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Willetts: Tackling the pension crisis

Speech to the Enterprise Forum

Our country faces a savings crisis. It also faces a crisis of growing dependence on means-tested benefits. Tackling these twin crises will be a central task for the next Conservative Government. I announced in October how we would do this. During our first Parliament we will take a million pensioners off means-tested benefits by increasing the basic state pension by earnings rather than prices. At the same time I announced a consultation on new incentives to save, replacing the existing structure of contracted out rebates. Rolling back the means-test and offering better incentives to save are the Conservative way to tackle the crisis.

Our approach has been welcomed by key organisations representing pensioners. Mervyn Kohler, Head of Public Affairs at Help the Aged, said "Help the Aged believes that the Pension Credit is totally over-engineered - the Forth Bridge of welfare provision. It would be so much simpler, and fairer, to boost the Basic State Pension to the Minimum Income Guarantee level, which could still be done with modest extra costs, allowing the dismantling of the spider's web of Pension Credit with no losers."

Our approach has also been welcomed by the savings industry as well. They understand that it is impossible to get people to save when they will find themselves losing means-tested benefits as a result.

The Association of British Insurers said: "Full marks for recognising the need to reduce the reliance on means-testing and provide better state pensions for all."

So far so good. But I realise that there are others who have reacted to our proposal with much more scepticism. Some commentators fear that our proposal is a threat to saving, or an expansion of the role of the state, or simply cannot be afforded. It is these concerns that I wish to address today.

We have to start with an honest assessment of the scale of Britain's pension crisis. It threatens the living standards and financial security of millions of people facing retirement. It threatens the profitability of our leading companies. It threatens the viability of our public finances. We will be living with the consequences for years to come.

It all used to be so straightforward. We had built up funded pensions to ensure that we had a decent income on retirement whilst the Continentals were facing ever increasing bills for expensive state benefits. Breaking the earnings link in 1980 plays a crucial role in this picture of British success. It was the biggest single expenditure saving made by the Thatcher Government. Alongside it we had the boom in the assets in funded pensions which rose from £42 billion in 1979 to £650 billion in 1997. That mix of tight control of public spending on benefits and a surge in the value of our pension funds was surely a triumphant success. And if breaking the earnings link played a part in that achievement of the 1980's and 1990's it is understandable that people ask how restoring it now could possibly form part of the solution today.

The answer is that our objectives remain the same as they were then - to encourage people to build up better funded pension savings and to reduce means-tested dependence on the state. But the circumstances facing us are very different and that is why different policies are needed. The environment is profoundly different in at least three ways:

· High taxation

· Low inflation

· Over regulation

High Taxation

One thing that has gone wrong is what Gordon Brown has done to our pensions. He has taxed our pension funds with the notorious abolition of dividend tax credits, taking £5bn a year from our pension schemes. At the same time he has pushed more and more pensioners into dependence on means-tested benefits. The extra money that he has put into benefits for pensioners has not gone into reforming the system and making it simpler, instead it has gone into extra complexity and more means-testing. The tax on our pension funds and the spread of complex means-tested benefits count as amongst the worst mistakes of Gordon Brown's Chancellorship.

It would be easy for me as an Opposition spokesman to leave it there with all the blame resting on Gordon Brown's shoulders. But there are deeper forces at work here as well. We won't really be able to understand the need for fundamental reform until we see the full scale of the crisis.

Low Inflation

As if Gordon Brown's mistakes were not bad enough, his biggest single success - giving the Bank of England independence and thereby securing the low inflation he inherited from us - has made the pension problem worse as well. Of course low inflation is good for the economy as a whole and should be good for savers too. But it has hit the finances of our company pensions in a way that is not widely appreciated. The guilty secret of post-war occupational pensions was that inflation was an important element in the whole deal. Wages were buoyant especially in the industrial sectors which had occupational pensions. That meant that pension contributions kept on rising. And because of future inflation the long-term liability, the obligation to pay the pension in the future, was always being eroded. We have now achieved a shift to low inflation. That means that promises to pay pensions in 20 or 30 or 40 years' time are much more expensive than they were in the old days when inflation was high and there was no statutory obligation to increase the value of the pension payment to match inflation.

