Testimony before
The Social Security Subcommittee of
The Committee on Ways and Means
United States House of Representatives
I appreciate the opportunity to appear before you today to discuss
what we in the United States can learn from the United Kingdom's
experience with public pension reform. This is an extremely
important subject, and I would like to thank both Chairman McCrery
and Representative Levin for scheduling this hearing. Let me begin
by noting that while I am a Research Fellow at the Heritage
Foundation, the views that I express in this testimony are my own,
and should not be construed as representing any official position
of the Heritage Foundation. In addition, the Heritage Foundation
does not endorse or oppose any legislation.
The crisis faced by the UK public pension
system
In 1997, just eight years ago, reforms
made to the United Kingdom's pension system under both Conservative
Party and Labour Party governments were regarded as a model for
avoiding the fiscal problems caused by the imminent retirement of
millions of baby boomers. Studies by international organizations
and a variety of think tanks showed that rather than the huge
increase in retirement-related costs that threaten to engulf most
Social Security systems, the UK faced a future where these costs
would be relatively stable in terms of the percent of GDP that
would be devoted to paying for retirement benefits. The combination
of reductions in government paid benefits and generous incentives
for workers to finance their own benefits through personal or
work-related pension plans looked like a complete success.
This impression did not fade quickly. As recently as four years
ago, testimony about the UK system by a leading British insurance
executive to this subcommittee was entitled: "Pensions: A British
Success Story.[1]" However, the last few years have been hard on
the UK pension system. Due to poor planning, constant government
tinkering, the closure of many corporate pension plans and other
factors, all political parties recognize the need for a
comprehensive pensions overhaul. A UK government pensions survey to
be issued this week is expected to reveal that only one out of
every six private sector employees can expect to have a "decent"
pension when they retire[2].
The British pensions system has become a national issue. As a
result, a late October 2004 poll showed that UK voters regarded
their pension system as the number one issue that needed to be
addressed in the May 2005 general election. A total of 54 percent
of those polled listed pensions as one of the top four issues,
above such usual political concerns as health care, crime and
immigration. While in fact, pensions played a small role in the
election, public concern remains high, and pension reform is
expected to be a major issue in the coming year.
As a partial response, the government of Prime Minister Tony Blair
established a blue ribbon Pensions Commission under former
Confederation of British Industry head Adair Turner that is charged
with issuing two reports. The first, issued in October 2004, paints
a gloomy picture of the current system, while the second, scheduled
for fall 2005 elections, will propose solutions.
Two nations separated by a common language: the relevance
of the UK experience to the US Social Security
debate
The British pension experience does have significant lessons for
the American Social Security debate. However, those lessons are
different from recent claims made by opponents of President Bush's
proposed changes to the American Social Security system. Although
there are superficial similarities between personal accounts in the
UK system and those proposed for the American Social Security
system, a closer examination shows major differences.
First, the accounts in the UK mainly invested in either
employer-sponsored defined benefits pension plans or to individual
investment plans similar to the American IRA. The American
proposal, on the other hand, is completely separate from any
employer-sponsored pension plans, and would be limited to
investment through a centralized, government-managed investment
platform similar to the Thrift Savings Plan (TSP), which is only
open to US government employees and to military personnel.
Further, the accounts did not cause most of the problems faced by
British pension system. Instead, the overall UK situation closely
parallels the problems faced by US defined benefit pension plans
such as those recently turned over to the Pension Benefit Guarantee
Corporation by United Airlines and Bethlehem Steel.
Finally, to the extent that personal accounts are a significant
problem in the UK, this is mainly due to design flaws and poor
planning that were present from the beginning, misguided short-term
fixes that had unforeseen consequences, and the bursting of the
late 1990's stock market bubble. While the British experience shows
mistakes for Americans to avoid, it does not prove that adding
personal retirement accounts (PRAs) to the American Social Security
system will be a failure.
The structure of the UK public pension system
The UK pension system is extremely complicated. There are two
levels of state pensions, which are supplemented in some cases by
two additional programs aimed at increasing the state pensions of
lower income retirees. In addition, there are a variety of
employer-related and personal pension plans. To make matters more
confusing, workers have the ability to shift a portion of the taxes
that fund the second state pension into either their
employer-provided pension plan or a personal account. Finally,
different governments over the past twenty years have revised and
re-named various parts of the state pension system, changing
benefit levels, tax treatment of pension contributions, and even
account structures seemingly at random. The result is a constantly
changing array of programs that are confusing to the British and
can bewilder foreign observers.
