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The pension puzzle

In the summer of 2001 the IPPR published its interim report on pensions and long-term care policy. The report suggested that a wide range of people – in the pension industry, the academic world and among other stakeholders – had begun to fear that the Government&#39s pension policy was unravelling.

In autumn 2001, the pensions reform group chaired by Frank Field and including the Liberal Democrats&#39 social security spokesman Steve Webb brought out a report that also argued that the current pension settlement was unsustainable.

The first week of November saw Nick Timmins, the doyen of social policy journalists, making the same argument in an article in the Financial Times that drew a direct rebuke in the form of a letter from the Secretary of State.

How has the Government found itself in the position of facing such doubts and are the criticisms valid? To answer this, we have to go back to the 1998 Green Paper that set out the Government&#39s strategy.

The Government&#39s objectives were most neatly laid out in the Prime Minister&#39s foreword in that document. The Government was aiming to:

Secure a decent income in retirement for all, with the minimum income guarantee playing a critical role.

Deliver better pension provision for those on low incomes, particularly through the state second pension that would replace Serps.

Increase incentives for middle and high-income earners to save, especially through the new low-cost stakeholder personal pensions.

Reduce public spending on pensions as a proportion of GDP.

It is understandable that the Government chose to make means-tested income support for pensioners more generous as the quickest means of channelling resources to the poorest among the elderly.

However, it quickly became apparent that the minimum income guarantee was going make significantly worse the incentives for people on mod- est incomes to save for their own retirement. Elderly people with a small income from private pensions and savings might see themselves little better off than those who had not saved.

The Government&#39s response was the pension credit announced in autumn 2000. This would effectively create a means-tested taper on income above the minimum guarantee level. This would extend means testing further up the income scale, eventually embracing more than half the retired population. It might not be a bad thing in principle but the overall impact on incentives would be ambiguous.

Most important, the pension credit would add another layer of complexity to the system. Having inherited a pension system with seven major features, the Government would be presiding over a system with 10 major features.

Government policy was in danger of decisively failing the test that it can be explained reasonably clearly to the ordinary citizen so they know what the state will provide and what they will need to do for themselves.

The pension credit has not yet been officially costed. Independent analysis suggests it will cost about 1.2 per cent of GDP by the middle of the century. Total public spending on pensions is now likely to rise from 5 per cent of GDP to around 6 per cent even if the basic state pension remains indexed in line with prices.

The objectives set out by the Prime Minister in 1998 have unravelled.

Public spending as a proportion of GDP was supposed to fall. It is now going to rise. This is not necessarily a problem in itself. Rather it raises the question – if we had known in 1998 that such an increase in spending was possible, would we have chosen a different means of delivering the other objectives?

Although stakeholder has lowered the costs of personal pensions, the incentive problems raised by having such a high degree of means-testing and such a high degree of complexity appear to be unresolved.

Given that, from 2007, it is planned the state second pension should become flat-rate, why add to the complexity of the system when increasing the basic state pension would have the same effect anyway?

The minimum income guarantee still appears to suffer from low take-up so it is not channelling extra resources to all poor pensioners.

The Government&#39s problems illustrate a real dilemma faced by all policymakers. There is a fundamental trade-off between the objectives of increasing the incomes of the least well-off pensioner households, maintaining incentives to save among the current working population and putting a cap on overall levels of public spending. Only two out of three of these goals can be attained at any one point in time.

A means-tested approach can channel help to the poorest at lower cost to the public purse but might create intractable incentive problems.

A higher basic state pension would be a much simpler way of delivering a minimum level of support for all pensioners while creating clear incentives to save but, at first sight, could be significantly more expensive than means testing.

However, now that the Government appears to have accepted that public spending as a proportion of GDP can rise, the option of using the basic pension as the key building block for reform is back on the agenda. Further thinking is needed in future options for reform. But what does seem clear is that the status quo is not sustainable and that a major simplification of the system has to be a priority.

Peter Robinson is a senior economist at the Institute of Public Policy Research

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