A Short History of Pensions: Part One
Try as you might, it’s hard to find a less enlivening or more complicated, jargon-infested subject than pensions – and yet they’re part of all our lives. If you’re reading this article, I’m guessing that you’re either retired or planning to retire one day. Yes, we’re all in this thing together! My challenge today is to try and summarise what pensions are and what makes running pension schemes so difficult (which may explain why so many pension managers have got it wrong over the years). I’ll summarise the main pension-related events since the first state pension was introduced a little over a century ago, and surmise what the future of retirement provision might look like.
This article will come in two parts. This first one will discuss pensions in general, the challenges of running them, and the history of state provision in the UK. The second will look at company pension provision, the growth and demise of final-salary schemes, and the advantages and disadvantages of the money-purchase arrangements that have largely replaced them.
I have a long history with pensions. As an adviser, I spent around thirty years setting them up and working with my clients to make them grow, and thought I knew a fair amount about the subject. In researching this article, I have been surprised to find out how much I didn’t know, or knew but didn’t understand. It has been quite an illuminating exercise.
There comes a time in everyone’s life when we become too tired or ill to go on working. It’s natural for anyone who hasn’t yet reached that stage to worry about what will happen when it does. No civilised society accepts the idea that people should be expected to work until they drop. So, governments and employers are under an obligation to provide workers with a living wage in the latter stages of their lives. Ideally one that will hold its spending power whatever happens to the prices of the items a pensioner needs to buy. Giving everyone that security reduces anxiety, frees workers to concentrate on what they’re doing in the present and, in so doing, gives a general boost to the economy. Introducing a pension scheme offers benefits to both provider and recipient.
And that’s when the problems begin. The money to pay for pensions has to come from somewhere and the provider never has more than a vague idea how much it’s going to cost. Anyone who initiates a pension scheme is opening a tab that may remain open for many decades.
One reason why pensions may be so complicated is because the whole idea of retirement income is still in its infancy. The UK didn’t have a state pension until 1909. We had railways, electricity, radio, an empire on which the sun never set, sophisticated sewage systems and manned flight before we had a state pension scheme. It’s astonishing to think that my lifetime spans well over half the entire era of the state pension. State pensions are something we take completely for granted today, and yet their introduction in 1909 took place just eight years before my father was born.
Funding and Life Expectancy
Anyone launching a pension scheme needs to know how much the project might cost. An important element in that equation is how long its members are going to live. The pension era has coincided with a time of ever-growing life expectancy, which has meant that all pension schemes have cost more than was anticipated when they were introduced. Britain’s original state pension was offered only to the over-seventies, whose life expectancy was 8.4 years (men) and 9.3 (women), meaning that the Government could expect to pay its pensioners for an average of only nine years.
There’s an important difference between someone’s life expectancy at birth and at retirement age. In 1909, life expectancy at birth was less than 70 for both men and women. By the age of 70, most of the population had already died. The life expectancy quoted above related to the remaining cohort, the fitter, healthier, luckier ones. The tendency of people’s life expectancy to go up as they get older is sometimes referred to as ‘mortality drag’.
After 1909 the state pension age went down (for a long time it was age 60 for women and 65 for men) but it is now rising again, though still lower than it was a century ago. Life expectancy has continued to climb. In 1951, the year of my birth, a 65-year-old man could expect to live another 12.1 years, and a woman of the same age, 15.5 years. By 2020, the last date for which I could find reliable figures, a 65-year-old man could expect to live 19.7 years and a woman of the same age 22.0 years.
Note how these figures work against the pension provider. A hundred years ago, a new-born baby could expect to live till about 70. Today, a new-born is expected to live to be 82, an increase of less than 20%. But the life expectancy of a 65-year-old has more than doubled in the same period.
Also, prices have risen remorselessly over the last century. The last year in which prices fell in the UK was (by a modest 0.5%) in 2009, and the last year of falling prices before that was 1933. Since 1909 prices have risen around 130-fold. A pension provider today can expect to pay their new 65-year-old retiree for twice as long as their forebears would have had to do a century earlier, (that is, for roughly two decades instead of one). The second half of that period is almost certain to be the more expensive half.