The Basic State Pension: The most basic
level of public pension benefits in the UK is the Basic State
Pension, which pays a flat-rate pension to all workers who have
both worked and paid taxes for at least a minimum period.
Currently, women are allowed to retire at age 60, while men are
only allowed to retire at age 65. The retirement age for women will
increase to 65 between 2010 and 2020 starting with women born in
April 1950. Approximately one in eight retirees receives only the
Basic State Pension.
Currently, the Basic State Pension pays single people GBP 82.05
($148.50) per week and couples GBP 131.20 ($237.50) per week. This
equals $7,722.50 per year for single people and $12,348.50 annually
for couples. As a comparison, the US Social Security system paid
individual retirees an average of $11,460 annually as of December
2004. Benefits are indexed to the change in prices, and are
adjusted every April.
In order to qualify for the Basic State Pension, men must work and
pay taxes for at least 44 years, and women must work and pay taxes
for at least 39 years. However, workers who are unemployed, unable
to work due to illness, or who stay home to care for a family
member may receive credits that can replace some of the required
earnings years. US Social Security benefits are based on the
worker's highest 35 years of employment, and do not give any form
of credit for these situations.
The State Second Pension (formerly
SERPS): Since 1978, the UK has also had a second
level of public pension that is based - at least in part - on past
earnings. Starting in 2007, this pension level will also pay a flat
rate benefit. Prior to 2002, the State Second Pension (S2P) was
known as the State Earnings-Related Pension Scheme (SERPS), and
paid benefits that are much more directly linked to earnings than
the new S2P is to be.
Workers receive credit towards their S2P benefits for income earned
between 15 percent and 110 percent of national average earnings.
Overall, they pay National Insurance Contributions (NIC) (which
help to fund several different benefits including the Basic State
Pension) equal to 11 percent on income between about GBP95 per week
($172 per week or about $8,941 annually) and GBP 625 per week
($1,131 per week or $58,825 annually) and 1 percent on incomes
above that level. In addition, employers pay 12.8 percent on all
income above GBP 94 per week. Both the income levels and tax rate
are subject to change annually, and if the employee has contracted
out of the S2P, taxes rates are different.
Workers have the ability to "contract out" of this pension level
and re-direct a portion of their taxes into either their employers'
pension plan or a personal plan. In the case of an employer
pension, the tax level is reduced, while for an individual pension
plan, the government pays a portion of taxes directly into the
plan. If a worker contracts out, he or she receives credit for
those benefits only on a prospective basis; benefits already earned
are not affected.
Since 1978, the UK has changed benefits payable under both SERPS
and S2P several times. These changes are more fully reviewed below,
but the mixture of changes combined with the ability of workers to
jump in and out of this pension level have resulted in some workers
gaming the system, and make it very hard to determine benefits. The
S2P is intended to improve benefits to low and moderate income
workers, and gives workers who earned under GBP 12,100 annually
(about $21,900) credit for earning that level.
Means tested benefits: In addition to
these two public pension levels, low income workers can qualify for
additional means tested benefits. The Pension Credit is intended to
ensure a minimum retirement income of at least 30 percent above
that paid by the Basic State Pension. These benefits are reduced by
40 pence for every pound that an individual receives above the
Basic State Pension level, and must be applied for. In addition,
low income retirees are eligible for non-cash benefits that mainly
rebate some or all of the local ("council") taxes they pay and a
portion of their rent payments.
Employer and personal pension plans: As
mentioned above, UK workers have the ability to re-direct a portion
of their NIC into either their employers' pension plan or a
personal pension plan. The UK had a highly developed defined
benefit (DB) pension system, but it has been hit with a series of
reverses similar to those that have hit DB plans in the US. As a
result, the majority of these private sector plans have been closed
to new entrants and replaced with less favorable defined
contribution plans.
Stakeholder Pensions: Since October 2001,
employers (including small businesses with more than 4 employees)
that do not offer workers another pension plan have been required
to offer their employees a "Stakeholder Pension" plan. Designed by
the government, and intended to be a simple and low cost pension
system that would especially appeal to moderate income workers.
Fees for these plans were initially capped at one percent of assets
under management, and plans were required to accept an opening
deposit as low as GBP 20 ($36). After initial enthusiasm, this plan
has widely been regarded as a failure, and in an effort to revive
it, the UK Department of Work and Pensions increased the allowable
fee to 1.5 percent of assets under management for the first ten
years an account is open in December 2004. At the same time, it
also reduced the regulatory burden (in the form of a required level
of investment counseling) for certain types of simple investment
products.
