September 29, 1997

September 29, 1997 | Testimony on Social Security

The Policy and Political Lessons of Britain's Success in Privatizing Social Security

A Special Report to the House Committee on Ways and Means

Today, I will address the changes that have been made in the British pension system2 over the past ten years. The experience and advice of American policy analysts and lawmakers has been of great value to the British people over the many years of friendship between our countries. I hope that you will find some of the things we discuss today of similar use.

Let me start with three facts.

First, although the ratio of pensioners to the population of working age in the United Kingdom (UK) is forecast to rise from 30 percent in 1995 to 38 percent in 2030, the ratio of public expenditure on pensions to GDP is expected to fall over the same period from 4.2 percent to 3.3 percent.

Second, UK private-sector pension funds have at least #600 billion3 worth of investments, more than the rest of the European Union put together.

Third, over the past decade, pensioner incomes have risen by 50 percent, there have been increases at all points in the pensioner income distribution, and pensioners are no longer concentrated right at the bottom of the population income distribution.

How has this been achieved? What more needs to be done? And what lessons can be learned by countries with different systems?

THE BRITISH SYSTEM BEFORE PRIVATIZATION

It might be helpful if I begin with a brief description of the pension system inherited by Britain's Conservative government when it came to power in 1979. Since the National Insurance Act was passed by the 1945 Labor government, Britain has had a non-means-tested basic state pension. Those who have paid national insurance contributions (i.e., payroll taxes) as part of their tax bill during their working life are eligible for this benefit. It has always been paid for by government out of current revenues, rather than out of investment funds. In other words, each generation pays for the pensions of its elders. When the system was originally proposed by the social reformer William Beveridge during the war, he intended that the pensions should be phased in over 20 years. Labor decided to pay in full from the outset. The judgment of Britain's foremost welfare state historian, Nicholas Timmins, is that "although it was a mighty expensive decision, almost certainly nothing else would have been politically tenable."

Beveridge's aim was to eliminate means testing as far possible. As in other areas of benefit provision, however, both the problem of providing housing for the less well-off and the difficulty of setting means-tested rates below non-means-tested ones frustrated him. Around a third of pensioners in the UK receive means-tested benefits in addition to their basic state pension.

In 1975, another Labor government introduced a second tier to the UK state pension system. They introduced a State Earnings Related Pension (SERPS) in an attempt to narrow the differentials between pensioners with a private occupational pension and those without. SERPS provided a pension based on 25 percent of the average of the best 20 years of earnings. The crucial second reading of the bill to introduce SERPS was unopposed. According to Lord Lawson (later, as Chancellor, an important player in the design of the reform program), the Conservatives were "clearly wrong to do this" but believed "that pensions ought not to be a political football."

THE THATCHER STRATEGY

When the Conservatives came to power under Margaret Thatcher in 1979, they inherited an ailing economy, a fast rising social security budget, and commitments far in excess of Britain's ability to pay for them. In 1950, social security spending represented 5.1 percent of national income; by 1980, it represented 8.4 percent. By far the largest group of beneficiaries were elderly people, and by 1965, the cost of pensions was twice that which Beveridge predicted. In addition, as Lord Lawson puts it, "it was clear to anyone who took the trouble to analyse SERPS that it was a doomsday machine." Clearly, reform was necessary.

Principles of Reform.
The best description of the welfare reform strategy of Conservative governments between 1979 and 1997 was given by their last and longest serving Social Security Secretary, Peter Lilley, MP, in a 1993 speech. He explained the principles behind the reforms across the welfare field. He set out his key propositions.

  • "There are no easy solutions. That should be self evident, since if there were, I or my predecessors would have adopted them." With this he dismissed such pet solutions of right and left as merging the tax and benefits system or using tax credits to save money.

  • "Any effective structural reform must involve either better targeting, or more self provision, or both." Yet he did not accept that targeting need lead him to an exclusively means-tested approach.

  • "Disincentives are inherent in statutory benefits. When there is a choice between universal and means-tested benefits, there is a trade-off between imposing disincentives on the claimants or on taxpayers."

  • "Means testing is not the only way of targeting benefits more closely on need." Alternatives included changing the categories of people eligible for benefits (for example, changing the pension age); defining need differently (by tightening the rules of receipt for certain benefits); tighter enforcement; imposing new conditions for receipt; or using the contributions test.

