October 16, 2000
Reforming Social Security: Lessons from Great Britain
Let me start with three facts.
First, although the ratio of pensioners to the population of working age in the United Kingdom is forecast to rise from 30% in 1995 to 38% in 2030, the ratio of public expenditure on pensions to GDP is expected to fall over the same period from 4.2 % to 3.3%.
Second, UK private sector pension funds have £700 billion worth of investments, more than the rest of the European Union put together.
Third, over the past decade pensioner incomes have risen by 50%, there have been increases at all points in the pensioner income distribution and pensioners are no longer concentrated right at the bottom of the population income distribution.
How has this been achieved? What more needs to be done? And what lessons can be learnt by countries with different systems?
The answers to these questions can be found in an examination of the history of the British pension system since the war.
Throughout that history there is a single recurring theme—the quest of politicians to ensure that pensioners are not left too far behind as earnings grow and the constant problems this has caused for public finances.
Since the National Insurance Act passed by the 1945 Labour Government, Britain has had a non means tested basic state pension. Those who have paid national insurance contributions as part of their tax bill during their working life are eligible for this benefit. It has always been paid for by Government out of current revenues, rather than out of investment funds. In other words, each generation pays for the pensions of its elders. When the system was originally proposed by the social reformer William Beveridge during the war, he intended that the pensions should be phased in over 20 years. Labour decided to pay in full from the outset. The judgement of Britain’s foremost welfare state historian Nicholas Timmins is that “although it was a mighty expensive decision, almost certainly nothing else would have been politically tenable”.
Beveridge’s scheme involved a flat rate pension paid for by flat rate contributions from employees and employers. By the late 1950s the view began to grow, starting on the left and spreading to the right, that for too many workers, the flat rate pension was too low as a proportion of earnings. Various solutions were advanced with one common feature. In place of a flat rate contribution, better off earners should be asked to pay higher contributions, as should their employers. In return, at least a proportion of their state pension should be earnings related.
The Conservative Government of the time accepted this argument. One aspect of it, however, concerned them. The establishment of occupational pension schemes was growing rapidly by the 1950s, with employers providing retired staff with an income in old age based on the salary they earned during their working life. The Government feared that higher employer contributions for the state scheme would slow or even reverse the growth of these highly desirable schemes.
When the graduated pension was introduced in 1961, therefore, an important provision was made. National insurance contributions from better off employees and their employers would indeed be raised. Yet occupational schemes and their beneficiaries would be allowed to opt out both of the higher contributions and of the extra graduated portion of the pension. A vital principle had been established.
By the middle 1970s the state pension was once again under review.
The incoming 1974 Labour Government argued that, despite the 1961 reform, pensioner incomes were still not keeping pace with other earnings and that something had to be done. They made two changes. The first was to make a formal link between the basic state pension and earnings by instituting an automatic annual uprating. The formula used was to increase pensions by a percentage equal to the growth of prices or earnings, whichever was the higher.
The second change was to go much further than the old graduated pension by introducing a full scale second tier to the UK state pension system—the State Earnings Related Pension, commonly known as SERPs.
SERPs provided a pension based on 25% of the average of the best 20 years of earnings. The crucial second reading in Parliament of the Bill to introduce SERPs was unopposed. According to Lord Lawson, later as Chancellor an important player in the design of the reform programme, the Conservatives were “clearly wrong to do this “ but believed “that pensions ought not to be a political football”.
Vitally, however, the Conservative opting out proposals of the 1960s survived. Occupational schemes were allowed to opt out of SERPs.
Yet despite allowing the continuation of opting out, the attempt to boost pensioner incomes through increased state spending was doomed to failure.
When the Conservatives came to power under Margaret Thatcher in 1979, they inherited an ailing economy, a fast rising social security budget and commitments far in excess of our ability to pay for them. In 1950 social security spending represented 5.1% of national income, by 1980 it represented 8.4 %. By far the largest group of beneficiaries were elderly people and by 1965 the cost of pensions was twice that which Beveridge had predicted. The prices and earnings link boosted the state pension in periods of depression and expansion and began to seem unaffordable. In addition, as Lord Lawson puts it, “it was clear to anyone who took the trouble to analyse SERPs that it was a doomsday machine”. Clearly, reform was necessary.
