Adding a smoothing mechanism to the triple lock to track inflation and earnings growth over a two-year period could help the government save £15bn in 2022/23, according to the Pensions Policy Institute.
In a briefing note looking at how Covid-19 could affect the triple lock, published today (September 8), the PPI said moving to a double lock, which has been touted by many across the industry, would not save money in the short term and a better saving proposal would be to introduce a temporary smoothing mechanism.
The current triple lock system ensures that the state pension rises by whichever is higher, earnings growth, inflation or 2.5 per cent.
Therefore, a double lock would still result in the state pension increasing above the level of earnings, but not as quickly as under the triple lock as there would be no baseline of 2.5 per cent.
But the concern is that this could still result in the government paying out a large sum as earnings growth is predicted to rocket in the coming years.
The Office for Budget Responsibility has predicted average earnings will fall by 7 per cent this year amid the Covid-19 crisis and in light of the fact a hefty chunk of the workforce has been receiving 80 per cent pay through the furlough scheme.
Next year, as the country is expected to recover and the furlough scheme has ended, the OBR said earnings could see an 18 per cent increase, triggering a hefty state pension state rise.
However, as the triple lock is one of the Conservative’s manifesto promises it is difficult to scrap it completely.
To get around this conundrum, the PPI suggested a temporary smoothing mechanism could be used and would even reduce the state pension bill.
Under a triple lock, and various scenarios of inflation, the state pension could cost between 4.7 and 5.2 per cent of GDP in 2022/23 and under a double lock the cost could be reduced, if there is low inflation, to a maximum of 5.1 per cent of GDP.
However, a smoothing mechanism could reduce the cost of the state pension to 4.7 per cent in a high inflation scenario or 4.6 per cent in a scenario of lower inflation.
According to the PPI, the difference between 4.6 per cent of GDP (£96bn) and 5.2 per cent of GDP (£111bn) is around £15bn.
Therefore, moving to a smoothing mechanism could, under a high earnings inflation scenario, reduce the impact of the Covid-19 bill from £192bn to £177bn.
Daniela Silcock, head of policy research at the PPI, said: “Using an earnings smoothing mechanism to inflate the state pension, which, for example, used the average for earnings over 2020 and 2021, (before returning to a triple or double lock in 2022) would mean that a spike in earnings inflation in 2021 would be less likely to result in a dramatic increase in the cost of the state pension, and could save around £15bn.
“Changing the state pension inflation mechanism would also mean that pensioner incomes do not increase as quickly.
“Under a triple lock, average pensioner incomes could reach around 31 per cent of national average earnings by 2040, compared to around 30 per cent under a double lock and 2 per cent lower at around 29 per cent under the use of a smoothing mechanism in 2021, followed by a return to the triple lock.”
But the PPI warned a smoothing mechanism may require changes to legislation, or to the definition of earnings, as the government is currently required by legislation to increase the state pension by a minimum of earnings.
Aegon had raised a smoothing mechanism as an option last month (August 24), saying the triple lock should be considered over two years rather than one, with state pensioners granted whatever the formula produces next April and the increase in 2022 based on a two-year period.
This would then average out any rise in earnings growth.
amy.austin@ft.com
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