RESPONSE TO HUTTON COMMISSION

Unfunded public sector pension schemes should not be allowed to contract out of National Insurance. This would improve fairness and affordability of public sector pensions, while also saving money in both short-term and long-term

by Dr. Ros Altmann

(All material on this page is subject to copyright and must not be reproduced without the author’s permission.)

---

Ros Altmann’s response to the Public Service Pension Commission highlights a policy option which can save money for taxpayers as well as remedying one of the hidden unfairnesses of the public sector pension schemes. Contracting out is the most complex part of our pension system, but the complexity has allowed an anomaly for unfunded public sector pension schemes which costs taxpayers billions of pounds every year. If he is looking for short-term and longer-term cost savings, John Hutton should seriously consider reforming the contracting out rules.

What is going on?

Did you know that public sector workers pay less national insurance than the rest of us? They pay 9.4% while the full NI rate is 11% and public sector employers pay just 9.1% while the full rate that most private sector employers pay is 12.8%.

The lower NI contribution is supposed to ensure that workers and their employers do not pay for any state pension beyond the Basic State Pension, so that taxpayers do not have any responsibility to pay the workers a Second State Pension (S2P) on retirement. The S2P will be paid by a private pension scheme instead.

But allowing unfunded public sector schemes to pay the lower rate of NI makes no sense because taxpayers will still have to pay S2P in future as part of the public sector pension scheme benefits.

So the reality is that public sector workers and their employers are wrongly paying the lower NI rate today, saving themselves money now, but taxpayers will have to pay S2P in future, costing much more later. In fact, the public sector workers have just not paid for their S2P, they get it for free, under cover of the complexities of the UK’s unique contracting-out system.

Not only that, but the workers will actually receive their S2P as part of their scheme benefits from their scheme pension age, which is often age 60, while the rest of the population has to wait till state pension age, which will be rising to 68 in future. But public sector workers will still get their S2P replacement benefits within the public sector pension scheme, from their scheme pension age which is much lower than the state pension age. The following diagram illustrates what is happening:

Cost savings from ending contracting out:

Ending contracting out could potentially generate significant savings for the Treasury immediately.

By ensuring that workers do start paying for their S2P properly, they will have to pay the correct full rate of National Insurance.

Requiring public sector employers to pay the full rate of National Insurance would end the current hidden subsidy to public sector employment but the savings are less clear cut. These employers will have to reduce spending elsewhere in order to be able to afford the higher NI payments that they should have been paying all along. However, they will finally be paying the proper rate, rather than being able to employ public sector workers with an unfair advantage over private sector employers.

Once public sector schemes are no longer contracted out of S2P, the costs of providing future pensions will be much lower. As S2P replacement will not form part of the public sector pension in future, public workers will have to wait until state pension age – as private sector workers and other taxpayers will do – before they start receiving their S2P. That will mean reduced spending on public sector pensions in the longer term.

ENDS
Dr. Ros Altmann
07799 404747
2nd August 2010

NOTES FOR EDITORS:

1. The UK National Insurance pension consists of two parts – a Basic State Pension and an additional pension called the Second State Pension (S2P) – which was previously called SERPS (State Earnings Related Pension). National Insurance contributions are paid by workers and employers and all workers are entitled to S2P unless they are ‘contracted out’ of the system. By contracting out, they do not pay the portion of National Insurance that is supposed to pay for the S2P. This means they pay lower NI, to reflect the lower pension entitlement that taxpayers will have to pay to them on retirement. Workers pay 1.6% less and their employers pay 3.7% less NI, so that this 5.3% of salary is supposed to cover the cost of providing S2P. Contracting out of National Insurance is a system unique to the UK. It was introduced in the 1970s with the idea of reducing state pension costs, by transferring responsibility for additional state pensions (beyond the Basic State Pension) to employers who would be providing a replacement for this additional pension from their final salary pension scheme. Although lower NI would be paid in early years, the idea was that taxpayers would save money in future by not having to pay additional pensions to these workers. The problem, of course, is that unfunded public service pension schemes are funded by taxpayers anyway, since there is no fund building up to cover the future costs of the S2P payments, so allowing workers to contract out in this way just means they pay less NI, but don’t save taxpayers any money in the long run at all. In fact, quite the reverse, because the replacement S2P that is included in their pension scheme benefits will be paid from scheme pension age. This is much lower than state pension age, so taxpayers actually have to fund S2P for more years than they would have to pay in the state pension system.
2. Ending contracting out could also benefit private sector schemes and bring in extra revenue to help reduce the fiscal deficit immediately.
3. The full separate note on ending contracting out is reproduced here:

