The case for change
In his foreword to the government’s proposals (Source: The single-tier pension: a simple foundation for saving) to reform the State Pension scheme, the Minister of State for Pensions, Steve Webb, refers to the simplicity of the original model implemented by William Beveridge over 70 years ago. How things have moved on! To quote from the foreword, ‘… a piecemeal approach to pension reform has resulted in an extremely complicated pension system, where many do not know what they will get when they retire. An increasing reliance on means-tested benefits and a patchwork of add-ons, compensating for long-term decline in the relative value of the basic State Pension, compounds this complexity.’
The government’s proposal after a period of consultation is radical, but sensitive to the many voters who will be affected by any transition. It will save money in the longer term as it is currently proposed, but not to the same degree as the increases in State Pension age which are in train and likely to continue beyond 2028.
The minister offers some context for the reforms:
• 36% of people born in 2013 will live to become centenarians. In the 1940s only a minority of men lived to 65
• the number of women in work has increased by 50%. In 1948 only four out of ten women were in paid work
• the number of divorces has increased as a proportion of marriages from 11% in 1948 to about 50% in 2012
• over a third of those working today are self-employed or in part-time work
• the number of people saving in an occupational pension scheme has fallen from 12 million active members in 1967 to 8.2 million in 2011.
The single-tier pension
At the heart of the reforms is a measure to abolish the earnings-related part of the State Pension and move to a flat rate. The previous government had already legislated for a more gradual change to the flat rate in about 2030, but the latest proposals for change are more precipitous.
The proposal is for the amount of the new pension to be set just above the minimum guarantee part of the current Pension Credit. That stood at £142.70pw for a single person in 2012/13 (£145.40pw in 2013/14) and the indicative single-tier pension was set at £144pw (£146.72pw in 2013/14). The pension will increase each year under the ‘triple-lock’ provisions (that is by the greatest of the increase in earnings, the increase in prices as measured by CPI, and 2.5%).
Under the current system, the basic State Pension in 2013/14 is £110.15pw and for those who have been employees, the maximum earnings-related pension is in the region of £130pw. Of course, these figures must be treated with caution. They are in respect of a single person and in any case, few people will qualify for the maximum earnings-related pension (and a number will not qualify for the full basic State Pension).
In order to qualify for the full single-tier pension, the individual will require a National Insurance contribution record of 35 years and a record of fewer than ten years will not qualify for a pension. Proportionate benefits are available for records from 10 to 34 years. This is a step backwards. Only recently the requirement for the maximum basic State Pension was reduced to 30 years and as little as one year’s contribution would qualify for a pension on a pro rata basis.
A simplifying feature of the new pension is that it will only be available in respect of the claimant’s own contributions. It will no longer be possible to claim or inherit a pension in respect of a spouse’s or partner’s contributions (assuming it was possible to understand what the entitlement was!).
Under the current rules, the State Pension can be deferred and will be increased by one-fifth of one per cent for each week of deferral (10.4% a year). The claimant has an option to take a lump sum instead of the increased pension.
The new rules will halve the rate of increase to 5.2% a year (1% for every ten weeks of deferral) and abolish the lump sum option.
The government is proposing to implement reform in April 2016 (one year earlier than originally planned).
Abolition of the Savings Credit
There will be a safety net for those who do not meet the contribution conditions and have little or no income from other sources or benefits. The guarantee credit element of the Pension Credit will be retained on a means-tested basis. However the government contends that the single-tier pension obviates the need for Savings Credit and this will be abolished.
It is projected that by 2050, the number of pensioners claiming Pension Credit will fall by a half; from 10% of all pensioners to 5% (Source: The single-tier pension: a simple foundation for saving). The argument here is that more people become entitled to the basic State Pension rather than relying on means-testing – with all that brings. Means-testing involved going cap in hand to government, asking for a subsidy; which became an emotive issue for many older people. It also involved the completion of a long financial questionnaire which was known to put off many eligible applicants.
Abolition of contracting out
There are many commentators who, with the benefit of hindsight, wish that contracting out had never happened. We only have to look at the intractable problem of equalising guaranteed minimum pensions (GMPs) to gain some insight into the technical problems that the option presents. However, abolition is a rather different kettle of fish and in consultation, employers have expressed concern at the sudden increase in National Insurance contributions that would accompany a withdrawal of the option.
