A ticking time bomb: can the state pension be reformed?
As the Labour government debates ways to reduce the spiralling welfare bill, eyeing £5 billion cuts to sickness and disability benefits, it continues to ignore another rapidly soaring component of welfare spending – the state pension. Just like its predecessors, the new government seemingly hopes to ‘wait it out’ and avoid confronting the long-term fiscal unsustainability of the state pension system and a need for comprehensive reform.
The triple lock, introduced by the Coalition government, ensures that basic state pension increases by the highest of price inflation, average earnings growth or 2.5% every year. Because it increases by the highest of the three, in the long run, pension expenditure is expected to rise faster than all of them. Meanwhile, the UK has a rapidly ageing population – the number of people aged over 65 is anticipated to reach 27% by 2072, up from 19% in 2022.
Currently, 45% of social security spending, or £137.5 billion, in Great Britain goes towards pensions, which is equivalent to 5% of GDP. This figure is forecasted to balloon to 9% of GDP in 50 years – about as much as the UK currently spends on healthcare, childcare and foreign aid combined.
While it is often assumed that individuals save for retirement by ‘paying into the system’ throughout their working life via National Insurance contributions, it is important to note that state pension is legally defined as a benefit, and this year’s state pension is paid out of this year’s welfare budget, rather than saved in an individual pot waiting for the contributor to retire. Because the system operates on a pay-as-you-go basis, the shrinking number of future taxpayers will need to fund a steeply rising number of retirees, while pensions continue to increase more than average earnings. It is a bit like a giant game of musical chairs, except when the music stops, there won’t be enough chairs – or workers – to go around. Not addressing this issue in the medium-long run may lead to fiscally unsustainable spending and debt levels as well as crowd out expenditure on areas such as health, education and infrastructure, which is likely to be detrimental to living standards across the UK.
Pension reform remains a deeply political question, not only due to its inevitable electoral unpopularity but also because policymakers leading the reform are unlikely to be around in 20 years to reap the political benefits of it.
Nevertheless, reform is necessary. One suggestion is for legislators to introduce a set target for a state pension as a proportion of average full-time earnings, as the government has done with the minimum wage. State pension would normally rise with average earnings, ensuring pensioners benefit from the rise in living standards, but in periods when inflation exceeds earnings growth, pensions would temporarily rise with inflation to protect pensioners from the reduction in their purchasing power. However, even when earnings growth resumes, state pension would continue to rise with inflation for a period of time until it reaches the benchmark proportion of average earnings. Like the triple lock, this system would protect the pensioners from recessions but would no longer reward them during booms.
According to estimates by the IFS and DWP, by opting for the smoothed earnings-linked state pension system described above instead of the triple lock, the UK economy will be saving up to 0.7% of GDP annually by 2050 and up to 1.4% of GDP by 2070. This policy may be accompanied by an increase in pensioner credit and even a return to means-tested winter fuel payments to prevent a rise in pensioner poverty. Additionally, the value of savings in personal private pension schemes has been steadily increasing since the introduction of auto-enrolment in 2015, a trend that is likely to continue, reducing individuals’ relative reliance on the state pension.
Ultimately, preserved funds may be invested in education, healthcare, infrastructure and levelling up, contributing to the increase in living standards across the country. While the benefits reform may be a step in the right direction, the lack of political will from either government to address the ticking time bomb that is the current state pension system means welfare spending will continue to soar in the long run. In this regard, reforming disability and sickness benefits is a bit like running for a mop when the bathtub is overflowing – you need to turn off the tap first. Sooner or later, policymakers will have to face the music and come up with a comprehensive reform of the state pension system.
Marina Barats