Equities provided a good hedge against inflation. In fact the risk of inflation and the risks from investment in equities neatly offset each other. In the bad times of particularly high inflation and high interest rates then the equity market might be low but at least the high inflation meant that your future liabilities were depreciating fast. Even if your assets were not performing well your liabilities were being cut. In the good times of strong growth and low inflation the equity market performed well also. So even if your liabilities were not losing their value your assets held up. The past few years in Britain have seen an exceptional combination of low inflation and low equity prices. That means that the future obligation to pay the pension is not being eroded and at the same time the assets in the pension scheme are worth less as well. This is the double whammy which has faced our pension funds.

On the Continent the problem of expensive pension promises is above all one that is faced by the state. It therefore presents itself as a long-term fiscal crisis. In the UK much more of the cost of these pension promises is born by companies. So we have our crisis too, but it is a crisis of long-term corporate profitability. Companies have made promises to pay pensioners in the future which are going to last for longer and are not going to be eroded by prices in the way they might have expected. It could mean higher contributions into pension schemes for years to come, with long-term effects on the profitability of major British companies.

One of the ways companies have responded to this is to close their schemes to new members, cutting their contributions to pensions for new employees at the same time. This means lower pensions for employees in the future. This is going to push up public spending on pensions in the future. Means-tested welfare is very sensitive to the value of income from other sources. If our funded pension savings do not grow, then means-tested welfare grows instead. And as companies close their pension schemes to new members they also contract back into the state second pension. These are two very powerful forces whereby on current policies the corporate pension crisis pushes up public spending in the long term.

Over-regulation

As well as high taxation and low inflation, there has been a third change as well - regulations on company pensions are much more burdensome. I know that there are criticisms to be made of companies which have tried to walk away from their pension promises in the bad times, having taken pension contribution holidays in the good times. But let us also recognise what companies have faced. Many of them set up their occupational pensions decades ago when regulations were much lighter. Successive governments have (for very worthy reasons) imposed new burdens on them which, they could say, have profoundly changed the nature of the company pension contract. One leading firm of actuaries has tried, heroically, to estimate the increased costs for companies of providing pensions as a result of the gradual growth of regulatory burdens upon them. They estimate that back in 1975 the cost of providing a classic final salary company pension accruing at a rate of 1/60th a year was approximately 13% of payroll, divided between contributions of employees and employers. They calculate that extra regulations imposed by government - price protection, rights for early leavers, better treatment of widows, etc., - have increased the contributions that are required to provide a final salary pension by 8% to 21%. Other changes such as Gordon Brown's tax and falls in real returns on assets have added almost another 8% as well. That means that now the cost of providing a classic final salary occupational pension has risen to a combined contribution rate for employees and employers of 28.5%.

Governments have been using company pension schemes to deliver public policy objectives off the Government's balance sheet. Indeed, for a long time before FRS 17 they were off the company's balance sheet too. No wonder it all looked so good. Other countries with funded pensions - USA, Japan, and The Netherlands - use them to top up a much more generous state social security system. Only in the UK do we use company pensions to provide bread and butter income for many people with a much lower state benefit. That has increased the temptation for governments to intervene to try to increase the benefits companies pay to their pensioners.

During the years of the bull market when there were surpluses in pensions we could afford these extra policy objectives. But now we can't. The days when we could use them to achieve public policy objectives off balance sheets are now over. What we need now is to disentangle governments from occupational pensions. They need to be less heavily regulated. This was the important message from the work of Alan Pickering who was asked by the Government to investigate all this. It is a pity his advice has not been heeded. Companies will only provide a pension if they can see that they are a worthwhile part of the employment contract and are not being used by governments to pursue other purposes as well.

There have long been intimate connections between company pension arrangements and the state in the British system. This goes right back to the original model in which companies could contract out from a second state pension provided their employees could join a company pension that met certain minimum requirements. These minimum requirements gradually became more onerous and we required more and more of company pensions in return for their contracting out. The value of the rebate no longer matches the cost of providing the pension which has to be offered by schemes which are contracted out. The Association of Consulting Actuaries has said "Contracting-out on its current terms survives by inertia only. It should also be abolished. At present, it simply adds to bureaucracy and confusion without offering - what it was supposed to do - a meaningful incentive to save privately to reduce forward State commitments." Alan Pickering said: "I am unequivocally happy to say that contracting out should not remain a permanent feature of the UK pension system." The whole machinery of elaborate obligations to provide occupational pensions that met a variety of conditions in return for contracting out from the state pension is no longer delivering its objectives. That is why we are proposing to end the current contracting-out regime.