Margaret Thatcher’s Government therefore did three things.
First, it removed the formal link between pensions and earnings and linked the basic state pension simply to prices instead. The decision was controversial, but was accepted because of the obvious crisis in the UK economy in 1980 and because there were no losers in real terms.
Second, in 1985 the Government turned its attention to the long term problem of SERPs. The Government didn’t just want to abolish SERPs since the arguments for its creation remained good ones. Instead it decided to offer taxpayers two alternatives. One option was to remain in a somewhat less generous SERPs. The percentage of your income that you would be paid, for instance, would be reduced from 25% to 20%.
The other alternative involved a massive expansion of contracting out. Until this point only employer run schemes had been allowed to opt out of SERPs. From now on individuals would enjoy the same right.
A new pension vehicle, the personal pension, was created. Individuals could save into this out of their pre tax income. In addition they could opt out of SERPs and have the state pay a part of their National Insurance contributions into a private fund. Indeed for a limited period those who decided to contract out would receive an extra 2% rebate above that which the state charged for SERPs.
Take up of this second alternative greatly exceeded expectations. The Department of Social Security’s working assumption was that about 500,000 would take out personal pensions and the number might ultimately reach 1.75 million. In the event, take up reached 4 million by the end of April 1990 and by 1993-4 it had risen to 5.7 million.
The results of this series of changes, from the 60s to the present day, have been dramatic. Three quarters of workers are contracted out of SERPs either through occupational or personal pensions. Only 17% remain in SERPs. For the last decade pensioner incomes have been growing faster than earnings. And, according to the OECD, public debt in the UK will be low by 2030, performing far better than almost any other OECD country. Concern that the UK should not be forced to accept joint responsibility for the pension liabilities of other European countries has become one of the most frequently cited arguments against joining the Euro.
This success did not, of course ended the debate.
Some wanted a much larger compulsory private pension. Margaret Thatcher was one such. She told her Chancellor that they had such a pension in Switzerland. “Yes Prime Minister,” he replied “but in Switzerland everything that is not forbidden is compulsory”.
Others were concerned about the security of private pensions. After the newspaper owner Robert Maxwell was found to have stolen from the Mirror Newspaper pension fund the Government introduced safeguards to prevent swindles and incompetence depriving pensioners of their income.
Still others believed SERPs remains too expensive and press for its abolition. Once again this option has been rejected, partly because some pensioner’s contributions to SERPs were too small to pay the administrative costs in the private sector. Instead the Government once again reduced long term SERPs entitlements but compensated with reforms to make it more worthwhile for older people to opt out.
Yet the most important debate of all concerned the basic state pension. It remained a large item of Government expenditure, yet current and future recipients believed it was inadequate. So the third stage of reform began. Over the summer of 1996 the then Secretary of State for Social Security, Peter Lilley began to work on new proposals to deal with the problem. His Basic Pension Plus plans were published in the New Year. Under these proposals, the basic state pension and SERPs would be replaced with a state guarantee. New entrants to the workforce would be given a rebate from their taxes paid into their choice of private plans. If, when they reached retirement age, market movements meant that their private plan was not large enough to replace the basic state pension, the state guaranteed to make up the difference. In reality, this wouldn’t happen very often, if at all, and the advantages of a funded scheme would yield the average pensioner a much more generous pension than they would otherwise get.
Of course, the scheme would cost money during the long transitional period. Because young people would be funding their own pension they wouldn’t be paying for the pensions of their elders. However, by the time this cost peaked it would be offset by savings from an earlier reform to raise the retirement age for women to the same as that for men. Another change was to switch tax relief from the time of saving to the time of receiving the benefit. This halved the transition cost.
Lilley’s proposals received a warm welcome in the press and across the political spectrum. The left wing Guardian newspaper, for instance, said that “like the concept of a share holding democracy, it could also be empowering a new generation, which will have much more control over its retirement arrangements”.