Policy option for short-term cost savings and improvement of fairness and affordability of public pensions

Summary:
Ending contracting-out will save money in the short-term and long-term. It will deliver fairer and more affordable pensions in the public sector, as well as tackling some of the complexity and inequalities in the current system. Public sector workers pay the wrong rate of National Insurance – they pay 9.4% instead of the full 11% and public employers pay 9.1% instead of the full 12.8%. It is illogical for unfunded public sector schemes to contract out of National Insurance and, in practice, this arrangement merely represents a hidden subsidy to public sector employment, benefiting today’s workers and public sector employers at the expense of future taxpayers.

Advantages:

1. Improve fairness and affordability of public service pensions, ending the unfair subsidy that currently allows them to pay lower National Insurance
2. Bring in extra revenue now to help reduce fiscal deficit and reduce public spending in future by ensuring public workers’ S2P is not paid before state pension age
3. Could save £2 billion a year as public sector workers pay higher NI
4. Could save £4.6 billion a year as public sector employers pay higher NI
5. Public workers would start paying for their S2P instead of receiving it ‘for free’
6. All workers would receive S2P from identical age, on the same terms, in future
7. Public sector workers would receive S2P from state pension age (65, 66 or higher), rather than age 60 or below from their unfunded public pension scheme
8. Future costs could be reduced by £10m a year for each 10,000 workers retiring
9. Reduce complexity of state pension and possibly pave the way for radical state pension reform to finally deliver a decent pension for all residents
10. Could help private sector schemes too – ending contracting out could improve private sector scheme funding and also improve Government finances immediately

Disadvantages:

1. Making the changes could be complex. May need to be phased in
2. Public sector workers – and employers – will pay higher National Insurance, rather than the artificially low rate they are paying now

What is the situation at the moment?
Public sector workers in unfunded schemes pay the wrong rate of National Insurance – 9.4% instead of the full 11%. Public employers pay 9.1% instead of the full 12.8%. This seems to be due to an historical anomaly that has never been corrected. As we are re-evaluating public sector pensions, this is an opportune moment to re-assess the contracted-out status of these schemes.

How does contracting out benefit public sector workers and employers?
Instead of paying 11% full National Insurance contributions, public sector workers are allowed to pay just 9.4% – so they receive a 1.6% discount.

Instead of paying full 12.8% National Insurance contributions, public sector employers have been allowed to pay just 9.1% – a 3.7% reduction.

These 1.6% and 3.7% underpayments of National Insurance are called ‘contracting out rebates’. They are designed to allow workers to opt out of the State Second Pension (S2P) scheme and replace their future National Insurance S2P payments with an alternative non-taxpayer-funded pension. For private sector employees this works by transferring S2P pension rights into private schemes, thus reducing pension costs and risks for future taxpayers. However, with unfunded public sector schemes the system does not work since taxpayers will pay S2P as part of the public sector scheme anyway. The idea of contracting out is that workers do not pay full National Insurance contributions when working, but then they will not get any additional state pension when they retire, so that future taxpayers will not have to pay them S2P in the future. In other words, workers and employers are allowed to pay less National Insurance when working only if they give up the right to a taxpayer-funded S2P payment when they retire. They are supposed to only be eligible for the Basic State Pension (BSP).

Contracting-out with an unfunded public sector scheme defeats the purpose of contracting out, it is just a hidden subsidy for public sector workers and employers allowing them to pay lower National Insurance. This is because public sector schemes actually include S2P payments in the scheme benefits. So taxpayers will effectively have to pay S2P to public sector workers anyway, as an unfunded pension scheme has no money set aside to fund the future pensions. However the public sector workers have not paid National Insurance contributions towards it. This is not generally understood and seems to be an anomaly that defies economic logic.

The situation is illustrated below:

Public sector workers effectively receive S2P for free. And, what’s more, it will be paid to them as part of their public sector pension, so it will start from the public sector scheme pension age, not state pension age. Therefore, when state pension age rises to 66 or 68 or beyond in future, public sector workers will still receive their S2P pension rights from age 60 or below.

What could be done to address this?
If unfunded final salary schemes are no longer allowed to be contracted out of S2P, then public sector workers would have to pay the proper rate of National Insurance contributions and the public sector employers would be charged the right rate too. This would bring in extra revenue to the Exchequer immediately.

