By how much should the state pension be increased every year? Attached to this seemingly innocent question is a multi-billion-pound price tag and a great deal of political controversy. Given the tendency of older people to turn out and vote, the politics of generous annual increases to the state pension seem pretty clear. But if we are interested in good pensions policy, what is the right approach going forward?
For 30 years, between 1980 and 2010, the answer to this question was simple. The state pension would rise each year in line with inflation, measured by the retail prices index. In this way, the spending power of state pensions would be maintained each year. However, there were two problems with this approach.
The first is that when headline inflation was very low, the cash increase in the state pension was embarrassingly small. When the September RPI was published in 1999 the rate was just 1.1 per cent, which meant the April 2000 increase was a meagre 75 pence. Although the government went ahead with this increase there was a huge political backlash. The following year, it felt obliged to hike up pensions by an inflation-busting £5 per week, implemented just before the 2001 general election.
The second problem with long-term price-indexation is that pensions are about helping you to maintain your standard of living in later life when you no longer have a wage. This means that, to do its job, a pension has to have some relation to what you used to earn. If the pension has been pegged to prices rather than to wages, then there is a growing risk your living standard will slump at retirement.
As a result of this relative decline over a period of decades, pressure grew to “restore the earnings link”, or to increase pensions by the higher of the growth in prices or earnings. The legal power to do this was included in the 2007 Pensions Act but the policy was only implemented under the coalition government.
The coalition actually decided to go further and introduce a “triple lock” on the basic state pension. Not only would pensions increase by the higher of the growth in prices or earnings but they would always rise by a minimum of 2.5 per cent. In part, this was a political device to avoid a repeat of the 75p fiasco, but it was also a deliberate upwards ratchet to start to reverse 30 years of relative decline in the value of the state pension.
The triple lock has been in force for just seven years and in my view it is premature to talk about scrapping it. The basic state pension is just over £119 per week and even the Department for Work and Pensions does not think that is enough to live on. Millions of pensioners have so little income they have to claim means-tested top-ups such as pension credit or housing benefit. Worse still, many of those entitled to top-ups fail to claim them and end up living below the poverty line.
Another important reason for good state pension indexation relates to increasing longevity and the changing mix of pensioner incomes. In the past, many people would retire with a state pension and an index-linked company pension, and would have a relatively short retirement before they died. This combination would enable them to maintain their living standards through retirement. Now, however, many more people will retire with a state pension and a defined contribution pension pot, which few people use to generate an inflation-protected income.
What is more, they may well be drawing a pension for a quarter of a century or more. If their private pension income is frozen in cash terms, then decades of inflation will substantially erode its real value. This makes a generously indexed state pension all the more important if we are to avoid increased poverty among the “old elderly”.
Some will say we cannot afford the triple lock but that is to take just one element of the system in isolation. Overall, the future cost of state pension provision has been substantially reduced compared with previous plans. State pension ages have risen sharply and will continue to increase. Indexation of other parts of the state pension system (mainly the Serps scheme) has been reduced from RPI to CPI, and the new “flat-rate” state pension costs substantially less than the system it replaced by the middle of this decade.
We have been moving from a situation where state pensions are paid relatively early and at a very meagre level, to one where there is a decent state pension paid at a realistic age. The triple lock policy has been a key part of that mix. This is a journey in the right direction and one which we should continue.
Steve Webb is director of policy at Royal London