So far we have identified three crucial elements in our pensions crisis:-

(i) Gordon Brown's tax has hit the value of the assets in our pension funds;

(ii) the shift to low inflation has meant that the promise to pay pensions in the future is much more expensive than it was;

(iii)successive governments have required too much of company

pensions

Now let us look at the implications.

The cost of doing nothing

It is perfectly clear the direction in which our country is heading is clear. The Government is presiding over a decline in funded pensions, for which it must take its share of responsibility. And as funded pensions decline so instead it is driving more and more pensioners onto means-tested benefits. This is bad news for pensioners and bad news for public spending in the long term. The Government says that it intends to increase the means-tested welfare payments to pensioners in general by earnings. They are not pledged to do this automatically every parliament but that is the direction of travel and the assumption on which some of their own expenditure forecasts are based.

Means-tested benefits are particularly sensitive to the size of pensioners' incomes from other sources. One of the ways in which the Treasury manages to disguise the long-term impact of the crisis in funded pensions (which has already taken place) to assume that pensioners' incomes from other sources rise by earnings. If you simply move to the more credible assumption that future pensioners' incomes from other sources rise by prices not earnings this alone adds 2% of GDP to spending on the Pension Credit by 2050. In other words the apparently modest change in assumptions pushes up expenditure on the Government's new benefit by something approaching half the defence budget.

There is another reason why this long-term expenditure cost is rising. Many companies are closing their pension schemes to new members because the sheer hassle of contracting out is no longer worth it. When they contract back in to the State Second Pension they also are handing new pension liabilities to the state as well. These are new promises to pay the State Second Pension that have arisen as a result of companies giving up on any promise to pay their alternative.

So current policy is creating a world very different from the one we hoped we created in 1997. We are seeing an expensive combination of earnings-linked welfare payments to pensioners that will soon go to three-quarters of all pensioners, together with a massive expansion in the state's long-term liabilities as companies contract back in to the State Second Pension and hand back their pension obligations to the state. It is not cheap. Moreover it affects behaviour. Means-tested welfare destroys the incentive to save. So the problem gets even worse. That is why this crisis is so serious and so expensive. It is why we need reform.

Reforming pensions

There is a widespread consensus about what needs to be done to tackle this problem. Just about all the experts in the pensions industry and people who care about rebuilding our funded pension savings agree on the following three-pronged strategy;

(i) we need to increase the value of the basic state pension to get pensioners off means-tested benefits;

(ii) we need to disentangle the state from over-regulation of company pension schemes and that includes replacing the existing elaborate regime for contracting out;

(iii) we need new incentives to save.

This is the growing consensus about how to tackle Britain's pension crisis. Those three propositions summarise the Conservative Party's approach to pensions.

There is of course lively debate about exactly how each of the three propositions should be fleshed out. There are various formulae that could be used for increasing the state pension. We have proposed linking pensions to earnings during the next Parliament.

The National Association of Pension Funds say our proposal to reform contracting out is "a very positive contribution to the debate which echoes many of the points we have been making. [We welcome] the recognition of the need for better incentives to save."

People also have different views about exactly what form the new incentives to save should take. I have been very influenced by the idea of BOGOF - buy one get one free. That is a very attractive approach but the details are for another day. It is the three principles which are crucial and those are widely supported.

Answering the key challenges

Now we can answer crucial challenges that have been raised by the sceptics since we first launched our policy in October. Let me try to answer each in turn.

"Isn't this a big expansion of the role of government. Isn't it more intrusive than sticking with the old policy of holding down the value of the basic state pension?"

