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Philip Booth: Why contracting out of the state pension should remain

Philip Booth 2010 Professor Philip Booth is Editorial and Programme Director at the Institute of Economic Affairs.

The recently published Green Paper on pensions was widely welcomed. Indeed, it contained some reasonable ideas. However, it also contained a proposal to abolish contracting out of state pensions. This could lead to possibly the biggest tax increase in history as well as the reversal of one of the most important post-war privatisations.

The three reasonable proposals were identical to those in a paper published by the IEA: Sharing the burden - How the older generation should suffer its share of the cuts.

These proposals were:

  1. To move to a position where there is only one state pension.
  2. To retain the contributory principle. There are serious dangers in undermining the contributory principle yet further so this is welcome.
  3. To link the pension age to improvements in life expectancy with the government appointing an independent commission to make recommendations relating to pension age.

This third proposal is important.

Independent commissions should not make political decisions. However, if a political decision is taken to keep the pension age such that the expected time between state pension age and death remains constant, then the technical aspects of that question should be depoliticised. Essentially, we would have a new approach whereby the pension age was adjusted so that the government would pay a pension for a constant expected number of years. This "de-risks" the pension system to quite a degree. It also allows those saving for their retirement to buy bridging annuities between their desired retirement age and the state pension age if they wish.

So far, so good…

Unfortunately, it also appears that the government wishes to abolish contracting out of the state pension. The way the Green Paper is written, abolition is one of two proposals but, without question, it is the favoured proposal. No consideration at all is given to whether contracting out could remain whilst the three reforms above are implemented – it is just assumed that it will not be possible.

In my view free-market Conservative MPs should not let contracting out die without a big fight. “Sir Humphrey” and his ministers will tell them that it is not practical to keep it – they should not believe them.

Contracting out began in 1959 and was extended by Barbara Castle in a Labour government that included Tony Benn. It was then extended further in 1988. Contracting out was not responsible for any – or at least hardly any – of the mis-selling scandals of the late 1980s/early 1990s. The concept is simple. If you can demonstrate that you are making appropriate provision, you can have some of your national insurance contributions back and invest them yourself (or be a member of an invested pension plan that provides you with appropriate benefits).

Sadly, contracting out was emasculated by Gordon Brown who reduced the national insurance rebates relative to the value of the pension provided by the state to such an extent that financial advisers had to advise their clients to go back into the state system. In general, only members of defined benefit schemes – including public sector workers – remain contracted out. A lack of understanding of the concept combined with the disheartening of the Conservative Party as the concept came under attack from Gordon Brown has led the party to want to throw the baby out with the bath water.

The Conservative Party now wishes to turn its back on one of the most important privatisations anywhere in the world – one that even had to be accepted and extended by a cabinet in which Tony Benn sat. It is a principle that should be extended further to the rest of the welfare system.

How can contracting out be retained? It is simple. The new state pension could be divided in two – the same contribution rules, uprating rules and so on should be used for both halves. Everybody should accrue the first half of the pension in return for national insurance contributions. Anybody who wants to contract out from the second half and make their own private provision should be able to do so. It just requires a computer keystroke at an office in Newcastle. The rebate of national insurance contributions that would be paid to those contracting out should be actuarially neutral (which, in practice, would make it a lump sum varying with age) and should be available to all those who are accruing the state pension – including those who are getting credits instead of paying national insurance contributions. In other words, some people could pay “negative” national insurance contributions. Non-working women who are looking after children, for example, would be able to accumulate their own pension pot.

If we simply abolish contracting out it will amount to a £9 billion tax increase – possibly the biggest single tax increase in history – as individuals and employers pay more national insurance. We are also loading the next generation with yet more debts if we go down this route. Instead of people receiving a rebate of national insurance contributions and saving it in a pension pot, the money will go straight to the state for spending on current pensions – whilst the state will incur more future pension liabilities because people will no longer be contracted out of part of the state pension.

Contracting out may sound obscure but it is worth fighting for. Do the Conservative MPs in this government want to preside over the biggest tax increase in history and the reversal of one of the most important privatisation reforms ever? Or do they instead want to extend that reform, tidy up the loose ends and adapt it around a new state pension system? If Conservative MPs take the former route, they are completing Brown’s work and they might want to ask themselves why they entered politics.

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