What’s the problem? The primary reason is that the national insurance fund is run like a current account rather than a savings account. There are no permanently maintained savings and, much like my own current account at certain periods of the year, the money currently coming in is less than the amounts being paid out.
This is despite the fact that the UK state pension already offers the lowest replacement income relative to average earnings of any Organisation for Economic Co-operation and Development (OECD) country. The cost of providing even this level of benefits is greater than the money being collected in national insurance contributions (NICs). The resulting overdraft is currently being met by Treasury grants; however, these are limited to 17 per cent of the year’s expenditure, and even with these payments the Government Actuary’s Department (GAD) estimates that the fund will run out completely by 2032/2033.
The problem is that the money coming into the national insurance fund is paid by people who are workers and the money going out is spent on people who are not. At the present time the balance between workers and pensioners is 1,000 workers to every 310 pensioners. By 2036 however, the ratio is projected to be 360 pensioners supported by 1,000 workers. If the state pension remains the same, each worker will have to contribute more, or pensioners will receive less. The state pension is not the only benefit paid from the national insurance fund; but it accounts for 94 per cent of its expenditure and it is therefore the key driver of change.
This situation is exacerbated by the fact that the money coming in from NICs increases in line with earnings, whereas the money going out in the form of the state pension increases under the triple lock. Following a longer than expected period of low wage increases the strain on income has become even greater.
So, what are the options?
According to research carried out by Royal London in 2016 two-thirds of young people do not expect the state pension to exist by the time they come to retire anyway, so why not accept the inevitable and just let it run out?
It could not be done in the short term. Recent research commissioned by Age UK found that many pensioners, particularly in older age groups, are heavily reliant on the state pension and expect to remain so.
Even if it were considered morally acceptable, if there were no state pension, many of these individuals would find themselves in poverty and the state would be required to support them in some other way.
The result would be that current workers would still be paying their costs, but in the knowledge that they would be unlikely to receive a pension themselves at retirement. It is not a vote-winner, and as a state benefit it needs to be. It is more likely that successive governments will make gradual changes and try to keep it going in some format, which means they will either have to increase funding or reduce the benefits – or both.
Reducing benefits is never popular, but in common with several other developed countries the UK has raised the state pension age and has more increases planned. The current proposal is that the state pension age be linked to average life expectancy with the result that roughly a third (32 per cent) of the average life will be supported. Life expectancy in the UK continues to increase so any starting point will need to be reviewable to reflect actual trends and ensure costs do not spiral out of control.
Pay out less
A third of developed countries have reduced the benefits paid from their state pension. In contrast the UK government introduced the new state pension, which was an attempt to direct benefits towards those who need it most. The flat rate of income means that in the long term those on lower income should do better under the new state pension, while higher earners will get less than they would have done.
Extending this approach to its logical conclusion might suggest reintroducing means testing of this benefit as in 1909.
One of the reasons the state pension is so expensive to deliver is that everyone who has paid national insurance will get it, regardless of whether they really need it. The chances of this happening will depend on the governments we have over the next 10 to 20 years.
Ideologically, a socialist government is more likely to advocate means testing, following the argument that it will allow them to pay more to those who need it.
Unfortunately means testing would mean that people could never really be certain that they will receive the state pension until they are old enough to qualify for it, and it is unlikely that they will be excused from paying NICs in the meantime.
The easiest solution for a Conservative regime would be to remove the current triple-lock that guarantees increases of the state pension in payment. The current government commitment to keep the triple-lock for the remainder of this parliament has led many people to conclude that it will not continue much beyond that point.
An element of inflation-proofing is required, since we already know that retirees become increasingly dependent on the state pension as they get older. In a low inflation environment, however, the 2.5 per cent floor begins to look less reasonable, particularly to the younger workers who are paying for it.
We also had an abortive attempt to increase national insurance, albeit only for the self-employed, in Philip Hammond’s 2017 Budget so this could be a viable future strategy.
An alternative approach would be to merge national insurance and income tax. This has been raised several times, but so far been left in the ‘too difficult’ box. It would be very complicated to implement, although the result could be a simpler system for taxpayers in the end.
Preferable to both of these solutions would be that people are motivated to increase the level of their private savings. Automatic enrolment is a step towards this; but minimum contribution levels are nowhere near the levels required to replace the state pension. It should also be remembered that the UK already relies on a much higher level of private savings than most other OECD countries.
Trust in hope
The cost of the state pension is highly sensitive to demographics, so it is possible that increases in longevity will slow, but we may also see an increase in birth rates.
Another possibility is that the number of UK workers is boosted by increased migration. This is unlikely to come from the EU following Brexit, but from other countries where people find the prospect of living in Britain more attractive than under their current regimes. Also, the economy may recover to the point that earnings increase and unemployment falls even further.
The government has limited or no control over these factors, and can only monitor them and use them to calculate whether the state pension is sustainable. At the moment it would seem it is not. Whatever happens, relying on the state pension for your financial future may not be the best strategy. Those who are able to should certainly consider increasing private pension contributions in order to augment anything they might receive from the state.
Fiona Tait is technical director of Intelligent Pensions