interested parties – including those representing both providers and recipients of pensions. However, it is the providers in the private sector (and their political mouthpieces in Westminster) who have the clearest grasp of what is at stake and of what must be done to try and defend their vested interest for as long as possible, even though many of them seem to understand that ultimately it will prove a lost cause.
The same cannot be said of the trade unions – representing the interests of millions of actual or prospective pensioners – who give the impression they are the only people left who believe the present pensions structures can and should be maintained more or less intact.
This pamphlet seeks a) to describe the realities behind the ongoing pensions crisis – which have been for so long obscured by the self-serving misinformation of the pensions industry (aided and abetted by the mainstream media as well politicians of all parties), and b) to set out a realistic basis for an equitable pensions system for the 21st century such as will meet the needs of everyone.
The key elements of the existing UK pensions system and the problems surrounding it are set out below.
Occupational pensions (linked to schemes run by individual employers)
Funded schemes (based on paying contributions into a fund over an employee’s working life), comprising
Defined benefit (DB) schemes, under which retirees earn entitlement to a pension which is supposedly more or less fixed in relation either to his / her final salary or average earnings over a period of years. Almost exclusively in the private sector, these schemes are being rapidly phased out since it was found (from around 2000) that they would mostly be unable to meet their pension promises thanks to a) the collapse of financial markets in which the funds were invested and b) false assumptions by actuaries as to longevity (i.e. that people would die younger than they were in fact doing on average). Hence hardly anyone not already in such a scheme now has the opportunity to join – and then typically with a much lower pension in prospect than in the past.
Defined contribution (DC)1 schemes, under which a fixed percentage of the employee’s salary is contributed but there is no guarantee as to the level of pension entitlement (i.e. all the risk is with the employee). Because they avoid any risk to employers this is now almost the only type of scheme offered by companies in the private sector – and forms the basis of the NEST (National Employment Savings Trust), the default pension scheme set up by the government and to which all employers without their own scheme will have to sign up and enrol their staff automatically unless the latter opt out individually. Aside from the added risk, such schemes typically involve a much lower contribution from employers (typically 60 per cent less than under DB schemes), so that the chances of their delivering adequate pensions are virtually nil.
Non-funded – pay-as-you-go (PAYG) – schemes. These DB schemes are the norm in all parts of the public sector (the only major exception is the Local Government Pension Scheme, which is funded). They were described by the Pensions Commission under Lord Turner (2005) as “currently the most stable part of the UK pension system”2 They have none the less been under sustained attack ever since then as either unaffordable (despite the fact that it has been consistently shown that their cost to the taxpayer is set to remain at or below 2 per cent of GDP for the foreseeable future) or unfair or even “gold-plated”. This claim of unfairness is based on the fact that, despite providing very modest pensions to the vast majority of beneficiaries, their level has not declined in line with occupational pensions in the private sector – even though these have failed precisely because they are funded and vulnerable to all the uncertainties of the markets and the inefficiencies of the fund managers (see below). In response to such attacks – from the City, the media and all three mainstream political parties – the trade unions have agreed to the watering down of benefits in terms of the level of pensions, higher contributions and later retirement – to the point where scheme members who are still working may soon be inclined to opt out of their respective schemes, especially as their pay is being squeezed by both spending cuts and inflation3.
Basic state pension (BSP)
The BSP is a universal state benefit payable to all retirees who have made the requisite National Insurance (NI) contributions. It is financed on a PAYG (not a funded) basis, so that each generation’s contributions notionally pay the pensions of the preceding one. Until 1980 it was uprated each year in line with the increase in average earnings; since then, when the Thatcher government broke the link, it has been uprated only in line with prices – an act of daylight robbery given that NI contribution rates have continued to be levied as a percentage of earnings. Partly to compensate for this a means-tested pension credit has been introduced to benefit pensioners with little or no other source of income. Additionally many people, particularly married women with a limited employment record, do not qualify for the full BSP (currently £102.15 / week).
On top of the BSP individuals have been able (through contributions from themselves and their employers) to build up rights to a second, earnings-related state pension (SERPs or S2P). Throughout the 1980s and much of the 90s the government sought to encourage people to “contract out” of the second pension and contribute instead to private, funded (“personal” or “stakeholder”) schemes. Taken together with the downgrading of the BSP, this makes clear that the official strategy was to make state pensions so unattractive that people would feel compelled to rely more on the private sector.
