A flat-rate pension – reasons to be cautious
There are powerful arguments in favour of a simpler flat-rate pension of the kind outlined by Iain Duncan Smith today.
The strongest argument is that it would mean the majority of the population would get a pension from the state that would take them above current means-testing levels. In addition, few people understand the state second pension or have much idea whether they will get one or how big it will be. Rolling it into the basic state pension is therefore an attractive option.
The idea therefore has support scross the political spectrum, particularly among pensions insiders.
But it is far too soon to pass judgement on whether this government’s proposals will be progressive. A flat-rate pension carries a hefty bill. The question is who is going to pay for it. Who will win? Who will lose? We do not know the answers to these questions yet. Simplification is always a good thing in principle, but in practice is almost always much controversial.
It helps to know a little about the history of the state second pension if you want to understand the thinking behind the flat-rate pension.
While there was a small second pension before, today’s second pension really dates back to Barbara Castle in the 1960s. This was when occupational pensions reached their high watermark in the UK. The majority of workers (at least men) were members of good defined benefit occupational schemes.
But even then not everyone had access to a workplace pension. There was therefore a degree of consensus that the state should step in and supply a contributory state earnings related pension (SERPS) for those not building up an occupational pension. The model was that the state should provide a foundation and on top of that either your employer or SERPS added to that to provide a replacement income when you retired that gave you a standard of living related to that you had when you were working.
Decent occupational schemes were allowed to contract out of SERPS. This meant their members were not eligible for SERPS, but in return both employer and employee paid lower National Insurance contributions.
But SERPS has been hacked about since then. The Conservatives in the 1980s not only ended the link to earnings for the basic state pension they also halved the value of SERPS.
Labour decided that it wanted to target the low paid and therefore decided to end SERPS in favour of a state second pension (S2P) that would be eventually flat rate by about 2050- at around £153 a week in today’s money.
A flat rate pension would bring forward this date significantly forward and extend it to people who had contracted out of the state second pension. Those who had build up significant earnings related SERPS pensions that took them above this would lose.
One way of finding the extra funds would be to end contracting out. This would mean everyone in an occupational pension would in effect pay more for their pension as they would lose the National Insurance reduction they currently enjoy. While there are declining numbers of private sector workers in contracted out DB pensions, this would affect all public sector workers as they are contracted out. This would be another blow on top of all the other changes being made to public sector pensions.
But even this still leaves a gap. Probably the best work on this is the research carried out by the Pensions Policy Institute (pdf) for the National Association of Pension Funds.
This suggests that a flat rate pension based on Labour’s slightly more ambitious target of £153 a week would cost £25 billion if introduced in 2017. This would take the cost of the state pension and related benefits from 5.5 per cent of GDP to 7 per cent.
While even with this there would be winners and losers, it is hard to believe this Chancellor is planning such a big increase in the cost of pensions. The question therefore is how will this be paid for.
The pensions gossip has been that the Treasury has been blocking a Green Paper originally planned for the run-up to Christmas, but it looks as if they have dropped their objections. Perhaps they have suddenly found a new pot of money by following the pigs flying over Downing Street. It’s more likely that the DWP have had to offer up sacrifices elsewhere.
This is a move that it would be good to be able to cheer. I’m sure pensions minister Steve Webb has the best intentions on this, as someone with a good track record of supporting progressive state pension reform.
But I’m staying cautious until I can read the small print.
(And incidentally I have deliberately not cited encouraging pensions savings by minimising the risk of losing benefits through means testing as a key benefit. It is true that it would end the pays-to-save problem for most people, but I think many on the right exaggerate its deterrent effects. They desperately want to believe in a world where people act in an economically rational way guided by market signals. But even a cursory understanding of how real people behave shows that this model doesn’t fit the real world – that’s why we need behavioural economics.)