  • "The existing array of benefits-contributory, universal, and income related-are rather more targeted than some comments suggest."

  • "No one has the right to opt out of contributing to help those who cannot provide for their own needs. But there is no reason in principle why people should not (in addition to contributing to others) opt to make provision for themselves privately rather than through the state system." With this, Lilley entered the debate about allowing people to opt out of the system and make their own provision.

  • "Contracting out inevitably involves a switch from pay-as-you-go to fully funded provision." Particularly in the case of pensions, he added, this would leave a gap in the public finances until the policies mature.

  • "The more the provision for needs and risks is monopolised by the state, the less the incentive to work and save to provide for them."

  • "Reform of something as vast as the social security system is best carried out sector by sector rather than by the `big bang' approach. Comprehensive big bang reforms invariably result in imposing elegant intellectual and bureaucratic structures on the inconvenient diversity of the real world."

The Three-Stage Reform Program.
The principles Lilley outlined were the basis of the Conservative government's three-stage reform program:

First, the government removed the link between pensions and wage increases, and linked the basic state pension to prices instead. The decision was controversial, but it was accepted because of the obvious crisis in the UK economy in 1980, and because there were no losers in real terms.

Second, in 1985 the government turned its attention to the long-term problem of SERPS. The government didn't just want to abolish SERPS, since the arguments for its creation remained good ones. Instead, it decided to offer taxpayers two alternatives. One option was to remain in a somewhat less generous SERPS. The percentage of your income that you would be paid, for instance, would be reduced from 25 percent to 20 percent. The other alternative was to contract out of the scheme and have the state pay a part of your National Insurance contributions into a private fund. "Take up," or the choosing of this second alternative, was encouraged by a number of measures. Those who decided to contract out would receive an extra 2 percent rebate above that strictly necessary to make their pension the equivalent of SERPS.

Finally, the government created a new private portable pension and provided tax relief on contributions, and companies were forbidden from binding employees to their own schemes.

Expectations Exceeded.
I shall not detain you with a detailed description of all the financial details and safeguards that were put in place to ensure the scheme was popular and secure.

These are set out in The Heritage Foundation's admirable paper on "Social Security Privatization in Britain."4 Suffice it to say that take up greatly exceeded expectations. The Department of Social Security's working assumption was that about 500,000 would take out personal pensions initially, and that the number might ultimately reach 1.75 million. In the event, take up reached 4 million by the end of April 1990 and, by 1993-94, had risen to 5.7 million.

This success did not, of course, end the debate. Some wanted a much larger compulsory private pension. Margaret Thatcher was one, and she told her Chancellor that they had such a pension in Switzerland. "Yes, Prime Minister," he replied, "but in Switzerland everything that is not forbidden is compulsory." Others were concerned about the security of private pensions, and after the newspaper owner Robert Maxwell was found to have stolen from the Mirror Newspaper pension fund, the government introduced safeguards to prevent swindles and incompetence from depriving pensioners of their income. Still others believed SERPS remained too expensive and pressed for its abolition. Once again this option was rejected, partly because some pensioners' contributions to SERPS were too small to pay the administrative costs in the private sector. Instead, the government once again reduced long-term SERPS entitlements, but compensated with reforms to make it more worthwhile for older people to opt out.

Proposals for the Basic Pension.
Yet the most important debate of all concerned the basic state pension. It remained a large item of government expenditure, yet current and future recipients believed it was inadequate. So the third stage of reform began. Over the summer of 1996, Peter Lilley began to work on new proposals to deal with the problem. His Basic Pension Plus plans were published in the new year. Under these proposals, the basic state pension and SERPS would be replaced with a state guarantee. New entrants to the workforce would be given a rebate from their taxes paid into their choice of private plans. If, when they reached retirement age, their private plan was not large enough to replace the basic state pension, the state guaranteed to make up the difference. In reality, this would not happen very often, and the advantages of a funded scheme would yield the average pensioner a much more generous pension than they would otherwise get. Of course, the scheme would cost money during the long transitional period. Because young people would be funding their own pension, they would not be paying for the pensions of their elders. However, by the time this cost peaked, it would be offset by savings from an earlier reform to raise the retirement age for women to the same as that for men. Another critical change was to switch tax relief from the time of saving to the time of receiving the benefit. This halved the transition cost.

