Reform of the state pension – is it intergenerationally fair?

Angus Hanton assesses the newly-announced government proposal for a flat-rate state pensionJar of Coins Labeled Retirement on White

Everyone in Westminster knows that Steve Webb is a clever bloke and a keen reformer. As pensions minister at the Department for Work and Pensions (DWP), he has been instrumental in organising auto-enrolment for pensions savings, and now he proposes a major reform of the state pension.

The current state pension at £107.45 per week if one of the lowest in Europe, though it is complicated by a second, additional, “earnings related” pension which means that many people have paid more contributions for a somewhat higher pension. On top of this there are various means-tested benefits available to poorer pensioners. The problem is that the basic state pension of £5,600 per year is not enough to live on comfortably.

What Steve Webb is doing is simplifying the system so that from 2017 there will be a single, higher state pension of about £144 per week (in today’s money) and to be entitled to it you won’t need such a long “contribution record” of national insurance payments.

Winners, losers and system failure

These changes will help women who have taken career breaks for their children and it will help both the lower-paid and the self-employed. But these changes are not neutral between generations: for young people, their pensions will be lower on average and they will be contributing disproportionately towards those of the older generation. This is partly the inevitable result of governments having taken too long to raise the retirement age.

There is, however, a potentially much larger intergenerational implication of retaining a pension that is currently paid regardless of wealth or other income – it could well make the system unsustainable.

Most economists think that the current pensions are not sustainable in their current form, which is not surprising when you consider that the current liability for promised state pensions is equivalent to about £150,000 for each UK household. If that’s right, and if the system has to be cut back brutally at some point, then the current contributors will have been paying in for pensions that older cohorts will receive but they themselves won’t.

As the current state pension is paid out regardless of wealth or income, there are very many millionaires who receive it. According to IF’s research on the number of pensioner millionaires, roughly one in ten recipients of the state pension are living in households worth over a million pounds.

In a system which is “pay-as-you-go” (called “take-as-you-go” by Professor Laurence Kotlikoff), this means that to some extent the state pension is a transfer of resources from poor-young to wealthy-old. Some countries, such as Australia, have moved to a means-tested system; whatever objections there may be to this, it has made the Australian pensions system demonstrably sustainable.

The implications of increased life expectancy

Part of Steve Webb’s announcement was the important decision to create a new Commission on life expectancies to study whether we’ve been getting this wrong in recent years by under-estimating likely future life expectancies. Indeed, we’ve almost certainly been too optimistic – the trend has been for life expectancies to increase by about 3 years every 10 years and there is no evidence that this is reaching a plateau.

This is a critical question in pensions because if we have been under-estimating longevity we have been also under-estimating the cost of the pensions promises. According to a recent article by Sarah Levy of the ONS, if pensioner life expectancies increase (at 60) by 1.4 years, it will add £30 billion to the state pension cost and increase pension costs by about 5%.

This Commission may well decide that the recent life expectancy assumptions have been very much too optimistic, in which case the pension burden will grow much more rapidly than currently forecast. If that’s right, today’s workers will be paying more for both retired people and their own pension. So, making adequate estimates of the increases in life expectancy is clearly a matter of intergenerational fairness.

Posted on: 23 January, 2013