However, the emphasis of government policy now appears to have reversed in favour of upgrading and restructuring the BSP (but see below – Recent Policy Developments). This is because of
The manifest abuses and scandals (including mis-selling) associated with private, funded schemes;
The collapse of financial / asset markets since 2000, rendering it difficult if not impossible to generate adequate returns in relation to pension commitments (this has reached the point where even Ros Altman, a leading spokesperson for the pensions industry, has been forced to admit that investing pensioner savings in the markets has been a disaster for the supposed beneficiaries)4;
The growing anomalies surrounding the inadequate BSP, particularly relating to means-testing and deficiencies in contribution records due to the growing fragmentation of the labour market resulting from recurring unemployment and part-time / contract working as well as the rising incidence of self-employment;
The evident danger / certainty that the NEST will fail and other private, funded schemes will die the death as low-paid workers opt out, especially as long as they can get means-tested supplements to the BSP.
As it has become ever more obvious that private funded schemes are facing extinction – particularly since the Pensions Commission in 2005 pronounced private DB schemes to be in a terminal state – supporters of the status quo, led by the City-based fund management industry with its huge vested interest, have been desperately fighting a rearguard action designed to avert or postpone the inevitable. To this end they have disseminated a huge volume of misinformation and false propaganda, evidently driven by Dr Goebbels’ maxim that the bigger the lie the more credible it becomes in the eyes of the public – particular with regard to three monumental red herrings / delusions.
The supposed “unfunded liabilities” of public-sector schemes. Even though the Turner Commission found that the public sector occupational schemes were the healthiest part of the UK pensions landscape in 2005, there has been a seemingly concerted campaign ever since then by City / right-wing interests and media to suggest that they are unsustainable5. The main basis for this claim is that these schemes have “unfunded liabilities” of hundreds of billions of pounds which amount to an unseen and intolerable burden on future generations of workers / taxpayers. This is despite the fact that
since these schemes are not funded but financed on a PAYG basis out of current tax revenue – including the nominal contributions of scheme members who are still working – they cannot (unlike private funded schemes) have unfunded liabilities; rather their cost is simply part of the total national budget for current spending (as it has been for centuries);
as noted by the Turner Commission, based on the Treasury’s own projections their cost is not likely to rise significantly above its recent share of GDP (around 2 per cent) in the foreseeable future.
While the basic dishonesty of the unfunded liabilities argument for claiming that public sector schemes are unaffordable has been exposed many times – and has not been accepted by Lord Hutton in his recent review of public sector pensions6 – it has been effective in generating support for the totally unjustified view (which is reflected in the Hutton report) that public-sector pensions are unfairly generous by comparison with those in the private sector. This seems to be the main justification for Hutton’s proposals that public-sector workers should accept a severe downgrading of the terms of their pension schemes, even though i) there is no serious suggestion that they are or will be any less affordable than hitherto (although this has not prevented shameless media spin to the effect that such “sacrifices” are necessary as part of the overall programme of public sector cuts), and ii) the failure of the inherently flawed private funded schemes is obviously no reason for penalising pensioners in inherently more viable PAYG schemes. Unfortunately the unions’ position is compromised by the fact that they have already conceded some watering-down of their pension rights under the last (Labour) government.
The “demographic time-bomb”. The most widely touted argument of those claiming that pension entitlements for the vast majority of people must be reduced is that the population is ageing as life expectancy rises. Consequently, it is argued, the ratio of retired people to those still working – or “dependency ratio” – is rising to an unsustainable level, although neither the Turner Commission (which supported this argument) nor anyone else has been able to define what that level might be (nor can they explain why this trend of rising life expectancy, which has been observable at least since World War II, has now become a problem when as recently as the 1980s it was thought compatible with encouraging people to retire in their 50s). If this irrational argument is none the less accepted – along with the implicit assumption that the burden imposed by the retired population has by now reached the limit of what is tolerable – it follows that, if pensioners’ living standards are to be maintained,
taxes – or at least pensioners’ share of existing state revenues – must rise to meet the cost of their extended retirement, or
workers’ rate of savings / pension contributions as a proportion of their incomes must rise, or
workers must retire later.
