Today's announcement by Iain Duncan Smith that there will be a simple state pension of £140 for all has been widely welcomed. Indeed, the proposals look a little like the proposals first made in the IEA's publication The Way Out of the Pensions Quagmire in 2005. But the devil is in the detail. In short, the important question is whether these proposals are a manifestation of IDS's desire to make people less welfare dependent or whether they are a manifestation of Steve Webb's long-held view that people should receive a citizens' pension from the state regardless of national insurance contribution record. I suspect they will turn out to be a strange amalgam of the two. Let us take the key issues one by one.
1. It makes sense for the state to combine together the two state pensions that currently have different accrual rules, different indexation rules and different rules for credits for carers. The current system is incomprehensible to most people.
2. This proposal has been floated as a boon for stay-at-home women. This argument is bogus. The idea is suggested that women who look after children are currently disadvantaged because they cannot make national insurance contributions. This is completely incorrect. It is true that, from 1979 until 2010, the system for giving credits to carers for state pension was very complicated and incomplete. That problem (if it was a problem) is now resolved. All women looking after children at home get credits to the state pension as if they had paid national insurance contributions. There may be some people who suffer because of the legacy of past rules but nobody can complain about the set of rules that now exists for basic state pension credits (and, as noted above, it makes sense to remove the distinction between the basic state pension and the second state pension with regard to these credits).
3. But why should the pension remain on a contributory basis? The first reason why it is useful to keep the state pension on a contributory basis is because it at least holds on (however tenuously) to the concept that the government is providing a benefit in return for contributions - in other words that we have a nationalised insurance system rather than a welfare system. Individuals and schemes should then be allowed to contract out of this nationalised system and have some refund of their contributions. Contracting out was brought into disrepute by governments reducing the rebates people received and, sadly, contracting out for individuals is in the process of being abolished. However, the principle is very sound - indeed it is very important. My fear is that these proposals - even if a contributory mechanism is kept - will also involve abolishing contracting out for all occupational pension schemes. Ross Altman, a pensions campaigner and CEO of Saga, has long been proposing this and politicians have welcomed the idea of abolishing contracting out. It is not surprising that politicians welcome it because the abolition of contracting out and the use of the national insurance rebates that no longer have to be paid by the Treasury to pay current pensions essentially involves a fraud on the next generation. The government will be taking, and using for current expenditure, national insurance contributions that it currently refunds to pension schemes so that those schemes can make long-term funded provision for their members. Furthermore, the government, if it abolishes contracting out, will be taking on higher future pension liabilities (because people will not be allowed to contract out of the state system and so they will receive the full national insurance pension) which are a charge on future generations. It is not surprising to see governments wanting to load still further burdens on future generations and rake in more money today.
4. The second reason why it is useful to keep the state pension on a contributory basis is that it is dangerous to have a pension that is decided by the whim of parliament today. It would be better to ensure that, when a year's national insurance contributions are made, they entitle the payer to a particular pension indexed according to a pre-defined index. Contributors are then making the sacrifice today in the form of a national insurance contribution for a pension that is also defined today. However imperfect this may be compared with private and funded provision, it is a whole lot better than having parliament (which will be increasingly influenced by the voting behaviour of older voters) decide on the level of the pension at any time.
5. We also need to know what is to happen to the state pension age. Currently, state pension age is rising much more slowly than life expecation at retirement. If the government is to provide pensions at all it needs to do what it can to 'derisk' the state pension system for future generations. Of course, governments do not care too much about such things - the costs, after all, are always left to another generation of taxpayers. My own view is that the pension age should rise with life expectation at retirement and do so automatically, unless parliament votes specifically to overrule this. Such an approach would reduce longevity risk for future generations but also lead to the creation of a strong incentive for individuals to save to bridge the gap between their desired retirement age and state pension age.