Pension providers also need to know what proportion of their beneficiaries women are. This doesn’t matter so much for a scheme like the state pension, which covers everyone indiscriminately, but in some company schemes the recipients can be nearly all men, or nearly all women. Women live longer than men, always and everywhere, by around five to ten percent.
As if that wasn’t enough, you also need to know where your beneficiaries live, as life expectancy varies significantly from place to place. In the UK in 2020, residents of the London Borough of Kensington and Chelsea could expect to live 84.2 years (men) and 87.9 years, women, while the lives of the residents of Glasgow City were roughly eleven years shorter (73.1 and 78.3 years respectively).
When I was looking at these figures, it struck me that men in Glasgow didn’t just live shorter lives than other men elsewhere, but their lives were also proportionately shorter than those of Glaswegian women. In Kensington and Chelsea, men’s lives were around four percent shorter than women’s, while in Glasgow men’s lives were around seven percent shorter. Could it be true then that in places where people tend to live longer, the men tend to live longer in relation to women? To check, I had a quick look at places where lives are short (Russia) and long (Japan) and found that in Japan men live 93% as long as women, but only 87% in Russia, which appears to prove the point.
As a pension provider, you would need to take all these factors into account, or risk finding yourself unable to meet the liabilities you had committed to – and the figures are always changing.
Besides, numerous studies have shown that people who are in pension schemes live longer than those who aren’t – so you would need to factor that in, too.
History of the Basic State Pension Scheme
The scheme commenced in 1909. It was paid to everyone over the age of 70, but unlike today’s version, it was means-tested, being available only to people with annual incomes below £21 a year. This very low figure, equivalent to around £2,500 today, meant that the pension was targeted at the poorest members of society, and covered only the very last years of their lives. However, again unlike today’s version, it was non-contributory. The scheme paid five shillings a week to a single person, and seven shillings a week to a married couple (around £1400 and £2000 in today’s money).
The first major change came in 1925, when the state pension became contributory. The eligibility criterion was hugely increased to £250 a year income, though because of high inflation during the First World War years, the change represented a five-fold increase rather than a more-than-tenfold one had prices stayed the same.
In 1940, retirement ages were changed to 60 for women and 65 for men.
In 1946, when the Welfare State was created, the state pension was made available to all.
In 1978, the State Earnings-Related Pension was introduced, of which more below.
Mrs Thatcher believed in individual self-reliance and a small state. One of her earliest pieces of legislation, the Social Security Act 1980, broke the link between the state pension and average earnings. High rates of inflation in the 1970s had been matched by pay rewards, dramatically increasing the cost of the state pension, which the Conservative government feared might become unaffordable.
The Triple Lock
In 2010, one of the first acts of the Cameron government was to introduce the ‘pensions triple-lock’, a formula directing that the basic state pension must be increased each year by the highest of price inflation, wage inflation or 2.5%. In the years before 2010, wages rose consistently faster than prices, and in a normal year both would exceed the backstop 2.5%. The idea behind this generous piece of legislation was to ensure that retired workers’ incomes kept pace with those of the working population. However, in the years since 2010, until very recently, inflation has stayed below its long-term average, and salaries haven’t always kept up even with the more moderate rises in price inflation. During the thirteen years of the Triple Lock, the state pension has been increased by the rate of price inflation six times, by wage inflation three times, and by 2.5% four times. In other words, the state pension uplift has been in line with wage inflation in only three years out of thirteen, and above wage inflation in the other ten. Overall, the state pension has almost exactly doubled since the introduction of the triple lock (from a maximum of £102.15 a week in 2011 to £203.85 in the current tax year), while price inflation has risen by around 40% over the same period, and earnings by just 26%.
The formula has been applied as usual for the 2023-4 tax year, resulting in a rise of 10.1%, in line with the CPI (an index of consumer price inflation). This year’s indexation will cost the Treasury around £12 billion, a vast sum even by the standards of the UK government, which always involve a lot of noughts.
The History and Future of Retirement Ages
As we have seen, the state retirement age was 70 for both men and women in the original 1909 state pension scheme.