Of these options the first was judged by the Turner Commission to be undesirable – though for no clearly defined reason – in favour of the other two. However, it was doubtful even in 2005 whether most workers had the capacity or will to increase their savings from their stagnating earnings – a doubt since reinforced by the evidence that investing in the financial markets represents an increasingly bad deal (see above). This points to raising the retirement age as the only option consistent with holding down pensioners’ share of total income (Gross Domestic Product).
In truth the whole argument in favour of seeking to limit or reduce pensioners’ share of national income is inherently flawed and illogical, in that
The very concept of the “dependency ratio” is bogus, since it implies that labour is the only source of value in the economy and that output per unit of labour is more or less fixed, whereas thanks to technological advances the output and value of labour (productivity) has risen by 3-4 times since World War II. Moreover, labour’s share of the value added (GDP) from which transfers to pensioners are made has been in long-term decline for 30 years7, indicating that the share of companies’ profits has been rising – even as their tax burden has been reduced.
Even if there were any shortage of resources in the economy to pay for adequate pensions, it is nonsensical to suggest the problem could be overcome by raising the pensionable age so that people would have to work longer till retirement. This is because there is already a large excess supply of labour – reflected in a high and rising level of unemployment – so that adding millions more to the workforce by raising the retirement age can only make this problem worse and increase dependency on welfare benefits among all sections of the labour force. Despite being repeatedly reminded of this rather obvious reality the political and business establishment unanimously continue to insist that working longer is an indispensable part of the solution to the pensions crisis.
The supposed need for investment. For a long time it was held that a particular benefit of channelling savings through pension funds was that they provided an important source of investment capital needed to support expansion of the British and other economies. This was undoubtedly a strong reason for trade union support for funded pension schemes – an attitude reflected also in the TUC’s consistent demand from the 1960s for a higher rate of investment in the UK. However, while this call might have been valid around 1970 when pension funds were still in their infancy in the UK, it has long since ceased to be so. This is because, for a number of reasons (including changing technology) the demand for investment capital is much reduced compared with the past, so that the global corporate sector has had increasing trouble finding outlets for its accumulated profits and has scarcely needed additional finance channelled through pension funds – as even the leading business consultants McKinsey have recently been forced to admit8. This process, it is important to note, has led to the return on capital being driven down and thus to the increasing incidence of financial crises, as investors seek to compensate for low returns on company shares by increasingly reckless (and often fraudulent) speculation in risky assets. Hence it is clearly irresponsible to invest pension contributions in such assets, given that there is no longer any shortage of investment capital and that the primary purpose of a pension scheme is to secure workers’ pensions on a predictable and cost-effective basis.
Weakness of the trade union position
By continuing to put their faith in pension funds which are largely invested in such shares (equities) of declining worth, British unions are therefore tying their members’ fortunes to a failing economic system with a chronic and growing tendency to misallocate resources. It is doing so, moreover, at a time when even the City establishment – the natural champions of the fund managers who are the only real winners from the funded pensions business – is increasingly recognising that continued support for it is untenable. Evidence for this can be found notably in the columns of the Financial Times, where there is very strong scepticism as to whether the NEST – or any other DC scheme focused mainly on equity investment – could ever hope to deliver worthwhile pensions for low-paid workers while at the same time allowing fund managers to cover their costs9. Indeed the burden of fund management costs on pension funds is finally being recognised as a major problem as the squeeze on the industry intensifies. Thus another recent FT article cites a report by the IBM Institute of Business Value indicating that the worldwide fund management industry is overpaid by as much as US$ 1.3 trillion every year in relation to the value it delivers, with 85 per cent of this amount representing losses to pension funds10. This obviously underlines the huge handicap of excess management costs making it virtually impossible for these funds to deliver decent pensions – in contrast to state-run PAYG schemes, which do not have to pay fund managers and which incur administrative costs that can be estimated as far less than 1 per cent of the pensions paid out11.
Against this background, and in the context of the current pensions debate, the unions’ continuing commitment to support funded schemes, rather than condemning their obvious flaws, is perverse. Worse still, it inevitably conflicts with and inhibits their support for upgrading PAYG state pension schemes (BSP, earnings-related or occupational schemes). For if the unions were to point out, as they should, that such tax-financed schemes are far more cost-effective and sustainable this would obviously raise queries about the logic of them continuing to support funded schemes.