Money purchase contracting out was abolished in April 2012. The proposal is that from April 2016, the option to contract out will be no more, with the ending of defined benefit contracting out. It will leave little trace other than GMPs, a legacy of court cases and a reduction in what the state will provide in respect of past accrual. We will look at this under ‘Transition’.
The way defined benefit contracting out has worked in the past is that in exchange for a reduction in National Insurance (the ‘rebate’) and the surrender of any accrual of earnings-related pensions, the scheme has been required to provide a guaranteed minimum pension (1978 to 1997) or benefits under a scheme that had to meet the Reference Scheme Test (from 1997). The Reference Scheme Test is, in effect, the standard required of a defined benefit qualifying scheme for automatic enrolment purposes.
The effect of abolition will be that:
• National Insurance contributions will increase.
• no special requirements will apply other than in respect of GMPs.
• there will be no reduction in State Pension accrual after 2016.
In effect, the only point of contention is likely to be the increase in National Insurance occasioned by the abolition of the rebate. This is recognised by the government’s proposals which propose that employers should be able to change scheme rules to reduce benefits without trustee consent. This comes with some important qualifications:
• it will not apply to past pension accrual and it is virtually impossible to reduce benefits that have already accrued by any other means
• an alternative would be to increase member contributions
• if there were to be a reduction in benefits under the scheme, this could be cushioned by the increase in State Pension
• any reduction in benefits without trustee consent would be limited to that required to offset the increase in National Insurance contributions
So far so relatively straightforward, but as any observer of the pensions scene knows, pensions involve such long timescales and such significant sums of money that transition from one idea to the next is extremely difficult. In this respect the proposals are bold.
Those who have reached State Pension age before the proposals are implemented will be unaffected by the changes. Those who retire after that date who have accrued benefits under the current scheme will be given credit for those benefits by way of a ‘foundation amount’. The idea behind the foundation amount is that individuals will be able to determine their entitlement for past accrual in 2016 (and do something about it if necessary) rather than having to wait until retirement.
The proposals identify four groups:
• Individuals who have a foundation amount equal to the full level of the single-tier pension. These are likely to be people who have a contribution record of at least 35 years, little or no additional (earnings-related) pension and have not contracted out.
• Individuals whose foundation amount is less than the single-tier pension. These are likely to be people who are too young to have a full contribution record or who have contracted out for significant periods. They will be able to increase their pension to the amount of the single-tier pension at a rate of £4.11 for each qualifying year before State Pension age.
• Those whose foundation amount exceeds the single-tier pension. They will receive the ‘excess’ as a top-up payment.
• Those who have no pre-implementation National Insurance record. They will qualify for the single-tier pension and other private pension initiatives.
The government believes that its boldness will be rewarded by over 80% of people qualifying for the full single-tier pension by the mid-2030s.
The key to the simplicity of the approach is that the foundation amount will be calculated after a deduction for contracting out on a pro rata basis rather than the claimant waiting until pension age for the deduction to be made.
State Pension age
The State Pension age is already in the process of change. It will have been equalised for men and women by November 2018 and will have increased for men and women to 66 by October 2020. Between 2026 and 2028 and dependent on an individual’s date of birth, State Pension age will have moved to 67, but the government has plans beyond that.
It proposes a five-year review with the first likely to take place in 2016 or 2017. An overriding principle of the review will be to maintain the proportion of retired life compared with working life. In determining length of retired life, the review will call on evidence from the Government Actuary’s Department. The review will also call on evidence from an independently led body that will consider wider matters such as variations and trends in life expectancy.
When the review leads to a recommendation, the government will give at least ten years’ notice of change.
The real objective
The proposals are relatively simple to understand and quite bold. However, there is a risk that those who congratulate the government on its efficiency at introducing the changes lose sight of the overall objective which is to provide a sustainable retirement for claimants and their dependants. Even if we avoid the temptation to make comparisons based on maximum benefits (which does not reflect reality for many), the State Pension is set to reduce and to be available later in life.
These proposals deal with difficult issues of transition and contracting out; the gauntlet has been thrown down and sustainable retirement will become increasingly dependent on private provision, of which automatic enrolment is only part of the solution.
If you would like to find out more about pensions, please get in touch.