It’s a brave politician who picks a fight with the UK’s growing throng of pensioners; the government’s decision – and subsequent U-turn – on winter fuel payments is a case in point. But with rising costs leading to ‘unsustainable’ public finances, and a failure of private pensions to plug pensioners’ income gaps, the appetite for reform has never been stronger.
The is the second-largest item in the government budget after health, and currently accounts for about half of Britain’s £350bn welfare bill. It has risen steadily over the past eight decades from around 2% of the UK economy to a current 5%, or a staggering £138bn.
The Office for Budget Responsibility forecasts the cost of the state pension will increase to 7.7% by the early 2070s, driven by a rise in the number of people above the state pension age. There are expected to be 25% more pensioners in 2050 than today.
The OBR also blames the triple lock, a government guarantee introduced in 2011 by the Conservative-Liberal Democrat coalition, that ensures the state pension increases each April by the highest of three measures: average earnings growth, CPI inflation or a minimum of 2.5%.
Triple lock lament
Despite being an effective lever to ensure pensions value keeps pace with living costs and wage growth, inflation and earnings volatility over its first two decades in operation has led to the state pension costing around three times more than initial expectations.
OBR estimates now suggest that the annual cost of the triple lock could reach £15.5bn by 2030. Despite increases to employer National Insurance contributions, modelling suggests that the National Insurance Fund – used to fund state pensions – could run out in the mid-2040s.
“It has helped to address levels of poverty among pensioners,” says Iain McLellan, deputy chair of the Institute and Faculty of Actuaries pension board. “But I don’t know anyone who thinks the triple block can last long term. However, I don’t envy any politician who suggests taking it away.”
It’s clear that balancing long-term sustainability with intergenerational fairness isn’t a task for the fainthearted.
The National Insurance Act 1946 introduced a universal basic state pension that would provide a basic level of support in old age. If people wanted a higher standard of living, they would also have to save in a private (second pillar) pension.
Professor David Blake, director of the Pensions Institute at Bayes Business School, part of the University of London, explains: “The popularity of employers’ defined benefits (final salary) workplace pension schemes meant most people who worked in the 60s and 70s would have enjoyed a good standard of living in retirement, taking account of both the state and private pensions.”
After the Thatcher government made participation in the employer’s pension scheme voluntary and introduced defined contribution schemes, employee participation in an employer’s scheme fell or workers joined the employer’s DC scheme with lower contributions. “Those working in the 80s, 90s and 00s had lower pensions when they retired,” Blake says.
Simplify and minimise
The introduction of auto-enrolment in 2012, one of the main reforms to emerge from the Pensions Commission in 2005, has been hailed as one of the great pension success stories. Certainly, it has significantly increased participation in workplace pensions – current figures suggest 90% of employees stay in their employers’ DC schemes – which has helped normalise regular retirement saving.
However, minimum contribution levels of 8% remain out of step with the level of income people assume they’ll need in retirement. “A common misunderstanding is treating the State Pension as a complete retirement income. In practice it’s a baseline, and for many people the difference between ‘getting by’ and feeling comfortable is made up through workplace and private pensions,” Blake says.
Meanwhile, a big increase in the number of self-employed and a dramatic drop off in their engagement with pensions over the last 20 years is cause for concern. At the same time, the traditional defined benefit, occupational sector has almost completely collapsed. Historically, almost half of private sector workers – certainly more than four in 10 – would be contributing into a defined benefit scheme. Today, that figure has dropped to less than one in 10.
The Pensions Review, a major project launched in April 2023 by the Institute for Fiscal Studies, published its final recommendations in July last year. More needs to be done to simplify decision-making for individuals, to help strike a fairer balance of responsibility among the state, individuals and employers when it comes to pension saving, it says.
Laurence O’Brien, a senior research economist at the IFS, says the emotive nature of the triple lock makes targeting it politically tricky. However, replacing it with a clear earnings-linked target – expressed as a fraction of average full-time earnings – would improve cost predictability for the state and ensure that pensioner incomes keep up with increases in living standards.
The IFS’s ‘four-point guarantee’ for the state pension proposes that it continues to increase in line with at least inflation every year and is not means-tested. “Our suggestion for replacement of the triple lock would be one way of creating more predictability, at least for public finances, and also for individuals, at the end of the day, about how much the state pension is going to be worth,” O’Brien explains.
The state pension age has been heavily influenced by a focus on life expectancy and a proposal by the previous government that people should spend “up to one-third” of adult life in receipt of the State Pension. Moves to increase the age of state pension access are already afoot – from April the State Pension Age will begin to increase from 66 to 67.
Rising expectations
McLellan believes that a state pension age review is too simplistic. “Looking at age is just one lever. The state pension is a cornerstone of the welfare system, therefore you need to think about how it interacts with the rest of the system. The question is, what’s the intent here? Is it to keep pensioners out of poverty, is it to provide a baseline income on which private savings are built on top? Depending on what you hope it will achieve will define policy.”
However, Catherine Foot, the director of the Standard Life Centre for the Future of Retirement, warns this raising state pension age is not a magic bullet to ensuring it remains sustainable, “not least because it disproportionately disadvantages those with lower life expectancies and those least able to remain in paid work up until [state pension age]”.