What is really intrusive is complicated, expensive, means-tested benefits, many of which are themselves supposed to rise in line with earnings. The Pension Credit now requires more than half of all pensioners to provide a Government official with the details of all their personal finances, both incomes and savings, down to the last £5. That is a much bigger and intrusive role for the Government than simply paying an automatic contributory state pension. It is why, incidentally, the administrative cost of means-tested welfare is ten times the cost of delivering the same amount of contributory pension.

Moreover, we have seen that when you try to hold down the value of state benefits below a basic living standard the state develops an unhealthy interest in regulating what company pension schemes offer. Then the intrusiveness takes the form of over-regulation which eventually becomes so burdensome that companies attempt to abandon their company pension schemes. Faced with the alternative of mass means-testing and over-regulation of funded pensions, then an increase in the value of the basic state pension to help deliver a radical reduction in the burden of regulation on companies is a much less intrusive policy.

"If breaking the earnings link was right then, why is restoring it right now?"

The answer is what we were trying to do 25 years ago was to hand the responsibility for building up funded pension saving over to the private sector. It worked when share prices were rising, companies were able to pay better and better benefits to their pensioners and personal pensions were worth more and more. Then the main means-tested benefit for pensioners was worth no more than the basic state pension. Now we are in a different world. Having tried to privatise company pensions, companies are now handing their pension costs back to governments. The main means-tested benefit for pensioners is now worth at least £25 more than the basic state pension. We face a ratchet driving ever higher state involvement in pensions. The only way to escape that ratchet is to establish a solid foundation of a decent basic state pension with a clear incentive to put money in to funded savings on top of decent basic state pension.

"Why don't you just make a step change in the value of the basic state pension?"

We need to roll back the spread of means-tested benefits by increasing the basic state pension. But there are different ways in which we should do it. One suggestion is that we should make a single dramatic step change in the value of the basic state pension so that it caught up with means-tested benefits. This has been proposed by the Blairite think-tank the IPPR and also by the robust defenders of funded occupational pensions, the National Association of Pension Funds. The proposal is that we end the system of contracting out rebates in which companies pay lower National Insurance contributions in return for contracting out of the State Second Pension. Instead all that money is used to pay for a higher basic state pension to get pensioners off means-tested benefits. This has considerable appeal but it is very expensive. All the money from contracting out rebates are used to pay for higher state benefits. The danger with such a large-scale shift of funding is that it could destabilise the finances of many company pension schemes. We have to use as much of this money as possible for new forms of incentives to save.

There is another problem with some versions as well. Some people envisage that we would make a one-stop shift to a higher basic state pension and then hold the line without any further increases in the state pension in line with earnings. My fear is that this is not the long-term solution that it is supposed to be. I doubt that it would last more than an economic cycle. A future Gordon Brown could come along and once more add earnings-linked means-tested welfare payments on top. The reality is that no other country imagines that you can eternally fix the value of the state pension in real terms. If we do so we are exposing ourselves to a long-term risk of the spread of means-tested welfare to boost the incomes of pensioners.

That is why I am driven to an alternative which seems to me to be more responsible and more affordable - increasing the basic pension by earnings not prices. It doesn't suddenly take the entire value of the contracted out rebate and use it for higher benefits. But it does put forward a formula which gradually increases the real value of the basic state pension taking each Parliament at a time. That enables one gradually to displace means-tested benefits.

"How can you afford the earnings link for the basic state pension in the long-term?"

We have been very careful in showing in great detail how we could finance the cost of the earnings link for the basic state pension during the next Parliament. Last October we set out detailed figures showing that offsetting savings on means-tested benefits, together with the abolition of most of the New Deal would finance our package over four years. That alone would enable us to take more than a million pensioners off means-tested benefits. I am not aware of any expert who has challenged those figures. But the question then arises as to what happens after the first term.

I said in October that I was confident we would be able to identify the savings that would enable us to carry on with this process. Provided that these are achieved, successive Conservative Governments would continue to increase the basic state pension by earnings not prices. Today I can explain, in rather more detail, why I believe that this policy can be afforded. Let me give three reasons why it is affordable.

