Department for Work and Pensions plans flat-rate state pension

In a Green Paper, the Department for Work and Pensions has outlined two options for reform to deliver a simple, flat-rate contributory state pension that lifts the majority of future pensioners above the standard means-test. The more likely option will also see an end to contracting out.

On this page:
Further pensions reform
Faster flat rating
Single-tier pension
Effect on defined-benefit schemes
Means-tested benefits.

In his foreword to the new green paper (on the Department for Work and Pensions (DWP) website) on reform of the state pension, the pensions minister, Steve Webb, writes: "As life expectancy projections continue to be revised upwards, we ... have a responsibility to ensure the pension system is sustainable and the costs of increasing longevity are shared fairly between generations. We have already brought forward provisions to increase the state pension age to 66 and this paper seeks views on introducing a more automatic mechanism to consider changes in the future."

One way of adjusting the state pension age could be through the use of a formula. Through this approach any increases in life expectancy would automatically adjust the state pension age to reflect revisions in projected longevity. This approach could provide a greater degree of certainty over how future increases in life expectancy would be reflected in the timing of increases in the state pension age. It could also provide a more objective means of setting the state pension age if the formula had widespread support.

An alternative approach would be to put in place a review at regular, predetermined intervals. This would give greater certainty about when the state pension age would be considered again in the future. A review would enable the latest life-expectancy projections to be taken into account and the review could be informed by an independent report covering some of the key factors around longevity, and could include a principle (such as the proportion of adult life in retirement) against which a recommendation or decision could be made on the timing of further increases.

Concerns have been raised that the complexity and uncertainty of the current system act as a barrier to individuals being able to understand and engage with pensions, and make planning and saving for retirement more difficult. A major factor in this complexity and uncertainty cited in the paper is the current high level of means testing, which is seen to act to reduce savings incentives. The paper points out that reliance on pension credit is projected to fall gradually but the Government is concerned that, in light of the challenges facing current generations of savers, "it does not fall fast or far enough".

Further pensions reform

The Government therefore believes that more reform is needed and that it is necessary to consider further reforms to the pensions system with a focus on reforming the state pension to better support individuals to save for their retirement; and to establish the most appropriate mechanism for determining future changes to state pension age to support long-term sustainability. The consultation paper seeks views on two broad options for reform with the aim of delivering a simple, flat-rate contributory state pension that lifts the majority of future pensioners above the standard means-test.

However, the Institute for Fiscal Studies says that "fully honouring past accrued rights - combined with the commitment not to increase spending on pensions in any year - by definition means that we will not be seeing a simple flat-rate pension any time soon".

Faster flat rating

Option 1 is to accelerate existing reforms so that the state pension evolves into a two-tier flat-rate structure more quickly.

The basic state pension is a flat-rate payment currently worth £102.15 per week. In addition, the state second pension (S2P) is partly flat rate and partly linked to earnings, so that higher earners receive a higher state pension. Option 1 would accelerate the pace of existing reforms so that S2P would become flat rate by 2020 instead of the current projection of a flat-rate state pension in the early 2030s. The paper argues that this would give individuals a clearer idea of the amount of state pension that they would receive in retirement as they would receive a set amount of pension for each qualifying year. At the end of the transition to the new system, all those with a full contribution record, for example 30 qualifying years, would build up the same state pension, currently estimated at around £140 per week, albeit through two tiers.

Currently, contributors can build up earnings-related S2P on earnings between around £14,000 and £40,000 and under current legislation this band is being reduced gradually. Under option 1, the upper band of £40,000 would be brought down to £14,000 over seven years. At the end of this period, individuals would build up a flat-rate amount of £1.60 per week for each qualifying year. Under this option, and in the longer term, those with 30 years of contributions to both the basic state pension and S2P could expect to retire on a state pension of around £145 per week. This would consist of around £97 in basic state pension and £48 in S2P. Those who contract out of S2P would, as now, receive part of that pension payment from their private pension rather than from the state.

Under option 1 it would be possible to go further by ensuring all earners built up the same pension, by better alignment of the detailed rules of entitlement between the basic state pension and S2P, and by using the same uprating for the two pensions when in payment. The consultation paper states that this would further simplify the system and increase the number of individuals receiving the full pension. Also under option 1, contracting out would continue for members of defined-benefit pension schemes.

