It is important to recognise the complexity of the pensions system in the UK before tackling the topic. Whilst the state pension has been around in one form or another since 1908, gradual reforms to keep it applicable to modern times have been few and far between. The greatest shake-up of the pension system since its creation came into effect on April 6 2006 – known as A-Day by industry professionals, in the form of a document entitled Pension Simplification. Prior to this, there were no less than thirty-two separate rulebooks governing how pensions had to be invested and managed in the UK. Bizarrely, A-Day did not shelve these rulebooks and many of them still contain important legislation that affects pensions in the UK. Industry professionals to whom I have spoken during the course of researching this essay agree that pensions are still one of, if not the most complex areas of British personal finance that can confuse even the most seasoned of veteran investors.
For this reason, I have dealt with pensions in the UK in a level of depth that is technical, but not needlessly confusing. The important factors have been mentioned and explained, though I freely admit there is a great deal more out there that anybody would struggle to cover within the confines of a book, let alone an essay! Hopefully, the arguments conveyed and discussed from hereon in are of sufficient detail to make an informed judgement upon the sustainability of the British pension system.
Abstract
It is important to recognise the complexity of the pensions system in the UK before tackling the topic. Whilst the state pension has been around in one form or another since 1908, gradual reforms to keep it applicable to modern times have been few and far between. The greatest shake-up of the pension system since its creation came into effect on April 6 2006 - known as A-Day by industry professionals, in the form of a document entitled Pension Simplification. Prior to this, there were no less than thirty-two separate rulebooks governing how pensions had to be invested and managed in the UK. Bizarrely, A-Day did not shelve these rulebooks and many of them still contain important legislation that affects pensions in the UK. Industry professionals to whom I have spoken during the course of researching this essay agree that pensions are still one of, if not the most complex areas of British personal finance that can confuse even the most seasoned of veteran investors.
For this reason, I have dealt with pensions in the UK in a level of depth that is technical, but not needlessly confusing. The important factors have been mentioned and explained, though I freely admit there is a great deal more out there that anybody would struggle to cover within the confines of a book, let alone an essay! Hopefully, the arguments conveyed and discussed from hereon in are of sufficient detail to make an informed judgement upon the sustainability of the British pension system.
Introduction
The state pension in Britain is a contentious issue; many claim that it is in crisis amidst falling mortality rates amongst a generation of ‘baby boomers’ from the 1940s and the impending retirement surge of the 1960s boom generation, who were followed by a generation of much lower birth rates.1 Governments have done their part in damaging the value of pensions with Margaret Thatcher linking the basic state pension’s value to inflation (as opposed to earnings) in 19802 and Gordon Brown “raiding” pensions in 1997 by way of a 10% stealth tax on pension fund dividends that is estimated to have cost over £100 billion.3
The recently appointed Pensions Minister, Steve Webb, admitted in his first major interview that the state pension “is not enough to live on”4 and his claim is not far from the truth. At a meagre £97 per week for individuals which is funded in majority by current tax revenues, it would appear that the British state pension is not only unsustainable, but also no longer fit for purpose. Despite a £1.2 trillion crisis,5 thanks to local government pension schemes amassing a deficit of around £100bn6 and final salary schemes within the public sector being over £242bn in deficit.7
The recent economic woes felt the world all over have served only to blacken the outlook within the UK. The aggregate deficit of British corporate pensions funds reached a staggering £253.1 billion in early 2009,8 despite firms resident of the FTSE100 share index paying a record £17.5 billion into their pension schemes,9 with volatile equity markets adding an extra £40 billion to the UK’s enormous pension deficit.10
Despite these eye-watering numbers, the public sector is in denial of how much trouble the state pension scheme is. Pensions expert John Ralfe claims that the highly risky and very costly system of defined benefits has been dealt with by the private sector, which has moved away from such schemes in recent years, whereas the public sector continues to run these negative balance schemes complacently.11
It is true that the troubles facing pensions are not endemic of the public sector, but the causes behind them are very different. The private sector struggles with not only providing wholly independent pension schemes, it is also encumbered with the costs of contributing to the state pension concurrently all of which is in the context of dramatically uncertain economic conditions at present. Conversely, the public sector’s struggles are due to the inefficient and loss-making systems being used to fund pensions that are in no way, shape or form sustainable either to the select few who receive public sector pensions or the wider public in receipt of the state pension.