In 1925, the retirement age was reduced to 65 for both men and women, but both spouses had to have reached 65 to be eligible for the higher married couple’s payment. Today, men are on average four years older than their wives. Assuming the same age difference in 1925, men had to wait until on average they were 69 years old before receiving the married pension, despite being both retired and married. To remove this anomaly, the retirement ages were changed in 1940 to 65 for men and 60 for women.
The rules remained unchanged for half a century until, in the early 1990s, a male member of the Guardian Royal Exchange pension scheme was forced to retire in his early 60s through ill-health. He was denied a pension on the basis that he hadn’t reached the scheme retirement date of 65. He argued that this treatment amounted to sex discrimination, as he would have received a pension had he been a woman. The case went to law, and rose through the courts, eventually reaching the European Supreme Court, which found in favour of the unfortunate claimant, who had died before the case was settled.
This judgement meant that the UK’s state pension was illegal. Retirement ages needed to be equalised once again. This could have been done in any number of different ways. Men’s retirement could have been brought forward to age 60, or the two could have met anywhere in the middle. However, the Government decided on the least costly option for itself, which was to increase the women’s state retirement age to 65. The change was to be tapered between 2010 and 2020. Though this amendment was made necessary by EU law, it could nevertheless be seen as grossly unfair. It would be most painful for a woman born in 1960, who by 1995 could have been working for almost twenty years and paying National Insurance contributions towards a state pension at age 60, only to find that she would have to continue working and contributing for an extra five years, with no compensation at all. The same argument is being employed by the protestors in France today. As far as they are concerned, they have been promised a pension at age 62, only to find that two years are going to be taken away from them. Mr Macron’s government replies that everyone is living longer, the sums no longer add up and change is inevitable.
After losing five years off her state pension, a woman born in 1960 was in for a further shock. The ten-year taper was accelerated to finish in 2018, so that in 2020 the retirement age could be raised to 66 for men and women alike.
Our current government is ‘minded to commit’ to a principle that people should spend 32% of their adult lives (which for some reason is deemed to begin at age 20) in retirement, or more specifically, should receive a state pension for that period of time. This principle embodies the idea that the state retirement date should fluctuate in line with life expectancy. The Pension Act 2014 directed the Government to conduct a review of pension ages every five years. The pension age is due to rise again to 67 between 2026 and 2028. The 2017 review anticipated that the eligible age would need to rise to 68 between 2037 and 2039. The more recent 2022 review has moved that date back to between 2053-5.
The author of the 2022 report, Baroness Neville-Rolfe, concluded that the target period for receiving a state pension should be 31% (not 32%) of a person’s adult life, and that state spending on pensions should be capped at 6.0% of GDP (Gross Domestic Product – the national income).
For the time being, the authorities are deferring a decision, due to a number of complicating factors. Life expectancy has been steadily rising since Victorian times, but the upwards trend has flattened since around 2013. The gain in the decade to 2023 has been glacially slow, just 1.1% from 80.9 to 81.8 years, the slowest growth rate for at least a century. The causes aren’t fully understood. Deaths in the UK peaked at 681,000 in 1976, then fell steadily to a trough at 552,000 in 2011, before shooting back up to peak again at 690,000 in 2020. We know that Covid has killed 225,000 people in the last three years. That’s a big factor, but the low point was reached nine years before Covid reared its ugly head. The answers to some of these questions may be revealed when the 2021 census results are published.
Either the last decade was a blip in the longer trend, or something has permanently changed. If it’s the latter, then the state pension age may start to come back down.
Is the UK State Pension Scheme a Generous One?
No – UK government spending on the state pension scheme costs less as a proportion of the national income than you would find almost anywhere else. Some examples – Italy spends 15.6% of its national income on state pensions, Greece 15.5%, France 13.6%, Spain 10.9%, Japan 9.4%, Denmark 8.0%, Turkey 7.4%, US 7.0%, UK 5.6% and New Zealand 5.0%.
Looking at these numbers, it’s interesting to note Baroness Neville-Rolfe’s recommendation that pension spending should be capped at 6.0% of our national income, a figure which would keep us rooted among the lowest providers in the developed world. French activists are setting their cities on fire in protest against an increase in their pension starting age to an age two years below the UK’s existing level.
