Improving the pensions system
5. We now spend £10.5 billion a year (nearly 1 per cent of GDP)1 more on pensioners than we would have done if we had simply continued the policies we inherited in 1997. Combined with growth in private pension saving, this has meant pensioner incomes have risen across the board, with the poorest benefiting most. We have achieved these gains while maintaining the affordability of the system as a whole.
Figure 2: Gains for pensioners from this Government's policies since 1997
Source: DWP Policy Simulation Model - see technical appendix for more details
Notes: Gains from 2006/07 policies compared with the 1997/98 system of benefits indexed to 2006/07 prices.
Pension Credit includes Housing Benefit and Council Tax Benefit knock-on effects.
6. In addition to tackling pensioner poverty, the Government has taken significant steps to improve other aspects of the pensions system since 1997.
7. We introduced the State Second Pension in 2002, crediting in low earners and some carers who missed out on its predecessor, the State Earnings-Related Pension Scheme (SERPS). Consequently, some 4 million people now have the chance to build up a decent additional pension for the first time. We introduced stakeholder pensions and required that all employers with five or more employees should provide access either to a stakeholder pension or to an occupational scheme, as an important step towards encouraging more private saving and bringing down the cost of saving.
8. The Pensions Act 2004 has improved security and confidence for occupational pension scheme members. The Pension Protection Fund (PPF) means that over 10 million members of salary-related pension schemes know that they will receive compensation if their employer becomes insolvent and the pension scheme is under-funded. The Financial Assistance Scheme (FAS) will help groups close to retirement who lost out before the PPF was established. Following the Prime Minister’s announcement to expedite the review of the FAS planned for CSR07, the Government has decided to extend the FAS so that it will assist eligible people who were within fifteen years of their scheme pension age on or before 14 May 2004. This should ensure that up to a further 30,000 people who lost significant amounts when their pension schemes were wound up, will benefit from the new arrangements. Under this extension, scheme benefits will be tapered so that the Government will pay the full 80 per cent to those within seven years of scheme pension age, 65 per cent to those within eight to eleven years of scheme pension age and 50 per cent to the remainder.
9. The Pensions Regulator will help to protect members’ benefits and promote good administration of work-based pension schemes. It has wide powers to investigate schemes and take action where necessary and takes a proactive, risk-focused approach to regulation. The Regulator also provides practical support for the regulated community. And the Finance Act 2004 swept away the complexity of many separate taxation regimes, replacing them with a single, flexible regime based on the simple concept of a lifetime allowance of £1.5 million for tax-privileged pension saving.
10. We have also supported private saving by helping people to make better informed choices about their retirement, introducing a range of pension forecasts to give individuals an understanding of the income they are likely to receive in retirement. Since their introduction, the Government has issued just over 20 million of these forecasts and we are developing web-based retirement planning services.
11. We have taken steps to outlaw age discrimination and promote older working. We have set a long-term aspiration to reach an employment rate equivalent to 80 per cent of the working-age population, including a million more older workers.
12. As the Pensions Commission made clear, private pension incomes are at an all-time high. Living standards have risen for all, but, over the past 25 years at least, more for pensioners than for working-age adults.
The case for further reform
13. So we have already made great strides to tackle the immediate problem of low pensioner incomes and put in place necessary reforms to help people plan for the future. But we have long recognised that further steps would be needed to ensure that people could get the retirement income they expect in the future. In December 2002 we established the independent Pensions Commission, to review the regime for UK private pensions and long-term saving. We asked it to consider the longer-term challenges faced by the pensions system and whether the existing voluntary pensions regime represented an adequate response. The Pensions Commission concluded that there is no immediate ‘pensions crisis’, but it outlined those key longer-term challenges, and the need for early action.
Demographic and social change
14. Today, people can expect to live longer than ever before. In 1950, a man aged 65 could expect on average to live to the age of 76. Today, he can expect to live to 85, and by 2050 to 89. Women will live for even longer – on average, perhaps, into their early nineties. This is a huge change, ranking among the greatest social achievements of the last century.
15. At the same time, lifestyles and expectations for working life and retirement have changed dramatically since the UK state pension system was first created. In 1948, divorce and remarriage were relatively rare, and it was not unusual for a man or woman to spend their whole working life with one employer.
16. Today, men and women work throughout their lives, and we recognise the value of the service that carers, both of children and of people with disabilities, contribute to society. It is much more common for people to be involved in more than one long-term relationship in the course of a longer life. And it is more likely that people will work for a number of different employers, and mix periods of working, caring, and studying during the course of their lives.
17. Increasing longevity is something that we should celebrate, but it also raises significant challenges. These challenges aren’t unique to the UK or specific to governments. Ageing societies are a challenge facing most of the industrialised world, and in many countries state spending is projected to rise to meet that challenge. Figure 3 illustrates the rising dependency ratio for other countries. Some of these countries have also shown the dangers of establishing unsustainable policies, requiring them to reduce commitments.
