A timely way to dismantle the pensions pyramid

Nikhil Arora argues that we need to radically reform the state pension, moving from the current pay-as-you-go model to a funded system based on personal pension accounts. Basing his proposals on a plan developed for the American Social Security system by the Cato Institute, Arora suggests allowing people to divert their employee National Insurance Contributions into private accounts (surrending their right to a state pension in the process), while employer National Insurance Contributions continue to be paid in order to finance the state pensions of current retirees.

An obvious choice, denied to voters

Imagine you were forced to pick between two options: Option one – you give me £10 today for me to safeguard for you, but there is a very high likelihood that tomorrow, when you wish to claim, I will default. Option two – you give me £5 today, and can invest your remaining £5 on your own, again with the assumption being that I will likely default tomorrow.

Whilst it’s hardly a wonderful choice you would surely choose option two, to minimise your losses. However, when it comes to National Insurance Contributions (NICs), the government only gives you option one, and then pretends that you’re safe.

What about if the government offered people both options?

Either; Every employee pays 11%, to be paired with a contribution of 12.8% from their employer. When the employee retires, provided there is enough cash in the National Insurance Fund, they receive a state pension, just as they would have under the existing system.

Or; Every employee keeps their 11% share as income to be invested into a private pension arrangement, and the employer continues to pay a 12.8% stake towards national insurance. The employee waives their right to a state pension, but receives a ‘recognition bond’ that entitles them to slightly less than the value of their employee contribution to the National Insurance Fund to date.

The choice is thus open for every individual to make, and logic dictates that the choices will be made rationally, relative to each individual’s age and circumstances. Most young people, and in particular those who have just started working will certainly be better off taking the private route, even if this means they will not get any personal benefit from the contribution of their employers. Older people, and in particular those close to retirement, who have been contributing to the fund over a lifetime’s work will be much more likely to stay with the national insurance scheme.

Of course, the need for this choice is largely depending on my initial analogy – it assumes that the government is likely to default at some point in the future.

A true national debt worse than Zimbabwe

Unfortunately, this is hardly an unreasonable assumption. The National Insurance Fund is nominally hypothecated for specific expenditure, including pensions. Whilst this means it cannot be easily raided by unscrupulous government departments, it also makes it easier to calculate the black hole in the financing. At the moment there exists a surplus; the amount being paid into the fund is greater than the amount being paid out in any given year. However, because the funds are essentially being spent as soon as they are paid in, and are not invested productively to secure future wealth, the fund is reliant on a young, working population to finance the lives of retirees. This simply isn’t sustainable. The ‘support ratio’ – that of young workers to old retirees is decreasing in most industrialised nations, and ours is certainly no exception.

Particularly once the baby boomers retire, there will be an unfunded liability that simply cannot be fixed by tax rises alone. A report by Nick Silver from the Institute of Economic Affairs demonstrated that, if the same accounting practices that private companies have to use were applied to the government, the national debt would have to include the pensions liability. This would leave Britain in more debt than Zimbabwe, as a proportion of GDP. Claiming it can be neutralised through taxing future generations is unbelievably dishonest – even by government standards. National insurance contributions already amount to a sizable proportion of salary, with knock-on effects for job creation and the wider health of the economy. There are no more pips left to squeak.

A model for reform from across the Atlantic

In the USA, the Federal Insurance Contributions amount to 6.2 % from both the employee and the employer. The Cato Institute proposed allowing the employee to keep and invest their 6.2% privately, whilst using the 6.2% employer’s contribution to fund existing retirees and disability benefit.

This is a higher percentage than other plans have suggested, including the one proposed and then mangled by the George W Bush administration. It is also, not coincidentally, the most effective at securing peoples retirements, and at reducing the burden on taxpayers.

When two US Congressmen introduced a Bill based on the Cato plan, the Social Security Administration (SSA) concluded that it certainly provided the best bang for the buck, and would halve the cost of meeting the government’s liabilities.