Does the UK State Pension Fulfil its Original Purpose as a Safety Net?
The married couple’s pension, just below £16,000 a year, is less than half the average earnings of £33,000 (2022). If each partner qualified for the maximum single pension in their own right, their combined income would be just below £21,000 a year, slightly below two-thirds of the income of an average single worker.
Anyone who doesn’t have enough qualifying years can receive the Pension Credit, which tops their earnings up to the state pension level. However, if they have savings above £10,000, the payment is slashed. The literature contains this astonishing statement ‘You’ll be treated as having £1 a week of income for every £500 above £10,000 of savings. An income of £52 a year from £500 equals an after-tax income of 10.4%. You have to wonder where such generous returns are available. Certainly not through investing in the UK government’s debt or in any of its savings products.
The State Earnings-Related Pensions Scheme (SERPS)
SERPS was the brainchild of Barbara Castle, Secretary of State for Health & Social Services in the Wilson/Callaghan government of 1974-9. It began in 1978 and was inherited by the Conservative government of Margaret Thatcher the following year.
SERPS was always an ambitious project. The basic pension, by now almost seventy years old, was seen as a safety net preventing older people from falling into poverty in retirement. SERPS would be the equivalent of the company schemes which were rapidly gaining in popularity, and would provide for anyone who wasn’t eligible for a company scheme. The more you earned, and the longer you were in the scheme, the bigger your eventual pension would be. The scheme was to be paid for in part by additional National Insurance contributions.
SERPS was a Final Salary Scheme, where benefits are linked directly to earnings, in contrast to the basic state pension, which gave the same flat payment to all.
It was also a Defined Benefit Scheme, where retirees are guaranteed to receive a pension based on their earnings and length of service. Where the money to pay that pension comes from is entirely the responsibility of the pension provider. The main difference between Government schemes (SERPS and the pensions of civil servants) and company defined benefit schemes, is that companies are required by law to build up a fund out of which to pay pensions and must obey any directions the scheme actuary gives them in order to ensure that the fund is able to meet all future liabilities. The Government, on the other hand, doesn’t have a separate pension fund, relying on future tax receipts to pay tomorrow’s pensions.
Members of their company pension schemes would contract out of SERPS. They paid the same NI contributions as SERPS participants, but the contributions went, not to the Government but to the company pension, which was obliged to pay its members a retirement income at least equivalent to what they would have received had they remained in SERPS.
The early years of a contributory pension scheme are a kind of honeymoon period, when all the members are contributing but there are no retirees. Cash flows in and stays in. As time goes on the number of pensioners steadily grows, and pensioners as they retire stop making contributions. Mrs Thatcher’s small state, low-tax, low-spend government looked on SERPS with horror. To make matters worse, life expectancy was increasing at a gallop during the 1980s. This was an albatross that needed shooting, they decided.
Some of the benefits of the scheme were quietly removed.
Then, in 1987, the government announced a scheme under which individual SERPS members could contract out, accepting a yearly payment into the personal pension of their choice. This initiative was advertised on national television with the striking image of a prisoner struggling free from heavy chains. The initial payment was around £2,500 for the two years 1987-8 and 1988-9. A nationwide scramble to collect the government’s largesse began.
I was involved in that ‘gold rush’ and remember it well, as I must have had the ‘contracting out’ conversation at least a thousand times. Of course, we advisers were motivated by self-interest. If our client contracted out we would be paid a small commission, and then have a sum of money to manage for a good long time. If our client stayed in SERPS, we would have nothing more than the satisfaction of having helped our client to the right decision (though we didn’t believe it was).
People needed little persuading. My line of argument went something like this – ‘you can look up some complex formula which will tell you what return you need on the contracting-out cash in order to match the SERPS pension – but it’s much simpler than that! If you take the money, it’s irretrievably yours to invest how you like with its value always visible. If it doesn’t perform well, you can always do something about it. The real risk of staying in is that by the time you come to retire SERPS may have vastly shrunk or disappeared altogether! SERPS is expensive for the state to run. The cost makes it tempting to cut it, and it’s easy to do because it’s so complex that no one will notice. This was true – I never came across a single person who could tell me what they were entitled to in SERPS.