Over any four-year period the cumulative gross cost of the earnings link compared with the price link works out at approximately £5bn. There is now so much means-tested welfare that the offsetting savings as the basic state pension replaces means-tested welfare would add up, over such a period, to about £2.5bn. That means that the extra net cost of the earnings link over an entire four year period is about £2.5bn. By comparison the total budget for social security benefits and tax credits is now running at approximately £125bn a year, or £500bn over a four year period. That means that we would need to find offsetting savings of less than half a per cent of the social security budget in order to finance the earnings link over a four year term. We have already produced a carefully costed proposal which shows how we could do that in our first term. I believe that it would be possible to identify savings on a similar scale in our second term. So the first reason why the earnings link is affordable is that its net cost is low compared with the overall cost of the social security programme.

There is a second argument as well. We will be phasing out the contracted out rebates which currently run at about £11bn a year £44bn over a four year period. We wish to put most, if not all, of this money into new incentives to save. We will be consulting the savings industry on the best way of using this money to rebuild the savings culture in our country. But if it proved necessary it would only require the diversion of a very small proportion of these contracted out rebates to finance the earnings link into a Conservative second term and beyond.

There is a third argument as well. This is perhaps the most fundamental of the lot. We will be stopping the accrual of new rights to the State Second Pension though we will of course respect any rights that have already accrued. We will be consulting on the detail of this because consolidating the State Second Pension into the basic state pension will be an intricate operation. We will be disentangling a complicated network and we must protect sensitive groups. But we can do it. That will mean that we start saving money as we stop accumulating new liabilities to pay the State Second Pension. These savings are potentially very considerable indeed.

Conclusion

Let me now take a step back and try to offer a vision of how our policy enables us to reform benefits for pensioners. Our commitment to the earnings link is only for one term but just imagine that we had been able to deliver a long-term reform of the system of state benefits for pensioners in the way that I hope. It would be a far simpler system. It would have far stronger incentives to save than at the moment. Moreover I believe it would actually be less expensive than a continuation of current policy.

The British system of state pensions has three main parts:-

· The basic state pension

· Means-tested welfare

· The state second pension

What is happening under this Government is that as the basic state pension declines in relative terms so more and more expenditure is going into means-tested welfare and the state second pension. We are going to reverse this and put the savings into a higher basic state pension instead.

Imagine what the world might look like in 2050. The figures I'm about to give are rough orders of magnitude but they are based on the Government Actuary's recent Report on the state of the National Insurance Fund. It showed that if the basic state pension carried on being linked to prices the rate of contributions from employees and employers combined needed for the National Insurance Fund to remain in balance would reduce from 19.1% in 2001 to 14.9% by 2050. By contrast, they estimated that if the basic state pension were linked to earnings rather than prices then the gross cost would see contributions rising to 25.8% of pay by 2050. This is what our critics see as the problem with our policy. That would make a difference of 10.9% of pay as the extra cost of financing the earnings link as against the prices link - but this is fortunately not the end of the story. We have seen there are at least two other important ways in which public expenditure goes on benefits for pensioners.

The main means-tested benefit for pensioners is now the Pension Credit. The Government's own projection for the long-term cost of this show it growing to over 4.7% of pay by 2050. But this assumes that income from private savings grows in line with earnings. This very favourable assumption has enabled them artificially to hold down their estimate of the long-term cost of the Pension Credit. Using the more realistic assumption that pensioners' incomes from savings grow in line with prices then the cost of the Pension Credit could be around 10% of pay by 2050, almost as much as the gross cost of the earnings link. If this expensive means-tested benefit is gradually replaced then the cost of the earnings link falls dramatically.

The other element is the state second pension. We estimate that phasing out new accruals of the state second pension would save 5% of pay in 2050.

On this admittedly simple calculation putting resources into the basic state pension, replacing means-tested benefits and phasing out the state second pension is actually cheaper than the continuation of current policy. It yields a net overall saving of around 4% of pay.

We must not get carried away here. These savings are of course going to have to be put to good use. They will help us to finance our new incentives for funded pension savings. We must also ensure that individual groups affected by the loss of future accruals of the state second pension are protected as the basic state pension rises. That is why it is important to consult with interested parties about the best way of improving incentives to save and our long-term plans for providing a higher basic state pension. This will be a major task for the next Conservative Government as we put in place a better structure for pensions. But I am confident that it is a better structure. It is an affordable one. And it is the right thing to do.

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