The Transition Costs issue

The main difficulty with any reform of government pensions is one of distributing the transition costs. It is frequently argued that one generation needs to pay twice; both for their own retirement, and that of the previous generation.

Whilst it is politically attractive to postpone these costs, to postpone indefinitely is simply impossible. The debt burden created will continue expanding, meaning that the problem compounds over the generations.

Both the Chilean privatised scheme, now considered an almost unmitigated success, and the American plan, as scored by the SSA, create costs as younger generations stop paying into the government scheme, but older generations continue drawing money out from it. In Chile, these shortfalls were met by the sale of government assets – a solution that is no longer available in the UK context. The Cato plan notes that some will be ‘recaptured’ by the increased corporate tax revenue as a result of the use of private pension money in the capital markets. However, the fact that the employers will still be paying NICs is of most help in meeting the shortfall.

Furthermore, it is important to note that the sudden increase in the shortfall within the first 10 to 20 years predicted under the American plan is largely the result of people claiming on their ‘recognition bonds’. This cannot be called a new loss for the State, for two reasons.

Firstly, this represents money that was already owed. The only difference is that the government under this reformed scheme is choosing to be more honest about it, and so is settling it upfront, rather than pretending it doesn’t exist, which ultimately will cost twice as much – The SSA in America estimates costs of $6.5trillion as opposed to $12.8 trillion if the problem is left to fester.

Secondly, the recognition bonds don’t have to represent the full value of the employee’s contributions to incentivise them enough to switch onto the private scheme. People will generally prefer a guaranteed, tradable bond in their name, to an I.O.U from the government that is potentially payable at a later date. Also, this reflects the fact that the government has incurred the opportunity costs of not having that money in the National Insurance Fund, where it can finance government borrowing until the employee retires – this cost can reasonably be passed on to the individual who has acquired their money sooner than expected.

Greater Returns for the people

The benefits of pension privatisation are undeniable. The Chileans are certainly richer as a result of their privatisation scheme. This is despite heavy regulation that accompanied the scheme in the early years, which forbade, for example investment in foreign equities. As Chile’s economy has developed, more opportunities have arisen, and even greater returns can be realised with less regulation being necessary. The plans from America have highlighted this trend too. The projections are much more favourable when regulation is looser, for example allowing a greater percentage of peoples’ money to be invested in stocks, as opposed to bonds. Nonetheless, even with a 50/50 split between bonds and stocks, the SSA scoring looked favourably on the financial returns of the Cato plan.

Those who invested in private pensions have comfortably produced returns more than three times greater than state pensions, because of the efficiency with which they are invested. It is because of this that most people will be better off, even if they have to sacrifice the share of NICs paid by their employers. Furthermore, Michael Tanner of Cato noted that notwithstanding the fall in the value of the stock market over the last year or two, an employee who started investing 40 years ago would still have done much better had they invested privately than had they relied on Social Security – had they been given a choice. This plan is a sustainable way to give them that choice.

To be a name, not a number

However, the benefits of this plan extend beyond the greater financial gains possible for employees to provide for their retirement. It actually redistributes the power to control their retirement from Whitehall to the people. Those who benefit most are clearly the poorer members of society who are far less likely to have built up other retirement assets. This plan presents a great opportunity for people who otherwise wouldn’t have done so to build up real wealth, not merely an allowance from the government to keep them alive in their old age. Crucially, this is accumulated in peoples’ own names – not in the form of a nameless I.O.U from the government tied only to a national insurance number. This represents a way for people to build up tangible property of real value.


Rather than trying to sweep the problem under the carpet, as Bernie Madoff did with his Ponzi scheme, government must cut the Gordion Knot, and dismantle the pensions pyramid with direct action, before it is too late. The best form for that to take is by offering employees a choice, and allowing them to invest a sizeable portion of their NICs privately. However, this still leaves current retirees, and those soon to retire, protected by a State scheme that is adequately funded. Furthermore, the burden for extricating ourselves from an unsustainable scheme is borne relatively evenly through the generations.