Usually, people didn’t wait for the explanation to finish, they just wanted to sign the form and get out. Older members, within around ten years of retirement, were an exception. We normally advised them to stay in SERPS.
The outcome was more or less as I predicted. During the 90’s, the pruning of SERPS continued, unnoticed by press and public alike. The scheme was renamed the State Second Pension. Contracting-out rebates were gradually reduced. Finally, in 2016, the earnings-related pension was merged with the basic one. The higher NI contributions were not reduced.
Summary So Far
It’s universally agreed today that state pension provision is an essential element of a fair and peaceful society. However, the governments responsible for managing these schemes continually vacillate between the desire to provide adequately for their retirees and the fear that they won’t be able to afford it. The issue is clouded by constant fluctuations in the data, which make predictions of future costs an ever-moving target. Political considerations tend to muddy the waters as well.
The state second pension, an attempt to provide people who weren’t in company schemes with an earnings-related income in retirement, suffered a slow death which began almost from its inception. It is unlikely to be revived.
Governments must abide by the law, but they can also change it. They can grant us benefits and then remove them again without compensation, as we have seen repeatedly, perhaps most starkly in the case of the women’s retirement age. We have seen that state provision in this country is among the lowest in the developed world, despite our taxes being among the highest.
Will the UK’s state pension become more generous in the years ahead?
My guess is – no!
The main barrier to higher payments is the growing number of older people. Over the next twenty years, our population is forecast to grow by around four percent, from 67.33m to 70.1m, while the number of state pensioners is expected to grow by a whopping 36%, from 12.4m to 16.9m. Put differently, the number of pensioners as a proportion of the population will grow from 18% to 24%. The government has set aside no funds to meet this liability which will be met, as they always have been, on a pay as you-go basis. My generation paid for our parents’ pensions. Our children are now paying for ours, and their children will pay for theirs, only by then there will be a lot more mouths to feed. Without a large drop in life expectancy, the next generation’s burden will be the heaviest yet.
We don’t fully understand the impact of Covid on the government’s finances. Covid blew a massive hole in the national budget, through the cost of PPE, the furlough scheme, bounce-back loans, ‘Eat Out To Help Out’ and so forth. What isn’t known, or at least, hasn’t been announced, is the savings being made on the pensions of the mainly retired 225,000 people who are no longer with us.
It looks as if the state pension is going to become less rather than more affordable.
If the state pension were to be trimmed, the two most obvious ways to do so are:
A table on Wikipedia shows that there were two-and-a-half million millionaires in the UK last year – not far short of the three million people using food banks. If true, then we know that around one in sixteen adults is a millionaire. Reading the small print, it turns out that these millionaires are actually dollar millionaires, with financial assets of around £800,000 each.
However, we look at the figures, it’s clear that there is a significant cohort who could afford to live comfortably without a state pension, or with a reduced one. It isn’t clear why some kind of means-testing hasn’t already been introduced, other than a general commitment to the idea that the state pension is a universal benefit, available to all, and which all working people have paid for. On the other hand, the state pension was means-tested in its original form, and at a time of growing inequality, it gets harder to argue against some form of targeting.
The Triple Lock
The triple lock was a well-meaning introduction, aiming to protect the most vulnerable in society, but it may now itself be vulnerable. Looking at the effort it has taken for nurses to achieve salary increases which look unlikely to exceed 5%, it gets harder to justify a formula which hands retired people an increase of over 10% at the click of a mouse. You might argue that the nurses should receive 10%, rather than that the pensioners shouldn’t, but the comparison is an awkward one.
These comments are not based on any personal desire to see the state pension reduced, but on analysis of why future governments might feel pressure to reduce the costs of the scheme and how they might go about it.
May 9th, 2023
Please note, these views represent the opinions of Tony Yarrow and do not constitute investment advice. This document is not intended as a recommendation to invest in any particular asset class, security or strategy. The information provided is for educational purposes only and should not be relied upon as a recommendation to buy or sell securities. The value of investments can go down as well as up and you may not get back the amount originally invested. Wise Investment is authorised and regulated by the Financial Conduct Authority, number 230553.