For Calum Cooper, head of pension policy innovation at independent pensions and financial advice organisation Hymans Robertson, gradual increases in state pension age help, as long as there is a long-term plan with clear policy intent. “Linking the State Pension age to life expectancy can be fair and sustainable, if implemented properly. It must be sensitive to inequality and give adequate and clear notice periods.”
Against a backdrop of a rise in pre-retirement poverty among people in their early 60s caught between rising pension ages and barriers to stable work, the IFS believes state pension age should continue to increase as longevity at older ages rises, but not by as much as that increase in longevity. Meanwhile, rises in state pension age should be offset by targeted increases in universal support.
Means-tested support for pensioners should be streamlined to boost take-up, and housing benefit should be made more generous for the growing number of pensioners residing in the private rental sector. “This could also help increase the political acceptability of future increases in the state pension ages,” O’Brien says.
Bearing in mind the vital role of private and workplace pensions in pension adequacy, Cooper proposes phasing minimum contributions up to 12%, extending eligibility to all workers and introducing a small liquid savings pot for resilience. Removing the £10,000 threshold brings more than a million women into saving on its own.
Meanwhile, the IFS proposes that minimum employer pension contributions should be extended to almost all employees and apply from the first pound of their earnings. At the same time, the automatic enrolment system should help people save at points of life when it is easier for them to do so, the IFS suggests.
By increasing defaults for total pension contributions when individuals are on (and above) average earnings, the government can protect take-home pay when individuals are on low earnings, but still deliver a boost to many people’s retirement incomes. “As you progress through your career and move up the earnings ladder, your contribution rate as a share of total pay goes up a bit more steeply,” O’Brien explains.
To address poor levels of pension saving by the self-employed, the IFS is calling on the government to make it easier for self-employed people to participate in a private pension, by drawing on the success of automatic enrolment. “At a minimum, they should be required to make an active choice about the level of pension contributions when filling out a self-assessment tax return, or even automatically enrolled into a private pension or Lifetime ISA at the point of self-assessment.
Cooper suggests changing the timing of tax relief so the government pays a simple top up now and pensions are tax free later could free £22bn a year for investment without penalising savers. “Scaling collective defined contribution schemes can deliver higher incomes for the same contributions. Defined benefit surpluses could support UK growth with the right safeguards. And we can phase out the triple lock once adequacy is secured.”
Seeking sustainability
Any changes to the UK pension system are a political hot potato, given the emotive nature of pensions, and the political clout of the grey vote. “Some reforms are more realistic in the near term, in particular, strengthening auto enrolment, expanding CDC and reframing tax timing. However, altering pension age or uprating rules risks trust if rushed,” Cooper warns.
For policy makers, concerns about the sustainability of the UK’s creaking pension system have prompted a flurry of activity including the re-establishment in July last year of the Pensions Commission, 20 years after its previous incarnation was disbanded, and the introduction of the government’s bumper Pension Schemes Bill currently wending its way through parliament.
Given the Pensions Commissions’ historic auto-enrolment success, optimism is rife that similar success could be achieved in further pension reforms – whatever form that may take. “Tactically, I think the government has got this right, in the sense that the Pension Commission will have the kind of appetite for bold changes that get cross party support,” McLellan says.
The Pensions Commission is not due to complete its work until March 2027, after which, Foot says it will be critical for the government to respond promptly with a clear roadmap for change that improves the retirement prospects of today’s workers.
Considering that public confidence in the state pension is low – only 46% of Gen Z think the state pension will be available to them and of those that think it will still exist, 73% think it will be smaller than it is now – clear, consistent policy signals and long notice of any changes are essential.
McLellan concludes: “You need to tell a compelling story about what the state pension is and how it will change to deal with the changing dynamics of a population that’s living longer but not necessarily at full health.”
Pensions in the public sector
Pensions make up a large proportion of remuneration for public sector workers. Public sector employers make contributions worth around 25% of the value of salaries, compared to an average private sector contribution of 6%.
However, this generosity comes at a significant cost; public sector pensions constitute a £1.4tn unfunded liability – equal to 45% of GDP and almost half the size of the official national debt.
At the same time, pay growth in the public sector has lagged behind inflation and private sector pay growth in recent years. It has led to a rather skewed situation where those who work in the public sector for their entire career and pays into their pension could well have a higher income in retirement than in their working life.
Moving new public sector employees onto defined contribution (DC) pension schemes with a standardised employer contribution of 10% and employees contributing 5% could save taxpayers £37bn a year in the long run, a Policy Exchange report published in January suggests.
“Such a scheme would still compare favourably with the majority of private sector schemes and would ensure public sector employees continued to receive a good income in retirement, with the total proportion of salary being invested into an employee’s pension being above the 12% recommended by Pensions UK, the think tank said.
Ben Paxton, a senior researcher at the Institute for Government, says giving public sector workers greater flexibility over the balance of pay and pension would allow remuneration to better reflect different people’s preferences at different points in their life. “This could help motivate people to join the public sector workforce, then remain and be productive in it – and therefore improve value for money from this costly part of remuneration.”
However, Calum Cooper of Hymans Robertson isn’t convinced that cutting public sector pensions would solve workforce challenges. “Reducing benefits and increasing pay would shift risks onto individuals and weaken retirement security.
“A better approach is to continue to seek improvements in private sector pensions by rebuilding workplace pensions to be more adequate, inclusive and provide long-term value and fairness – just like open public service schemes already deliver.”
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