A mean and complex pensions system our grandchildren will not thank us for

The package of pension reforms set out in the last pensions white paper has been described by the Secretary of State John Hutton as the most radical reform of pensions since Beveridge. The rhetoric suggests a grand and elegant vision. The reality is rather more prosaic.

Rarely has such care and deliberation gone into an area of public policy. A Pensions Commission, under Adair Turner, has pondered for three years, produced two major interim reports, and one final report. White papers have been written, interested parties have submitted evidence, parliament has examined the issues, and now the first of two Bills to implement the changes is being introduced into parliament.

The timescale for implementation is on the grand scale. There will be a gradual raising of the state pension age to 68 over the next forty years. The reforms to the UK state pension system will only be implemented in full in ‘around 2080’. That is the date at which the first fully flat-rate state second pension will be paid out.

It is easy to mock the pretentiousness of the plan. What confidence can there be in any planned sequence of changes unrolling over such long horizons when the Department of Work and Pensions itself has only been in existence for five years, and during that short period has had no fewer than five secretaries of state?

But the need for reform is patent. The Pensions Commission, quoted approvingly in the white paper, described the UK pension system as the most complex in the world. Unravelling the complexity is bound to take time. If accrued rights are respected, then they will be reflected in the pension packet of all current workers until they die. And the politics of pension reform means that if future entitlements are to be reduced, it is easier to cut the expectations of younger generations, who are politically inactive and uninterested in pensions, than to cut back on the benefits to be paid in retirement to those who are currently middle-aged and elderly.

The Grand Design

So what is the grand design towards which we are moving at such a stately pace? By 2080, when the new system is fully bedded in, the UK will still have two state pensions: the basic state pension and the state second pension. They will both be flat-rate, but will be computed on the basis of different criteria, with different rules of entitlement.

You might wonder why there will be two pensions; the answer lies in the administrative complexity of combining them into one, rather than because anybody actually wants to have two.

It will be only marginally simpler than the current system. The earnings-related component of the state second pension, which people can contract out of, will be eliminated. But the system will remain complicated, with these two parallel state pensions supplemented by two credits: the guarantee credit that declines with pensioner income, and the savings credit that first increases and then declines with income.

The principles underlying entitlement to a state pension will continue to be complex and contradictory. The UK pension system is based on the contributory principle — you are entitled to the pension in old age that you have contributed to over your working life. But this principle on which the Beveridge settlement is founded is becoming increasingly vacuous.

For the last forty years, employees’ contributions to the basic state pension have been earnings related while the benefit has been flat-rate. This means that two people who have contributed the same may end up with very different pensions because one has had steady low paid employment while the other has had sporadic higher paid employment.

Many people (carers, the unemployed, people on sickness and incapacity benefits) will accrue rights to the basic state pension (though carers, oddly enough, are excluded from the state second pension) without paying national insurance contributions.

People who have more than thirty years of contributions will continue to contribute to the basic state pension without accruing any additional benefit. And those who have not contributed enough to get an adequate state pension will get one anyway, through the guarantee credit, if they have little other income.

The virtues of simplicity

The New Jerusalem to which we are heading looks like a pretty messy, complex sort of place, with lots of history but little coherence or overall design. Does this matter?

Most of the parties to the debate have argued for a simpler system, and simplicity is one of the five tests for reform that the government has set itself. There are good reasons why a simpler system is better.

Pensions policy is intended to enhance social security. Yet it is hard to see how people can get security from a system that is so complex that they cannot understand it. Furthermore, the state provision is intended to complement occupational pensions and private pensions savings. The complexity of the state system makes it exceedingly hard to devise pension products and give sound advice to people on moderate incomes who may well be subject to means testing in retirement.

Complexity brings another problem: if the system has no coherent design or philosophy, it is hard to resist the conflicting arguments of pressure groups to modify the system — to ensure that those who have contributed more receive more, to give more to those who have greatest need, to avoid discouraging people who can work from working, to help those who have been unable to contribute. With no clear public understanding of how the system works, there is no significant constituency that rallies to the defence of the existing system. Complexity itself then breeds change, further complexity and lack of predictability.

So why not simpler?

At various stages in its report, the Turner Commission analyses the scope for more fundamental change, and rejects it. Radical change creates losers. To develop a consensus for change you have to buy off the losers, and despite all the rhetoric there is no consensus to spend more on pensions.

The UK state pension system is notably meaner than almost any other in the developed world. While state expenditure on pensions is planned to rise by 30 per cent relative to GDP over the next half century, the increase is far less than the increase in the pensioner population. There are not the resources to maintain pensioner incomes relative to the general population, simplify the system and avoid creating losers.

Another major impediment to reform is that much of the complexity in the system comes from the understandable desire to target benefits to particular groups who are felt to be deserving. Moving to a simpler system, then, necessarily means extending benefits precisely to those who are felt to be undeserving.

But I suspect that, despite protestations to the contrary, both ministers and civil servants are addicted to complexity. Only because the system is so poorly understood can ministers present measures to gradually dismantle past reforms (notably the move to state earnings related pensions which started in 1961 and culminated in SERPS in 1978) as radical new initiatives. Complexity also makes it easier to provide goodies — by relaxing a contribution requirement here, by adding a credit there — to buy off particular pressure groups without spending too much money.

It is no coincidence that the UK state pension system is among both the meanest and the most complex in the developed world. The complexity is an effective device for keeping costs down. The system will end up delivering what is very close to a flat-rate universal pension.

But if there were a single, universal flat-rate pension, the pressure to raise the level of the pension would be hard to resist. By having a system of multiple interlocking pensions and credits, the target of campaigners for change is diffused and any proposal for changing part of the system can be resisted on the grounds of its adverse effects elsewhere. An increase in the basic state pension would not help the most needy; an increase in the guarantee credit would increase the amount of means testing.

The outcome of the Great Pensions Debate and the hard work of the Turner Commission is a UK state pension system that will closely resemble the one we had forty years ago, but with added complexity. There is no consensus calling for radical reform. This suggests that, despite protestations to the contrary, there is a deep political attachment to our mean and complex state pension system that is likely to remain substantially unreformed for many more years to come.

Anthony Neuberger is Professor of Finance at the University of Warwick.