Single-tier pension

Option 2 is a more radical approach whereby the basic state pension and S2P would be combined to create a single-tier state pension for future generations of pensioners set at a level above the pension credit standard minimum guarantee. To qualify for the full amount of the single-tier pension, individuals would, as now, have to build up 30 years of national insurance contributions or credits. Individuals would qualify for the single-tier pension, irrespective of whether they were married, divorced or widowed, reflecting the fact that most national insurance contributors now working can expect to build up sufficient state pension in their own right. Also, the rules governing state pension entitlement would be simplified so that there would be no special rules for bereavement, marriage or divorce.

The self-employed, as well as employees, would be able to build up entitlement to the single-tier pension. There would be a minimum level of seven years of contributions or credits to qualify for a single-tier pension so that state pension expenditure would be targeted at those who make a contribution over their working lives. The full amount of the single-tier pension would be uprated in line with the current triple guarantee (the higher of earnings inflation, price inflation or 2.5% pa) so that it maintains its value over time.

The savings credit element of pension credit would be abolished for future pensioners because the vast majority of workers could expect to retire with a state pension above the level of the pension credit standard minimum guarantee. Under this option S2P would end and so it would no longer be possible to contract out. The paper states that this would be a significant simplification of the personal tax system, but that it would also have major implications for employees, employers and pension schemes.

The Department for Work and Pensions (DWP) assesses that a state pension estimated at around £140pw at current values would be cost neutral. The consultation paper argues that this state pension model could be funded within the overall spending on state pensions because the higher state pension would be achieved through the abolition of the savings credit element of pension credit, the closure of S2P for future service, and the introduction of a seven-year minimum qualifying rule for future pensioners.

The DWP reports that the revenue from ending contracting out (ie removing the national insurance rebate) has been excluded from this assessment of costs and that the final proposals are "subject to confirmation, including on affordability, and will reflect the projections set out in the Office for Budget Responsibility's forthcoming Fiscal Sustainability Report".

Effect on defined-benefit schemes

The consultation paper points out that if a decision is taken to close S2P to new accruals and to end contracting out, sponsors and members of defined-benefit schemes contracted out of S2P would face an increase in national insurance contributions, so that they would pay the same rate of national insurance as other employers and employees.

Based on the value of the rebate in 2012/13, the increase for employers would be 3.4% of earnings between the lower earnings limit (£5,304 in 2011/12) and the fixed upper accrual point of £40,040. Employees would see an increase in national insurance contributions of 1.4% on the same band of earnings.

The consultation paper notes that, although employers sponsoring contracted-out schemes would lose the rebate, the legislative requirement for schemes to provide a certain level of benefits would no longer apply. The consultation paper adds: "In theory, scheme rules could be changed to reduce the benefits payable and hence reduce the contributions that employers are required to make, so that there is no impact on employers from the loss of the national insurance rebate. However, it may be difficult for some schemes to do this in practice and the Government would wish to support a balance being struck between the need to ensure provision is sustainable and that it provides good value for members."

Means-tested benefits

The consultation paper acknowledges that "there will always need to be a safety-net benefit to help those pensioners who do not have sufficient resources to meet their basic needs in retirement." Pension credit currently provides this support for pensioners' basic needs. The paper explains that means-tested support raises two issues for those saving for their retirement. First, there is the possibility that they will be subject to means-testing when they retire; and second, if they do end up on means-tested support there is uncertainty about the extent of withdrawal of benefits for every pound of income. Nevertheless, around one-third of pensioners do not claim the pension credit to which they are entitled.

The Government believes that these issues mean there is scope to improve savings incentives by reforming means-tested support. Although the paper states that pension credit has been, and will remain, an effective means of delivering additional support to many of those who retire on existing state pensions, it also notes that "the situation in the future will be different. As more people get a decent pension in their own right, the proportion of people needing means-tested help will fall gradually." The Government believes that the proposals outlined above would potentially reduce reliance on means-tested benefits far more sharply than is currently forecast.