What Americans should learn from the UK public pension
system
Simplicity in program design and administration is
essential: The UK system is overly complex both in
its design and in its administration. To some extent, this is the
unintentional consequence of program changes intended to correct
specific problems, but the end result is a system that is extremely
difficult for even professionals to understand.
As a result, a December 2004 survey
found that only 6 percent of felt that they understood the pension
system very well, while 29 percent did not know about key tax
benefits. Not surprisingly, only 5 percent of those polled felt
that they were "very confident that they would have enough to live
on in retirement, and only 3 percent thought that state benefits
would provide a comfortable income.
Unfortunately, this complexity also
applies to the administration of certain benefits. The Pension
Credit, a means tested benefit intended to improve the retirement
incomes of lower income retirees, must be applied for, and is not
automatic. Retirees are required to answer a complex survey in
order to qualify, and despite the fact that individuals could
answer the questions over the phone, many have not bothered to
apply for the benefits. As of September 2004, 40 percent of those
eligible had not claimed their benefits. Experts believe that most
of those who have not claimed the credit are those who need it the
most - the lowest income retirees. Interestingly, the government
had assumed that 30 percent would not claim benefits in its
planning.
Programs can have unintended motivational
consequences: A side effect of the Pension Credit has
been to reduce pension savings by low and moderate income workers.
While the 40 pence per pound of income above Basic State Pension
levels reduction in this benefit is actually significantly lower
than the program that it replaced, the net result has been a sharp
drop in pension savings. A June 2005 study found that almost 20
million workers earning between GBP 9,000 and GBP 25,000 annually
($16,200 to $45,000) are not saving for retirement because they
fear that a means tested system would penalize them for their
savings. In the aggregate, the means tested program is estimated to
reduce annual pension savings by about GBP 3.7 billion a year ($6.7
billion).
Constant change increases confusion:
Change has been a constant feature of the UK public pension system
since the 1980's. Programs and new benefit levels have been
created, revised, and re-named many times. A side effect of this
has been to increase confusion among UK workers.
Looking at SERPS alone, the program was created in 1978 and
promised to pay benefits based on the 20 best years of a worker's
earnings. In 1986, SERPS benefits were changed to being based on
all earnings between the age of 16 and retirement, and in 1995,
changes to the pension formula further reduced benefits. In 2001,
SERPS was replaced with the S2P, while the benefit formula was made
more generous to lower income workers, and after 2007, the S2P will
become another flat-rate pension. In 2002, thousands of workers who
had contracted out of SERPS and its successor received letters from
their financial services companies advising them to contract back
in, as the amount they were savings was unlikely to be enough to
equal what the government was likely to pay. Even though most
benefit credits earned prior to these various changes were
grandfathered in, workers can be excused if they feel completely
confused and unsure what their benefits will be.
The availability of individual accounts does not alone
solve problems: Despite massive publicity and fanfare
when they were first offered in April 2001, Stakeholder pensions
have largely been a failure. Even though about 305,000 employers
started these pension plans for their employees, and that number
grew to about 350,000 by the end of 2003, 82 per cent of those
remained as "empty boxes" with no members, while only 13 per cent
of employer-based pensions have contributions from employers. To
make matters worse, only about 1.5 million plans were sold by the
end of 2003, and sales have steadily dropped annually since then.
Even these poor numbers do not indicate new savings, for about half
of all Stakeholder plans were funded with money transferred from
another existing plan. In addition, a significant number were
estimated to be set up by wealthier individuals in order to claim
the tax benefits of opening such an account.
Merely designing an "ideal" account structure and making it
available does not guarantee that industry will aggressively sell
it - especially if there is an unrealistic cap on fees. In the UK
case, one key error seems to have been including marketing charges
in the fee cap rather that limiting it to fees directly associated
with the individual's account. Faced with such a limited profit
potential, companies were unwilling to spend the amount necessary
to continue to promote Stakeholder accounts. While the December
2004 fee increase may help, these plans have been labeled a
failure, and are unlikely to revive as a significant retirement
investment vehicle.
Price indexing can reduce
benefits below poverty: Since 1980, the Basic State
Pension has been calculated using price indexing rather than growth
in wages. As a result, the flat rate pension amount has dropped to
only about 17 percent of average wages (GBP 82.05 ($148.50) per
week and couples GBP 131.20 ($237.50) per week or $7,722.50 per
year for single people and $12,348.50 annually for couples). The
roughly 12 percent of retirees who only receive this pension have
incomes that are below poverty level. If the wage indexing had been
retained, the benefit levels would equal GBP 109 a week ($197.29
week - $10,259 year) for individuals and GBP 174 a week ($314.94
week - $16,377 year) for couples.