Recent policy developments
In face of the ever mounting problems facing the existing UK pensions structures as described above – failing funded DB schemes, doubts about the viability of the NEST and serious anomalies surrounding the inadequate BSP – last October the Coalition government signalled its intention to move in a new direction. As originally announced at that time, this would centre on introducing a “Citizen’s Pension” in place of the existing BSP and Pension Credit by 2015. This would be non-contributory at a flat rate and payable to all retirees who qualify as citizens – whether by birth or length of residence in the UK12. Such a proposal – which would mean eliminating much of the complexity and uncertainty of the present system – would be in principle be welcome provided the flat rate was set at a level that could provide an adequate minimum retirement income for all. However, in line with the Coalition’s trade-mark tendency to flip-flop on many of its policy pronouncements, the Consultation Paper ultimately presented to Parliament in April 2011 (and on which interested parties are invited to submit comments by 24 June) shows it has substantially backtracked on its original proposals. Hence it now appears that, for all its claim that the new system would be simplified and non-contributory, the government is proposing a model that would still mean entitlement was determined by the number of years of each individual’s NI contributions, thus negating the core principle of a Citizen’s Pension. At the same time the Consultation Paper appears extremely unclear as to what exactly the Coalition’s proposals would mean in practice, so that it consequently remains to be seen whether they will result in any improvement at all, bearing in mind that the central priorities of government policy are revealed as
to create a system that will benefit the fund management industry by (they hope) reducing or eliminating means-testing and thereby lessening people’s disincentive to save through (DC) pension funds;
To avoid increasing the aggregate cost of the BSP to the public purse above its current meagre level.
The way forward?
The above analysis points to the need for a campaign – particularly among trade unionists – in support of a radical, simplified pensions structure designed to meet the basic needs of all retired people. This should be based on the following key demands / principles:
Priority focus on a fully adequate BSP / Citizen’s Pension funded out of taxation13 – to be set at no less than £175 / week at 2011 prices – backed up by properly funded health and social services (e.g. social care);
Contributory state second pension / SERPS for those who wish in lieu of all existing occupational schemes (public and private);
NEST to be cancelled / aborted; in the event that it goes ahead workers should be recommended to opt out;
No further watering down of public-sector occupational schemes to be accepted (in respect of benefits, contribution levels or retirement age) – pending the introduction of an adequate Citizen’s Pension (and SERPS equivalent);
Statutory maximum pensionable age of 65 for BSP and all occupational schemes;
Private funded schemes should be allowed but without tax breaks.
Transitional arrangements should be designed to ensure fair treatment for
BSP recipients who have already made substantial NI contributions (e.g. through lump-sum supplements);
occupational pensioners who have contributed to schemes in both the public and private sectors (the accumulated funds should be nationalised to help pay for this – as has already happened in the case of failed funded schemes in Argentina, Hungary and elsewhere).
Harry Shutt, May 2011
(This paper was commissioned and published by the Hammersmith and Fulham Trades Union Council)
1Also known as “money purchase”. It should be noted that this the only type of scheme (aside from the Basic State Pension – see below) open to the increasingly large proportion of self-employed workers.
2Pensions: Challenges and Choices – The First Report of the Pensions Commission (November 2005) – page 120
3In fact it has been revealed that participation in the Local Government Pension Scheme has already declined by 7 per cent in the last 5 years – partly, it may be supposed, in response to the imposition of inferior terms by the Labour government after 2006.
4DC pension savers head for poverty by Ruth Sullivan, FTfm 13 March 2011
5E.g. The Taxpayer’ Alliance – a self-styled “non-partisan” pressure group claiming to represent “ordinary taxpayers” but which in fact is a right-wing pressure group funded by big business
6Independent Public Service Pensions Commission: Final Report – 10 March 2011
7From around 68 to 61 per cent. See Bank of England Quarterly Bulletin 2010 Q1
8Farewell to cheap capital? The implications of long‐term shifts in global investment and saving.
McKinsey Global Institute, December 2010. As the title implies, the authors feel obliged to suggest that this long-term trend of devaluation of capital is about to be reversed, although they fail to produce any concrete evidence that this is likely.
9See The fine line between risk and return by Pauline Skypala, FTfm March 27 2011
10Industry “overpaid by $1300 bn” by Steve Johnson, FTfm April 4 2011
11The precise figure is not given in the published accounts of the National Insurance Fund.
12Such a system would be in line with a similar Citizens’ Pension already operating in New Zealand
13National Insurance to be merged with income tax