Our emptying pension pot

Over the coming years, those who are better-off will be at the sharp end of the problem
August 16, 2017

The point of most investment is to create income and assets for the time when we will no longer support ourselves through work. Increasing the value of our savings by investing them is inevitably a slow process so we do best to focus on long-term goals, notably our pension.

That’s how today’s personal and occupational pensions work. But what about the income we are promised by the state? Ostensibly the same principle applies. During our working life we build up a state pension by paying National Insurance (NI) contributions (although the self-employed, including me, pay a lower rate than employees). Then, when we retire, our decades of contributions to the National Insurance Fund deliver our basic retirement income, in my case from the age of 67.

There’s another factor that makes the state pension system look like a private retirement fund: once you start taking out, you no longer have to contribute. This is why people who are drawing a pension do not pay NI, just income tax.

But the apparent similarities between private and state retirement systems are misleading. Our NI contributions are not invested over decades to generate the pension the state promises us—the money you put in today goes straight out again to pay today’s state pensioners. Rather than operating as an investment vehicle, therefore, the National Insurance Fund is more like a giant, taxpayer-guaranteed insurance company: we pay premiums through our working lives via NI contributions and claim when we retire. Provided we have paid enough, our claim is valid and we receive a state pension until we die, funded from the NI contributions of those still in work.

This huge state insurance company is heading into the red, however. Every five years the Government Actuary estimates how long projected NI contributions, plus any surplus remaining from earlier years, can continue to meet the likely demand for state pensions. According to the most recent estimate, published in 2014, the historic surplus in the NI Fund will be used up in 10-15 years’ time. At that point, assuming current contribution rates, the premiums working people pay in will not cover pensioners’ claims and a deficit will open up. The crunch could well come sooner—the 2014 estimates cover the period to 2010 and the picture is sure to have deteriorated since then.

How will this gap be filled? NI contribution rates could rise, forcing today’s workers to pay more towards their parents’ and grandparents’ state pensions. That puts the entire burden on younger generations (as does increasing the state pension age).

Or the fund could be topped up by raising income tax, placing most of the burden on the working population but also taking more money from pensioners who pay it. A third option would be to abolish NI and roll it into income tax. This would compromise the contributory principle that underlies the NI system but would raise significant new money from pensioners who would then, in effect, pay both NI and income tax. Another option would be to means-test the state pension (as happens in Australia) so the better off no longer qualify.

I have no idea which, if any, of these will prove politically possible. But, one way or another, better-off people heading for retirement over the next decade are very likely to find themselves at the sharp end of this problem.