Analysis of the State Pension
The format of the state pension has not changed enormously since its inception in 1908 as part of the Liberal Reforms under Herbert Asquith and David Lloyd-George.12 In essence, the majority of the state pension is made up of tax revenues paid out to pensioners each week and although certain aspects have changed - such as legislation introduce an earnings-related component of the state pension,13 closely monitoring contracted-out pensions following the scandal of Robert Maxwell14 and the introduction,15 removal16 and reintroduction of an earnings link17 - the core ideology behind it of purchasing an annuity by participation in the workforce has not. The state pension is a non-optional contribution to the state and is a means for smoothing consumption,18 i.e. when a person leaves the workforce and becomes a pensioner, some of the consumption that was forgone in earlier life by way of taxes is reimbursed to them. 19
The state pension runs in the form of a Pay as you Go (PAYG) defined benefit scheme. Today’s pension payments by the state are funded by today’s taxes from the workforce. This element of the system allows the government to underwrite the risk of inflation more comprehensively than any private agency.20 From 2012, it also means that current pensioners have an intrinsic benefit in economic growth by means of increased pension payments as they are once again linked to earnings rather than inflation. 21
The Social Security Pensions Act 1975 was one of the largest pieces of legislation to affect the state pension during its lifetime; it introduced the State Earnings-Related Pension Scheme (SERPS) to replace the graduated pension22 (its theoretical predecessor) and proscribed definitive contributory requirements for individuals.23 In simple terms, SERPS allowed members of the workforce to opt-in to additional pension payments in order to top-up their state pension.24 It did not affect the basic component of the state pension that participants would receive, but instead allowed them to claim a portion of their pension that was proportional to their working wage or salary either across or at a certain point of their working life.25 Since 2002 SERPS has been replaced by the State Second Pension (S2P), a scheme which works in much the same way as SERPS in that it is still based upon an individual’s record of National Insurance contributions, but promises a more generous top-up than SERPS.26
Understanding the system
In place of SERPS/S2P it is possible to subsidise one’s pension with a private scheme component͖ though choice here is limited to two options; either an occupational pension or a personal pension, the latter of which (since 1988)27 can be contracted out to financial institutions or (since 1989)28 self- managed.29 Occupational pensions are gained usually as the result of salaried employment and are calculated based upon an individual’s basic salary and the contributions received from it. These schemes can be run in different ways, with ‘final salary’ and ‘money purchase’ schemes being the most popular; a final salary scheme pays out relative to the individual’s final salary (or salary during final years of employment) whereas a money purchase scheme pays pensionable income linked to the performance of the fund and its value from contributions. Money purchase schemes also allow for the purchase of an annuity on the open market.30 Finally private schemes allow for the opt-out of the S2P scheme, in order to reclaim National Insurance contributions, allowing them to use the reclaimed cash to invest in either a pension scheme run by a private agency or build their own pension portfolio.31 In this situation, the individual is able to purchase annuities and other financial products on the open market of government approved instruments and schemes. From 2012, individuals opting to have a personal pension plan will cease to be entitled to opt-out of the S2P scheme; individuals opting into occupational schemes will continue to have an opt-out.
For both occupational and private pension schemes, income tax relief is available in such a way that part of an individual’s income tax liability for that fiscal year can be written off against the pension contributions made in the same fiscal year.
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1 Barr, N. Economics of the Welfare State 4e, p.195 (Oxford: Oxford University Press, 2003).
