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WELFARE & PENSIONS 31: Pensions for the people: Contracting-out of state retirement benefits The problem: poor return in the state sector State pension systems often deliver a poor rate of return for most of their members. Being mostly managed on a pay-as-you-go basis, the future benefits they pay out can increase only as far as future taxation can be raised. Members might be able to get a much higher rate of return in a private pension plan - but because they are already obliged to pay into the state system, they are not usually able to afford to. The idea: allow contracting-out Why not allow people to take some of the money they are presently paying into a poorly-performing state pension plan, and place it instead into a funded plan of their own? Example: pensions in tiers This is precisely what people in the United Kingdom have been able to do since 1959. In that year, the UK moved from a flat-rate pension system, to one which paid larger benefits in return for the larger, earnings-related contributions paid by better-off workers - a concept which prevails in most developed countries today. However, the UK legislation included a novel feature. The old flat-rate state pension system remained in place as the 'first tier' of the state pension, and the earnings-related scheme supplemented it as the 'second tier'. And the government allowed contributors to opt out of this second tier if they were participating in a private pension plan that promised benefits at least as good as those promised by the state. At first, the choice was not up to the individual: all members of a private pension scheme had to opt out at the same time. But at that time, most private pensions were defined-benefit plans (usually promising a pension of half or two-thirds of the employee's pre-retirement salary) run by employers; so opting-out was very simple. All opted-out plans had to be registered, and to meet various requirements about how pension rights were accrued, when they could be drawn, investment security and risk, and minimum benefits for surviving dependants. Approved schemes also had to guarantee to pay members a minimum pension, equal to the amount of the state earnings-related pension which the worker would have accrued if he or she had not been contracted out. The effect of this was that workers knew they could not possibly lose by being in a contracted-out plan. But potentially they could gain substantially if the underlying investments in their plan performed very well. Unsurprisingly, within ten years of the 1959 legislation, more than half of the UK labour force were members of private pension arrangements. Some firms used their pension schemes to help them 'lock in' experienced workers, promising the most generous pensions only if they stayed with the firm until their retirement age - a system known as 'golden handcuffs'. However, this practice was limited by the imposition of new rules designed to ensure that all workers received a fair return on the private pension contributions they made through their employer, even the so-called 'early leavers'. The growth of private employer-led pensions grew so important that, in the 1980s, it was decided to extend the opting-out principle to individual pension plans too. Thus, if an individual now wanted to take out a private pension arrangement, that individual was entitled to a rebate on his or her state pension contributions in recognition. Again, this led to a big boom in private pension uptake. Since these individual pension savings plans are generally defined-contribution schemes, however, it is harder (without insurance) for them to guarantee a minimum benefit at retirement, and the guaranteed minimum pension rule was dropped. Some unions and other activists were concerned about this. Also, individual pension plans are more expensive to administer than group plans of the sort promoted by employers. It was argued that, because of this and in the absence of the guaranteed minimum pension rule, some savers were sold inappropriate plans, or induced to leave workplace plans into which the employer was contributing generously - leaving them worse off than they might have been. Undoubtedly there was truth in this. A member of a company pension plan, whose employer is matching (or sometimes exceeding) the employee's own contributions, is unlikely to be able to match the performance of that plan by moving to a personal arrangement to which the employer makes no contribution at all. (However, the fact that many people did unwisely elect to do this is perhaps as much a comment on the byzantine over-complexity of the UK's pension rules as it is on the greed of private pensions salesforces. And it is often hard to know whether someone who has been 'mis-sold' a pension would in fact end up worse off: since employer schemes are typically much less flexible, and less advantageous to people who move jobs often, some supposed victims might actually have done better than if they had stayed.) In an effort to address these problems, the post-1997 government of Tony Blair proposed group-based 'Stakeholder Pension' schemes, aiming to give better value to opted-out pension savers. These are still private pensions, but they are run for large groups of savers by insurance companies and employers. They are relatively inflexible, but the idea is that they should be straightforward and easy to access, and there are limits on providers' administration charges. Assessment: saving from disaster Today, British citizens have around £1000 billion invested in private pension funds, more than the whole of the rest of Europe combined. More is saved into these plans each year than the government pays out in state pensions and welfare benefits. Britain is therefore in an enviable position as against the governments of the EU and other developed countries, who face severe difficulties in meeting their future unfunded state pension liabilities (see chart). Net pension liabilities as a percentage of DP 1995-2050 United Kingdom 4.6 Sweden 20.4 United States 25.7 Canada 67.8 Italy 75.5 Japan 106.8 German 110.7 France 113.6 Source: Chand & Jager (1996), Table 8 Many other countries have gone much further in moving their pension systems more fully to a system of individual accounts, along the model pioneered by Chile (see the chapter Save Yourself!). However, for countries with an established basic state pension system, this partial privatization mechanism might well prove a more politically acceptable way forward. For further information:
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Copyright 2002: Adam Smith Institute
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