The starting gun for the General Election has been fired, with less than 100 days to go before we vote. But, asks John Read, will the parties have the courage to discuss how future governments will pay for workers’ retirement?
Financing the state pensions of the next generation of retired workers is a key challenge for future governments. Yet it has not been mentioned in the early election discussions. This is despite the retired over 65 population projected to increase substantially over the next 20 years – estimates for the increase range between 35% and 50%. National Insurance contributions from employers and employees will become insufficient to meet these costs, unless contribution rates rise significantly.
Currently, income from National Insurance contributions exceeds state pension costs. National Insurance contributions in the 2012/13 year amounted to £107bn, of which £82bn was allocated towards state pensions, with £25bn used to support the NHS. Even the £82bn was not used in its entirety to make state pension payments – a surplus was held back for future requirements, building up a reserve fund of £30bn. But this situation will be reversed in the coming years, with state pension costs increasing on current trends to £115bn by 2033. This would require employee and employer National Insurance contributions to rise from 13% to more than 18%.
The Department of Work and Pensions 2014 cost projections present an even worse picture. Even though SERPS and the state second pension have been abolished – and many more people are delaying retirement – DWP projections show pension costs rising to £172bn in 2033/4 and then to £415bn by 2063/4 – based on 2014/15 prices. This financial nightmare does not even include the cost of pension credit and welfare benefits.
These DWP figures do not, though, make sense, as they infer retired population increases of 210% by 2033 and 500% by 2063, whereas the latest ONS 2012 projections show increases of 139% and 144% respectively for the UK.
But it is indisputable that a National Insurance and pension crisis is looming in the next Parliament and beyond. By 2020, the NHS subsidy will cease to exist, with all the proceeds of the fund required for state pensions.
It seems inevitable that the state pension will eventually degrade into a means-tested benefit. There have already been proposals from the Institute for Fiscal Studies to turn National Insurance into a tax, with the proceeds of the new workplace pension used to replace the state provision. A generation of workers would in effect then be paying twice for their pensions, without receiving the enhanced benefits that a previous generation of pensioners did from SERPS.
This situation arises because of the unfunded ‘pay as you go’ nature of the state system; contributions are not saved to accumulate and grow into a retirement fund and, moreover, are eroded by inflation. At the average wage, total National Insurance contributions cost £4,655 per year. A well managed funded scheme will accumulate contributions – without including investment returns – of £150,000. With modest growth, a fund of this size should provide enough to pay twice the current single tier pension of £7,500, or more at higher wages.
If everyone in work carried a pension pot adequate for their needs into retirement on the basis of self-sufficiency, the problem of ‘age dependency’ – younger adults who are in work paying for those who are retired – would disappear. Instead, it is projected that by 2050 there will be just two people in work for every pensioner, resulting in a serious dependency problem.
The Government’s recent moves to allow pension funds to be accessed at retirement through withdrawals – rather than requiring people to buy annuities upon retirement – create new dangers. Withdrawals will in many cases be subject to substantial tax penalties and many new pensioners will spend their funds unwisely, forcing pensioners into the poverty of state welfare and dependency on those in work.
Analysis that I have conducted reveals that because the demand for pensions is spread, due to the age range, then transition to a funded scheme could be implemented in an almost cost neutral manner by funding liabilities through debt. The main problem would be how to pay for existing members: the state pension liability is currently £3,800bn and represents contributions collected from members and spent on others, effectively creating a national debt. If interest was paid at 4%, the cost would be £152bn per year – almost twice the present pension cost. If private schemes were run in this manner, managers and trustees would be in jail for misuse of funds or fraud!
There are 27 million National Insurance employee contributors. If each were to receive a £2,000 rebate – 8% of the average wage – the cost would be £54bn per year. This could be financed through a 20 year transition, with bonds maturing over 35 years. That would be sufficient for each worker to have their own pension fund of £100,000, which over 35 years should yield an equivalent amount to the single tier pension. Contributions would reach £40,000 over 20 years and £70,000 over 35 years, with only modest investment returns required to achieve target levels.
This would provide a basic earned pension for everyone. It would also provide an incentive to join a workplace or other scheme to bring retirement income to the minimum suggested levels of half average wage. This would bring major advantages to individuals and big cost savings to the state.