Figure 3: Worldwide dependency ratios
Sources: For non-EU countries, Population Division of the Department of Economic and Social affairs of the United Nations Secretariat, World Population Prospects: the 2004 revision; for EU counties, Ageing Society Indicators, EUROSTAT 2005.
Notes: Dependency ratios for EU and non-EU countries are taken from two separate projection exercises based of different assumptions and methodologies, and thus are not strictly comparable. The definition of the dependency ratio in this chart differs slightly from that used elsewhere in the White Paper in that it represents the ratio of the population aged 65 years or over to the population aged 15-64 (rather than aged 20-64).
18. In addition, we are about to experience a dramatic acceleration in the dependency ratio – the balance between the numbers of people of working age and those over State Pension age. Rising longevity means this is on a long-term upward trend. However, with the large cohort of baby-boomers born just after the Second World War swelling the workforce, this ratio has been artificially depressed in recent decades. As that generation goes through to retirement, we will rapidly catch up with the long-term trend.
19. Figure 4 shows the pensioner population as a percentage of the working-age population. In 1950, this ratio stood at just 19 per cent. Today, it has risen to around 27 per cent. By 2050, once the ratio has caught up with the underlying trend, it might be 47 per cent. This demographic shift is transforming the context for pensions policy.
Figure 4: Old-age dependency ratio
Source: DWP esitmates based on Government Actuary's Department's 2004-based principle projection, UK
Notes: The old-age dependency ratio shows the number of people aged 65 and over divided by the number of people of working age (i.e men and women aged between 20 and 64). The long-term development of the ratio was captured using a modified linear trend.
Undersaving for retirement
20. Retirement undersavers can be defined as those who are likely to receive an income that does not provide for their reasonable expectations of quality of life during retirement. These expectations will vary to reflect different circumstances and aspirations – and consequently a single, fully comprehensive measure of undersaving for retirement is not easily identifiable. However, some analysts have used the idea of replacement rates, that is income in retirement as a percentage of an individual’s final salary. In providing an income for their retirement, individuals will have different intentions regarding their retirement age and different types of assets at their disposal. In addition to pensions, they may have other financial and non-financial assets, including property. Total net wealth is now higher than it has ever been before, having risen by around 60 per cent in real terms since 1997. However, the numbers of people saving in pensions vehicles are declining.
21. Since the 1970s, employers have been retreating from occupational pensions as rapid increases in life expectancy and then the end of the high equity market in the late 1990s pushed costs higher than had been anticipated when occupational pension schemes were designed. This trend has continued, with 2 million fewer members of open private sector occupational pension schemes in 2004 than in 2000.2
Figure 5: Active members of occupational pension schemes
Source: Government Actuary's Department's Occupational pension schemes survey
Notes: The 2004 split between private and public sectors are not perfectly comparable with splits in earlier years, since from 2000 onwards the public sector figures have included only those members who are in public service schemes. It follows that, from 2000 onwards, figures from the private sector also include members from the wider public sector (such as the Post Office and the BBC).
22. Occupational schemes have changed in nature as well as decreasing in scale, with a shift from defined benefit (DB) to defined contribution (DC).
23. The Pensions Commission suggested benchmark replacement rates which vary by in-work income. Their analysis found that between 9.6 million and 12 million people were saving at a rate which would not deliver them retirement incomes in line with those benchmark rates.
Figure 6: Percentage of people aged between 50 and State Pension age at risk of falling below the Pensions Commission's benchmark replacement rates 3
Source: Futher analysis of those at risk of inadequate resources in retirement (Emmerson and Tatlow, Institute for Fiscal Studies, forthcoming).
Notes: Percentages refer to percentages of individuals in families with some earned income. Includes those not in paid employment whose partner has employment income. Earnings bands represent equivalised family gross earned income, including any profits from self-employment.
24. Retirement undersaving has arisen for a variety of reasons: because individuals have not trusted private pensions, because suitable savings vehicles have not been available to them, and because, in the face of a historically complex pensions system, financial short-sightedness and inertia have left inaction as the default option.
25. Stakeholder pensions reflect our belief that the workplace provides the best environment for delivering private pensions. But although over 2.7 million stakeholder pensions have been sold, they have highlighted the areas where further action needs to be taken, especially for those people not traditionally served by the savings market. Barriers to saving mean that, unprompted, people often do not take the decision to start saving – and as people move jobs, persistency in pension saving is low. This means that administration, advice and sales costs for providers are high, and makes it difficult for them to serve some sectors of the market profitably.
26. We need to do more to overcome these barriers to saving and drive costs down still further. Information and significant financial incentives are often insufficient. A long-standing feature of the UK pensions system has been its complexity, which can confuse both employers and individuals trying to make the best financial decisions for the long term. The high cost of saving for those without good employer-based provision and a lack of access to suitable products remains problematic. In other words, and as the Pensions Commission has concluded, the current structures need to be reformed to address the challenges of an ageing population.
