Reform Scotland, the Edinburgh-based think tank, has proposed a wholesale reform of the UK public and private sector pension system. In its paper The Pension Guarantee, published on 27 February and available in full here, it identifies a number of issues with the current system and sets out recommendations for a possible solution.
The cornerstone of Reform Scotland’s proposal is the replacement of the state pension and public sector pension schemes with a Universal Contributory Pension (UCP), through which all workers would pay a mandatory minimum contribution into a defined contribution arrangement of their choice. National Insurance would be scrapped and a compensatory increase in income tax rates would be introduced.
Below, we set out the main issues that Reform Scotland has highlighted in its paper and the ways in which it proposes to tackle these through the UCP.
Issue 1: Uncertainty for workers
A key issue identified by Reform Scotland is the perceived uncertainty of the current system, particularly in relation to the state pension. It claims that workers in their 20s, 30s or 40s today have “no clue” when they will be entitled to take their state pension, how much their state pension will be worth, or indeed whether they will receive a state pension at all.
While both the UK and Scottish governments have announced commitments in relation to the amount and timing of future state pensions, Reform Scotland argues that this remains subject to change by future generations of politicians.
To address this uncertainty, Reform Scotland proposes that the state pension should be scrapped and replaced with the UCP. Under this system, members would be entitled to retire at any time after age 60, giving them greater control over when their benefits start. As the UCP would be a defined contribution scheme, members would receive annual updates of the value of their pension pot which, it is claimed, would provide better visibility of their likely retirement income.
Workers would be automatically enrolled into the UCP but, unlike the present auto-enrolment system, would not be permitted to opt out. This is a key element of the proposal and is intended to meet the core pensions objective identified by Reform Scotland: encouraging all citizens to establish financial security for their retirement.
Issue 2: Insecurity of benefits
While uncertainty about timing and amount of pension is seen as less of an issue for those in defined benefit schemes, nevertheless Reform Scotland points out that members of such schemes are reliant upon the financial strength of the sponsoring employer or, in the case of unfunded public sector schemes, on ongoing government support.
State pensions and most public sector pension schemes are “unfunded” in the sense that pensions are paid on an ongoing basis, with no underlying pension pot to meet future benefits. Reform Scotland notes that today’s state pensions are supported by National Insurance contributions being made by current workers, and the ageing population puts the future of state pensions at risk as the proportion of the population that is of working age decreases.
Reform Scotland’s solution is to propose that all public sector and state pension provision is moved to what they term a “defined contribution funded pension”. By “funded”, they simply mean that a pot of money would exist for each worker, consisting of his or her own pension contributions and tax relief. This would ultimately be used to provide an income on retirement. It should be noted that the usual risks associated with defined contribution schemes, notably investment return and annuity rates, would be borne by the member.
Issue 3: Escalating costs
Reform Scotland’s paper emphasises the financial burden on the state of the current public pension system, and claims that it is “unsustainable” in light of increasing numbers of pensioners. It sets out its proposed funding strategy for the UCP. Broadly, National Insurance would be scrapped and the personal allowance would be raised to protect lower-paid workers. To balance this reduction in government revenue, tax relief on pension contributions would be restricted to the basic rate and an initial 7p increase would be applied across all income tax bands. While the reduction in revenue would initially outweigh the potential increase, Reform Scotland claims that the gradual phasing out of the state pension could eventually lead to overall savings for government.
The paper also considers the financial impact on individuals and sets out how workers earning different amounts would be affected. Broadly, it is claimed that lower-paid earners would benefit while higher earners may receive a reduction in their net pay. Full details of the proposed changes to the tax regime and their effect on earners are set out in the paper.
The impact of the proposals on employers is less clear. Reform Scotland proposes that employers’ national insurance contributions would be retained and renamed “payroll tax”, so there would be no NI saving for businesses. While public sector employers may benefit from the closure of expensive defined benefit schemes, many in the private sector have already taken this step (the paper notes that only 14% of defined benefit schemes were open to new members in 2012). No mandatory employer contribution to the UCP is proposed, but Reform Scotland acknowledges that employees may negotiate higher contribution levels than the mandatory minimum of 8% as part of their employment package.
The UK and Scottish governments will doubtless be watching industry reaction to Reform Scotland’s paper with interest. While many commentators might agree that the issues identified – uncertainty, insecurity and increasing costs – are valid concerns in the current pensions climate, it remains to be seen whether Reform Scotland’s proposed solution will be considered an attractive alternative.