Extra potential £2billion a year from employee NI contributions
By charging public sector employees the full 11% National Insurance, Government revenue could potentially immediately rise by around £2billion a year.

Potential £4.6billion a year from employer NI contributions
By charging public sector employers the full 12.8% National Insurance, there could be an extra potential £4.6billion a year notionally received in National Insurance – although the saving would only occur to the extent that the higher NI forced public sector employers to make offsetting savings elsewhere in order not to overshoot their spending targets.

Save £100 million a year for each 1,000 public sector workers retiring
By removing the replacement S2P rights from the public sector pension scheme benefits, the long-term costs of providing public sector pensions would be reduced. The S2P pension payments would only start from state pension age, not from scheme pension age, so workers would have to wait longer, just like other workers, to receive their S2P.
Assuming an average S2P entitlement of £1000 a year, the saving could amount to £10million for every 10,000 public sector workers each year between their scheme pension age and state pension age.

Conclusions:

If the Public Service Pensions Commission is looking for a policy change which can cut the taxpayer costs of public service pension provision in both the short-term and long-term, then ending the ability of unfunded public sector schemes to contract out of the National Insurance system would be a powerful policy option. Indeed, ending contracting-out for all defined benefit pension schemes could raise billions of pounds of much-needed additional revenue for the Exchequer in coming years.

APPENDIX 1 – Further information

Ending contracting-out could also benefit private sector pension schemes
Ending contracting out of S2P could benefit employers struggling with final salary scheme deficits. Contracting back in to National Insurance would reduce future scheme liabilities as well as bringing in extra National Insurance revenue. It could also allow a simpler benefit structure for all final salary schemes, ultimately ease the burden on employers and help scheme funding.

Employers are desperate to find ways to reduce the funding burdens of their final salary schemes. Government has not yet managed to introduce policies to do so. The impending introduction of Solvency II, the downward pressure of Quantitative Easing and the recession on interest rates and continued volatility of asset prices have all added to the costs and risks of running final salary pension schemes. The recent announcement about linking revaluation and inflation increases for private pensions to cpi, instead of rpi, may not help much if schemes cannot change their Trust Deed. However, by ending contracting out for all schemes, the Government could help mitigate some of the ongoing costs of pension provision by reducing the future liabilities. Of course, changing benefit structures could be complex, but once we determine to end contracting-out, this could offer longer-term benefits to scheme funding, as well as the potential of increasing Government revenue in the shorter-term. In fact, as scheme trustees will already need to revisit their Trust Deed terms to accommodate a possible change from rpi to cpi uprating, it could make sense to consider the implications of ending contracting out at the same time. Reform of GMP and protected rights rules would be a welcome relief to many schemes.

Ending contracting out could also pave the way for a better state pension
If Government seriously wants radical pension reform, overhauling the State pension system is the best way to start. The UK state pension is far too low and far too complex, with nearly half of pensioners ending up entitled to means-tested benefits in retirement. This mass means-testing also undermines incentives for pension saving.

Rather than slowly increasing the state pension, by tiny amounts each year, we should sweep away the complexities of having a Basic State Pension guided by one set of rules, S2P guided by a different set of rules plus Pension Credit and many other benefits on top. Merging the Basic State Pension with S2P, could provide a decent, flat-rate, universal pension for all British Citizens – perhaps from age 70 or 75. This would be truly radical reform and could finally free the private market to sell pensions safely to all.

APPENDIX 2 – Calculation of cost savings estimates:

Employee National Insurance: £2billion extra revenue each year if public Sector workers pay full National Insurance.

Assume that 6.25 million public sector workers pay the reduced 9.4% rate, instead of the full 11% rate.

If we assume an average salary of £25,000, then the National Insurance will be levied on salaries between £5,000 (lower limit for NI) and £25,000, so the extra revenue from the additional 1.6% NI will be:

1.6% x £20,000 = £320 extra per year per worker

£320 x 6.25 million workers = £2 billion per year

Employer National Insurance: Extra potential £4.6billion a year if public sector employer National Insurance contributions rise from 9.1% to 12.8%

Assume 6.25 million public sector workers with an average salary of £25,000.

Employer contributions are levied on salaries between £5,000 and £25,000, so the extra 3.7% National Insurance received could be:

3.7% x £20,000 = £740 per year per worker

£740 x 6.25 million workers = £4.6 billion per year

4. My full response to the Hutton Commission on Public Service Pension Reform can be found on the following link http://tinyurl.com/32hjqqd