27. As well as saving more in response to increased life expectancy, many individuals will choose to work longer in order to build up a retirement income that meets their expectations. More years in work can enable greater accruals of state pension entitlements as well as providing the opportunity to save more. Since 1997, the employment rate of those aged between 50 and State Pension age has increased from 65 per cent to over 70 per cent, and there are now more than a million individuals over State Pension age who are in work. 4
Inequalities in the state pension system
28. The pensions system we have today is rooted in the society of the 1940s. Society has moved on and, unless we act now, women and carers retiring in the next two decades will continue to suffer the effects of the system of contributions which applied during their working lives. Figure 7 shows that among those recently reaching State Pension age, around 85 per cent of men have entitlement to a full basic State Pension, compared with only about 30 per cent of women. The introduction of Pension Credit has improved the position of women, who represent two-thirds of those to have benefited from its introduction. We published a detailed analysis of the pensions position of women – past, present and future – with an analysis of the effect of existing National Insurance rules in the Department for Work and Pensions Research Report Women and pensions: The evidence, in November 2005.
Figure 7: Basic State Pension entitlement of people reaching State Pension age in 2005
Source: Government Actuary's Department's Retirement Pensions Model, GB
Notes: Women's entitlement is based on their own and their husband's contribution record. Includes widow's pension over age 60 and deferrers.
Complexity
29. The first State Pension – a means-tested scheme for those aged 70 or over – was introduced in 1908. Since then, a series of legal and other changes have modified, reformed and adjusted that simple provision, towards a pensions system today described by the Pensions Commission as the most complex in the world.
30. Our changes to the state pension system since 1997 have been essential to tackle the immediate problems that we found, and, as we have set out, they have been very successful. Incentives to save in the current system remain strong. Recent research has shown that incentives for many on low incomes have improved as a direct result of the introduction of Pension Credit.5
31. Problems with incentives could, however, develop if a pensions system evolved in which a significant majority of pensioners were entitled to Pension Credit in the long term. That has never been the intention of this Government.
History of pensions legislation
1908 The Liberal Government came forward with a plan for a non-contributory pension. Implemented from January 1909, this ‘Lloyd George Pension’, worth 5 shillings, was payable equally to men and women from age 70.
1911 The National Insurance Act required workers and employers to pay compulsory flat-rate contributions for health and unemployment cover. The insurance scheme was extended in 1926 to provide contributory pensions for old-age, widows and orphans.
1948 The basic State Pension was introduced as a universal State Pension in return for
flat-rate contributions paid by all workers and their employers (except by married women, who could opt out).
1961 Graduated Retirement Benefit (GRB) introduced three new concepts to state provision: earnings-related contributions, an earnings-related pension, and contracting out of GRB for those with occupational pensions.
1974 A legal base for regular uprating (by the best of prices or earnings) was introduced. The ‘best of’ legislation ended in 1979 and was replaced by a prices link.
1978 The State Earnings-Related Pension Scheme (SERPS) was introduced to replace GRB, which had been wound up in 1975. Home Responsibilities Protection (HRP) was introduced for carers.
1995 The Pensions Act established an equal State Pension age of 65 – to be phased in between 2010 and 2020 – strengthened the regulation of occupational pensions, and altered the terms for contracting out of SERPS.
2002 SERPS was replaced by the State Second Pension providing low earners with around twice the pension they would have earned under SERPS.
2004 Pensions Act (see paragraph 8)
Alongside the contributory system, a comprehensive means-tested pension has developed. Means-tested Supplementary Pensions were introduced in 1941. National Assistance, introduced in 1948, was replaced with Supplementary Benefit in 1966, then with Income Support in 1988 (developing into the Minimum Income Guarantee in 1999), and with Pension Credit in October 2003.
Looking to the future
32. To address these challenges, we established the Pensions Commission in December 2002. We asked it to review the operation of the UK pensions system and make recommendations for reform. In November 2005 the Commission published its recommendations.
33. The Government has set five tests for the reform package, building on our successes and principles for reform to date. Any reformed pension system must:
- promote personal responsibility: tackling the problem of undersaving for retirement;
- be fair: protecting the poorest, and being fair to women and carers, to savers, and between generations;
- be simple: clarifying the respective roles of the State, the employer and the individual;
- be affordable: maintaining macroeconomic stability and striking the right balance for provision between the State, the employer and the individual; and
- be sustainable: setting the basis of an enduring national consensus, while being flexible to future trends.
34. Having assessed the recommendations of the Pensions Commission, we will:
- Introduce low-cost personal accounts to give those without access to occupational pension schemes the opportunity to save. People will be automatically enrolled into either their employer’s scheme or a new personal account, with the freedom to opt out. Employers will make minimum matching contributions.
- Improve the foundation for all while continuing to tackle pensioner poverty. We will reform the state pension system by uprating both the guarantee element of Pension Credit and the basic State Pension in line with earnings growth, rather than prices. We will make the State Pension fairer and more widely available and we will raise the State Pension age in line with increasing longevity.
35. The reforms set out here will make an immediate difference to those working and saving for retirement, striking a new balance of responsibility between employer, State and individual. At the same time, we will continue to protect the poorest pensioners from poverty, and we will ensure that all pensioners share in rising national prosperity. We will bring forward legislation on these reforms during the second session of this Parliament.