Lilley's proposals received a rapturous reception in the press. The left-wing Guardian newspaper, for instance, said that "like the concept of a share holding democracy, it could also be empowering a new generation, which will have much more control over its retirement arrangements." The defeat of the government in the general election in May means that Lilley's plans have not become law, but it is widely anticipated that the new government will conclude that some sort of funded basic pension system is necessary.

THE POLITICAL LESSONS

How was such a radical program of reform possible? In Britain, as in America, pensions are an extraordinarily sensitive subject. No government could survive unscathed if it made a gross mistake in this area. I think that the program's success teaches a number of political lessons.

First, the reforms were the result of a debate about the long term-the security of young people and the country's finances. Budgetary problems were often the ally of reformers, but they were not seen to be the main reason for reform. Indeed, almost all the reform involved spending money in the short term and a recognition that without this, long-term change was impossible.

Victory in this debate was not inevitable. As late as 1992, Labor made large increases in the basic pension its central election promise, and it also promised to restore the wages link. Yet when they were defeated in this election, Labor realized that the voters did not believe their promise could be delivered, and they didn't, in any case, want to pay for it. They dropped the pledge and quickly began to join in considering long-term reform and the control of costs.

The result of winning the debate was that, when a Labor spokesman weighed in against Peter Lilley's new pension plan, press reaction made the Party backpedal very quickly. The next day, Tony Blair welcomed the way Lilley had widened the debate. It is thought by some press analysts that the unsuccessful attempt by some Labor members to raise scares about Lilley's plan lost the Party the endorsement of The Times newspaper.

Second, victory in the debate about long-term reform would have been useless if pensioners feared their income was under threat. At every stage, it was necessary to ensure that there were no losers among current recipients and that, as far as possible, future recipients felt they were making a one-way bet. The sacrifices this involved were that there could be no short-term saving and that the reforms would have to be phased in over very long periods. Basic Pension Plus would have yielded only costs until nearly halfway through the next century. Where savings had to be made to offset these costs, they too were phased in over a long period and did not leave any current recipients worse off. To ensure that fears were not allowed to take hold, the government was always very clear about the costs of its schemes and the nature of the guarantees it was giving.

Third, the reforms were not all introduced at once. Voters were more inclined to support the next stage of reform because they could see that the previous changes had not left them worse off. It was also less easy to attack the proposals as unworkable or to defeat the entire package by concentrating on its weakest point. The temptation to demonstrate how radical the government was and its farsightedness-by announcing the entire program in advance-was also eschewed. Each part of the program was advanced on its merits and given time to work before further innovations were considered.

Finally, the provision of choice was vital. The reforms of the mid-1980s were not imposed on future pensioners; they were given a choice and a financial incentive to choose the private option. Much of the popularity of the scheme depended on the feeling that the government was providing the opportunity to get a better deal. If voters thought instead that they were being forced into a scheme to save money, they would have been much more resistant.

Your natural political instincts will, I am sure, make you suspicious of the idea that in the UK we have found the perfect formula for painless reform. Your instincts would be right. Pensions remain a controversial topic, and throughout the 18 years we spent in government, Conservatives had to face criticism of the system we were developing. Yet there is now a remarkable consensus that the decisions were the right ones, that in general they have helped rather than hindered the Party at the polls, and that the new government is far more likely to extend the program than to reverse it.

About the Author

Related Issues: Social Security

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Endnotes

1 This is an updated version of testimony presented to the Subcommittee on Social Security of the Committee on Ways and Means, U.S. House of Representatives, by Daniel Finkelstein, OBE, September 18, 1997. As director of the Conservative Research Department, the British Conservative Party's policy development and briefing unit, Mr. Finkelstein worked closely with the Prime Minister and Ministers at the Department of Social Security to develop plans for social security reform. He also served as director of one of Britain's leading welfare reform think tanks, the Social Market Foundation.

2 For additional information on this subject, see Louis D. Enoff and Robert E. Moffit, "Social Security Privatization in Britain: Key Lessons for America's Reformers," Heritage Foundation Backgrounder No. 1133, August 6, 1997.

3 Almost $1 trillion.

4 Enoff and Moffit, "Social Security Privatization in Britain: Key Lessons for America's Reformers," op. cit.