2 Flanagan, G. ‘Government pension review will add 2.5% to basic state pension,’ Principle First. May 28, 2010. URL: http://www.principlefirst.co.uk/pensions-news/government-pension-review-will-add-2-5-to-basic-state- pension/
3 Barrow, B. ‘Brown’s pension raid cost savers £100bn,’ This is Money. October 16, 2006. URL: http://www.thisismoney.co.uk/pensions/article.html?in_article_id=413695&in_page_id=6
4 O’Grady, S. ‘State pension is not enough to live on, minister admits,’ The Independent. July 29, 2010. URL: http://www.independent.co.uk/news/uk/politics/state-pension-is-not-enough-to-live-on-minister-admits- 2038076.html
5 Walyat, N. ‘Public sector pensions deficit of £1.2 trillion adds to Britain’s debt crisis,’ The Market Oracle. June 29 2009. URL: http://www.marketoracle.co.uk/Article11661.html
6 (s.n.) ‘Local government pension deficit totals £100bn,’ BBC News. December 15 2010. URL: http://www.bbc.co.uk/news/business-11996504
7 Bowers, S. ‘£240vb final-salary pension deficit threatens to swamp lifeboat,’ The Guardian. April 14 2009. URL: http://www.guardian.co.uk/business/2009/apr/14/final-salary-pensions-shortfall
8 Cohen, N. ‘UK pension deficit hits £250bn,’ Financial Times. April 14, 2009. URL: http://www.ft.com/cms/s/0/b3008330-2921-11de-bc5e-00144feabdc0.html#axzz1BQ73LALe
9 (s.n.) ‘Record pension deficit payments made by big firms,’ BBC News. August 4, 2010. URL: http://www.bbc.co.uk/news/business-10855116
10 Litterick, D. ‘Market falls add £40bn to UK pensions deficit,’ The Telegraph. March 25, 2008. URL: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/2786935/Market-falls-add-40bn-to-UK- pensions-deficit.html
11 The Today Show, 2010. Radio, BBC Radio 4. Broadcasted December 15 2010.
12 (s.n.) ‘ chievements of Liberal Reforms,’ The National Archives. (n.d) URL: http://www.nationalarchives.gov.uk/education/britain1906to1918/g2/background.htm
13 (s.n.) ‘History of pensions: brief guide,’ BBC News. December 9, 2002. URL: http://news.bbc.co.uk/1/hi/business/2488513.stm
14 Pensions Act 1995 (c.1)
15 (s.n.) ‘Q& : Basic state pension,’ BBC News. October 26, 2010. URL: http://news.bbc.co.uk/1/hi/business/3197943.stm
16 (s.n.) ‘History of pensions: brief guide,’ BBC News. December 9, 2002. URL: http://news.bbc.co.uk/1/hi/business/2488513.stm
17 Teather, D. ‘George Osborne restores pension link to earnings,’ The Guardian. June 22, 2010. URL: http://www.guardian.co.uk/money/2010/jun/22/budget-2010-pension-link-to-earnings
18 Barr, N. Economics of the Welfare State 4e, p.186 (Oxford: Oxford University Press, 2003).
19 Ibid. p.188
20 Ibid
21 Teather, D. ‘George Osborne restores pension link to earnings,’ The Guardian. June 22, 2010. URL: http://www.guardian.co.uk/money/2010/jun/22/budget-2010-pension-link-to-earnings
22 (s.n.) ‘History of pensions: brief guide,’ BBC News. December 9, 2002. URL: http://news.bbc.co.uk/1/hi/business/2488513.stm
23 Barr, N. Economics of the Welfare State 4e. p.186 (Oxford: Oxford University Press, 2003).
24 (s.n.) ‘State Earnings Related Pension Scheme,’ Finance Glossary. (n.d.) URL: http://www.finance- glossary.com/define/State-Earnings-Related-Pension-Scheme/1359/0/S
25 Barr, N. Economics of the Welfare State 4e. p.187. (Oxford: Oxford University Press, 2003).
26 (s.n.) ‘Pensions Tips & Guides: The State Second Pension,’ This is Money. (n.d.) URL: http://www.thisismoney.co.uk/s2p
27 (s.n.) ‘Pensions Timeline,’ The Pensions Advisory Service. (n.d.) URL: http://www.pensionsadvisoryservice.org.uk/pensions-timeline
28 Ibid.
29 Barr, N. Economics of the Welfare State 4e. p.188. (Oxford: Oxford University Press, 2003).
30 (s.n.) ‘Occupational Pension Scheme,’ Sharing Pensions. (n.d.) URL: http://www.sharingpensions.co.uk/glossary19.htm
31 Barr, N. Economics of the Welfare State 4e. p.188. (Oxford: Oxford University Press, 2003).
- Quote paper
- Alex Boni (Author), 2011, Sustainability of the State Pension, Munich, GRIN Verlag, https://www.grin.com/document/168247
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