Andrew Tully assesses what impact a single tier state pension system will have.
The Government confirmed during the recent party conference season that it intends to press ahead with the introduction of a flat-rate state pension of £140 a week.
While this has been widely trailed the detail has been delayed again, and we're now told it will arrive later this year. The concept sounds simple, but working out how this fundamental change will fit with the many complexities in our current system could create a minefield for a mid-term Government.
The aim is laudable. While the basic state pension is relatively straightforward, the second tier benefit is very complex and has been changed many times over the past 30 years. When you add in the widespread means-tested benefit system, working out with any accuracy what you might get from the state is close to impossible.
By moving to a simple flat-rate benefit the Government can provide everyone with greater certainty over what they will get from the state, allowing them to properly plan what they need from their private retirement savings, essential as automatic enrolment starts to bed in.
Three key issues
There are three main issues which the Government needs to resolve before it can move to a single tier system. The first is how those with existing entitlements are treated. Some moderate and higher earners will be entitled under the existing system to far more than £140 a week, and would lose out as a result of the proposed changes.
In terms of fairness, the benefits which people have built up by contracting-out should be deducted from the £140 a week; otherwise those people will get greater state benefits than people who chose not to contract-out.
But continuing to work out exactly how much less those who contracted-out should get retains complexity in the system for a generation. An alternative is a simplified offset for those who have contracted-out benefits, but any simple system will always have winners and losers.
The second issue is how to introduce the flat-rate benefit. If it were introduced overnight, for all those who retire after a certain date, there are likely to be many media stories illustrating how someone retiring one day is significantly worse off than an almost identical individual retiring the next day.
The case studies would focus on women who have taken career breaks or paid small stamp National Insurance, carers and lower earners - those individuals who will see the most benefit from the introduction of a flat-rate system. This makes an overnight introduction politically difficult. But there is no obvious simple alternative.
However the originally suggested introduction date around the time of the next election may well be a casualty, with changes being pushed to a later date.
The third issue is perhaps the most troubling for the Government. One consequence of the flat-rate pension is the abolition of contracting-out in defined benefit schemes, as there is no separate second tier system from which schemes can opt-out.
Stopping contracting-out for defined benefit schemes comes with a major impact: higher National Insurance contributions for both employers and members. That would mean a 1.4% increase in National Insurance contributions for active members of final salary schemes, the majority of whom work in the public sector.
So a Government, which is already facing potential industrial action over pay freezes and changes to pensions, would effectively be introducing up to a 1.4% pay cut for millions of public sector workers. It would be an understatement to say that this is unlikely to be popular with unions.
Despite these three issues, I believe it is essential the Government take what could be seen as the brave option and introduce a flat-rate benefit as quickly as possible.
Automatic enrolment has started and over the next few years millions of lower earners will be enrolled into workplace pension schemes.
If the Government fails to reform state pensions, many lower income workers could simply end up replacing means-tested state benefits with the savings they and their employers are making.
Above all else, we need to simplify pensions in the UK. Only that way do we have any hope of encouraging and persuading more people to take the responsibility of saving for their later life.
Andrew Tully is pensions technical director at MGM Advantage
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