A State Pension for the 21st century?

Introduction

With the ultimate aim of providing “a better foundation for saving”, in its latestGreen Paper, the DWP sets out proposals for overhauling the state pension system. The consultation closes on 24 June 2011.

In this Alert:

• Key points
• Current state pension
• Context for reform
• The options
• Demise of DB contracting-out?
• State Pension Age

Key points

• The DWP puts forward two broad options for delivering reform:

• accelerating existing reforms so that S2P becomes a flat rate structure more quickly; or
• moving to a single-tier flat rate pension.

• The consultation also seeks views on introducing a “more automatic mechanism” to consider and / or implement future changes to SPA.
• It is not yet clear whether DB contracting-out will be abolished.

Current state pension

The current system comprises the basic state pension (BSP), the additional state pension (commonly known as S2P but formerly SERPS), which is linked to earnings, and the pension credit (a means tested benefit). The Government is concerned that, left unchanged, this system “would not provide the foundation that is needed to support people in taking greater personal responsibility for saving for their retirement”. It has identified three main problems with the state pension:

• Complexity and uncertainty of outcomes – it is difficult for people to know what they will get when they retire, making it more difficult to plan and save for retirement;
• High levels of means testing – which can deter saving as the incentives for doing so are not sufficiently clear. (The Green Paper notes that around a third of pensioners do not claim the Pension Credit they are entitled to.)
• Significant inequality remains in the system – groups such as women, the low paid and the self-employed tend to have lower state pensions.

Context for reform

In formulating its proposals for reform, the Government is working to four “clear” guiding principles:

• Personal responsibility – enabling individuals to take responsibility for meeting their retirement aspirations in the context of increased longevity;
• Fairness – ensuring an adequate level of support for the most vulnerable, ensuring everyone with a full National Insurance record should be entitled to a state pension above the standard level of means tested support, and ensuring all groups are treated fairly;
• Simplicity – making it easier for people to plan and save for their retirement; and
• Affordability and sustainability – ensuring options for reform are cost neutral to avoid placing an unsustainable burden on future taxpayers.

According to the Green Paper, some progress has already been made to achieve the above, with the introduction of the “triple guarantee”,1 automatic enrolment from 2012 and the scheduled increase in SPA. However, for the principles to be fully addressed, changes to the state pension system are considered essential.

The options

Option One: Faster flat rating of S2P

Legislation is already in place to morph S2P into a flat rate structure by the early 2030s. Option one involves accelerating the pace of reform so that this is achieved by 2020.

In addition to their flat rate BSP, people would then earn a set amount of S2P for each qualifying year of National Insurance payments. In the Government’s view, this would give them a clearer indication of their future pension entitlement. Those with a full contribution record (probably 30 years) would build up an estimated pension of around £140 a week in total.

In the future, it would be possible to simplify the system further by, for example, aligning entitlement to BSP and S2P (the self-employed and jobseekers are not currently eligible for S2P) and applying the same rate of increases to both pensions in payment.

Option two: Single-tier

The more radical option of the two, this would see BSP and S2P being combined into one single-tier state pension which would be available to all, subject to a minimum qualification of seven years of National Insurance contributions or credits. Future pensioners with at least 30 qualifying years would receive approximately £140 a week.

Demise of DB contracting-out?

Despite reports to the contrary, the end of DB contracting-out is by no means a foregone conclusion.

If the Government chooses option one, it would remain, although the National Insurance rebates paid to contracted-out schemes would reduce over time. Under option two DB contracting-out would eventually disappear completely, but this will take time to achieve. Many pensioners would therefore receive their single-tier pension through a combination of their state pension and contracted-out pension scheme provision.2

The consultation is light on detail on this issue but notes that, in theory, scheme rules could be changed to reduce the benefits payable in order to prevent employers being affected by the loss of National Insurance rebates.

State Pension Age

An appropriate SPA is essential to ensure that the state pension system remains affordable and sustainable. The Government therefore proposes to move to a “more automatic mechanism” for addressing continuing changes in longevity. The options are either (or a combination of):

• a formula which would automatically adjust SPA to reflect revisions in projected longevity; or
• a regular, scheduled review of SPA.

In determining the best approach, the Government intends to balance the need to provide people with sufficient notice of what their SPA will be, against the need to address changes in longevity.

1 State pension is guaranteed to rise each year by the higher of earnings, prices or 2.5%
2 The DWP estimates that around half of pensioners could have a contracting-out offset applied to their single-tier pension by around 2050