The General Election did, however, reveal one weakness. The scheme was open to attack as “abolishing the state pension”, even though there would be a guarantee in place and no current pensioners would be affected.
Now the Party is revisiting the scheme with one major change—new entrants to the workforce won’t be forced to join it. They will have an option to do so.
What lessons can be learned from the British experience. I have some lessons for those who oppose such reforms and some for those who support them.
For those who oppose reform.
First, reforming the state pension by allowing opting out into private funds is not as you often suggest, risky and extreme. It has been part of British pension policy for 40 years and in the last decade, in particular, it has become its most recognisable feature. It is almost universally accepted by politicians across the political spectrum and there is no prospect whatever of it being reversed.
The results have been increased pensioner incomes and improved public finances. The only debate in Britain is over how we should go further in increasing the number and amount of funded pensions.
Second, not only are you wrong to describe a move to a funded scheme as risky, it is in fact the only sustainable solution to a recurring problem. In Britain there have been repeated attempts, some of which actually became law, to boost state pensions through long term increases in tax funding. The reason for these attempts is that the state pension keeps falling behind earnings. Yet again and again these attempts have failed. With demographic and political changes the proposals were simply too expensive for future taxpayers to bear. One after the other, either before or after they became law, they were abandoned.
The only proposals that have stuck have been those that have increased private funding and contracting out. They have kept pensioner incomes growing in line with earnings and, primarily because they hand money over to separate non government funds, have not been reversed
This leads to a third point. The truly risky and extreme policy is to ask today’s workers to depend for their pension on the promises of politicians and the goodwill of future taxpayers. In the United Kingdom, someone who stayed entirely in the state system has seen their SERPs entitlement cut and the earnings link on the basic state pension broken. And, although, the latter was accompanied by all sorts of assurances, all to often uprating has not involved any earnings element at all.
What about the lessons for those who would like to see British style reforms introduced in their country?
First, make sure you focus your debate on the long term, the security of young people and the country’s finances. Short term budgetary problems were often the ally of welfare reformers in the United Kingdom, but they were not adequate as the main reason for pension reform. Indeed, almost all the reform involved spending money in the short term and a recognition that without this, long term change was impossible.
Second, victory in any debate about long term reform is useless if pensioners fear their income is under threat.
At every stage in the UK it was necessary to ensure that there were no losers among current recipients and that, as far as possible, future recipients felt they were making a one way bet. The sacrifices this involved were that there could be no short term saving and that the reforms would have to be phased in over very long periods.
Basic Pension Plus would have yielded only costs until nearly half way through the next century. Where savings had to be made to offset these costs, they too were phased in over a long period and did not leave any current recipients worse off. To ensure that fears were not allowed to take hold, the Government was always very clear about the costs of its schemes and the nature of the guarantees it was giving.
Third, you do not need to introduce all the reforms at once. Indeed, in the UK voters were more inclined to support the next stage of reform, because they could see that the previous changes had not left them worse off. It was also less easy to attack the proposals as unworkable or to defeat the entire package by concentrating on its weakest point. The temptation to demonstrate how radical the Government was and its farsightedness, by announcing the entire programme in advance was also eschewed. Each part of the programme was advanced on its merits and given time to work before further innovations were considered.
Finally, the provision of choice is vital. The reforms of the mid 1980s were not imposed on future pensioners, they were given a choice and a financial incentive to choose the private option. Much of the popularity of the scheme depended on the feeling that the Government was providing the opportunity to get a better deal. If voters thought, instead, that they were being forced into a scheme to save money, they would have been much more resistant. The biggest political mistake made with Basic Pension Plus was to make it compulsory.
Your natural political instincts will, I am sure, make you suspicious of the idea that in the UK we have found the perfect formula for painless reform. You instincts would be right. Pensions remain a controversial topic and throughout the 18 years we spent in Government Conservatives had to face criticism of the system we were developing. Yet there is now a remarkable consensus that the decisions were the right ones, that in general they have helped rather than hindered the Party at the polls and that the new Government is far more likely to extend the programme than to reverse it.