This is not to say that changing the
method of indexing is a mistake, but that policy makers must be
aware that doing so could result in unacceptably low benefit
levels. As a result, such a move should be accompanied with a
benefit floor that guarantees an adequate minimum retirement income
level.
Poor planning increases costs: When SERPS
was created 1978, the UK government failed to conduct accurate
longer-term studies of the cost that these benefits would impose on
their government. Its failure to estimate benefit payments after
2007, despite the fact that most younger 1978 workers would only be
retiring then was a key reason why benefits had to be revised in
both 1986 and 1995.
This was also seen after the 1998 SERPS
changes that were intended to encourage workers to contract out of
SERPS and into either an occupational or personal pension plan. The
government estimated that only between 500,000 and 1.75 million
workers would take advantage of this option, while by 1993, almost
5 million workers (about 85 percent of those most likely to benefit
from contracting out) actually did.
A 1990 government study showed that
while about GBP 9.3 billion (about $17 billion) would be paid by
the government in the form of rebates and special bonuses into
accounts, the cost of paying SERPS benefits in the future would
only decline by about GBP 3.4 billion (about $6.2 billion).
Pensions expert Edward Whitehouse has an even higher estimate of
GBP 12 billion (about $22 billion) revenue lost in return for the
same level of reduction in future benefit payments.
A retail-based account system requires close
monitoring: The most famous problem with the UK
system, the so-called "mis-selling" scandal, is widely
misunderstood in the US. When individuals were allowed to move out
of SERPS into personal accounts in 1988, many were poorly advised
by ill-trained insurance agents, and either moved out of
employer-based plans that included an employer contribution and
into personal plans that did not include that employer
contribution, or failed to make an appropriate level of additional
voluntary contributions that would be necessary to reach their
retirement goals.
The mis-selling scandal resulted more
from a sales force that was used to selling conventional insurance
products and did not themselves understand the products they were
selling than from other reasons. The fact that the agents'
compensation was also tied to commissions exacerbated the
situation.
As a result, however, a thorough
investigation was conducted, and companies where mis-selling had
occurred were required to compensate their customers. In addition,
a new financial regulator, the Financial Services Authority, was
created from several smaller and weaker regulators, and it has, if
anything, overly compensated by requiring levels of disclosures to
individual customers far in excess of those required in the US.
For Americans, this problem is
interesting, but does not apply to Social Security reform
proposals. For one thing, the SEC and other financial regulators
have long monitored sales to individuals and require significant
consumer disclosures. More importantly, the proposed US Social
Security reforms are based on a government-managed centralized
investment system, and neither individual companies nor agents and
brokers will not be allowed to participate.
Conclusion
It would be a mistake to assume that the UK pensions experience has
only been one of failure. The opposite is actually true. The
country still has a higher level of pension investments, about 70
percent of GDP, than any other country in Europe, and the cost of
public pension benefits is substantially lower than most countries
in the world. In addition, roughly 50 percent of the workforce is
covered by some level of private pension.
While the current UK government is responsible for some of the
problems in their current system, most notably the Pension Credit
that has destroyed the incentive to save for many of their workers,
others have resulted from the collapse of the defined benefit
pension system and problems caused by mistakes by earlier
governments. The current government is also responsible for the
Pensions Commission, whose recommendations are expected to result
in an overall reform of their system.
However, their experience teaches Americans that even well
intentioned individual changes can only make matters worse. In
addition, it is important to consider the overall structure of the
complete pension system. The UK has well learned this lesson, and
the expected October 2005 final report of the Pension Commission is
expected to give a full picture of proposed changes in light of the
complete pension system.
It is important for Americans to remember that much of the UK
experience results from special circumstances unique to that
country, and that they do not apply to the United States. In
addition, it would be a serious error for Americans to assume that
the lesson of the UK experience is to discourage individual
accounts, whether as part of Social Security or as part of 401k or
other retirement savings options. The opposite is rather the
case.
Personal accounts are a source of strength, both in the UK pension
system and in their economy, and the current government has been
actively seeking ways to increase the number of workers who have
them. It would be both ironic and sad for Americans to draw the
opposite conclusion from their experience at the same time that the
UK is working to build individual pension savings.
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Heritage Foundation or its board of trustees. [1] Statement by
Keith Bedell-Pearce, Executive Director of Prudential, plc to the
Subcommittee on Social Security, Committee on Ways and Means, July
31, 2001.
[2] "Crisis looms for 'private' pensioners," Scotland on Sunday,
June 12, 2005. Available at: http://news.scotsman.com/index.cfm?id=645242005
(June 13, 2005).