In search of security: earnings-related pensions in Britain and Europe

Noel Whiteside | 01 May 2003

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Executive Summary

• Many European states now face public-expenditure problems due to political opposition to restructuring their generous earnings-related pension schemes. This crisis is different to the one found in the UK where rising public expenditure is likely to be brought about by mass pensioner poverty leading to means-tested supplementation.
• Current British policy promoting voluntary funded pensions has been in place since the 1950s, but numbers with inadequate cover today are the same as in the 1960s.
• This is partly because current voluntary provision in Britain is inequitable. It offers far less security than its continental equivalents to the contributor who changes jobs, whose firm merges or goes bankrupt, or whose pension provider fails.
• Moreover, recent UK regulation of private pension providers only distorts market signals, burdens industry and the financial services sector, and obscures lines of public accountability.
• The British approach was originally intended to advance private investment in domestic enterprise but, in contrast to European experience, it has not served this objective because funds have been invested overseas.
• Dutch and French private, earnings-related pensions offer more sophisticated examples of public-private partnership than those found in the UK: pooled resources sustain pension rates while governance of private schemes involving representatives of the insured promotes equitable solutions to financial problems.

Introduction

British pensions are in a sorry state. Pensions for the post-war baby boom generation, soon to move into retirement, are looking increasingly insecure. Prospects for later generations are little better. The problem is worst for women, whose longer lives and interrupted careers mean lower savings and a greater threat of poverty in later life. Yet demographic change (increased life expectancy and shrinking birth cohorts) is putting enormous pressure on the future of our pensions system: pressures further compounded by the recent severe downturn in global financial markets.

Pensions and pension policies are highly complex topics. Today, there are six different state pension schemes in Britain, excluding tax advantages offered to occupational pension schemes and personal pension plans. Few non-specialists can name them all. The examination of earnings-related provision requires our understanding the relative merits of defined benefit and defined contribution plans, of individual and collective protection, of the difference between funded and PAYG [Pay As You Go] schemes and the different degrees of security offered by each. It is deeply confusing territory. Feeling insecure and uncertain, the population hesitates before the wide choice of commercial financial products that promise a decent income in old age. Hence the much-publicised 'savings gap' that, we are informed, is undermining future pensions.

One thing is sure: the present government does not intend to revive the universal PAYG state pension introduced in Britain after the Second World War. For many years, policy has aimed to reduce public liabilities and to raise private provision, cutting back the welfare state. Yet what has been gained in public expenditure savings has been bought at the price of security. Corporate malfeasance (Maxwell and the Mirror Group scandal) and mismanagement (Equitable Life) have corroded public trust in private commercial solutions. Faced by the political risk that future taxpayers will refuse to fund pensions, and the economic risk that pension providers will fail to deliver, the citizen stands paralysed. Loath to endorse compulsion, New Labour has tried to win confidence and simplify the market by subsidising customer-friendly pension and savings products - the Stakeholder pension being a prominent example. This policy has not met with notable success, yet more legislation is promised along the same lines.

As is widely acknowledged, the pension problem is not confined to the UK. Some EU member states are apparently in an even worse mess. However, the nature of the problem over the Channel is quite different. There, the pension issue is a public-expenditure problem, for earnings-related pension provision is guaranteed by law. And compared to Britain, these are very generous pensions that provide up to 70% of previous salary. Their popularity reinforces opposition to reforms that cut state guarantees: witness the strikes in May 2003 that paralysed the French public sector.

We might want to understand why British pension policy has diverged so strongly from that of our continental neighbours. It was not always so. In the mid-twentieth century, all European states, including Britain, offered mixed schemes of pension protection: special schemes for public-sector workers, pensions for everyone else based on citizenship or social insurance, and various supplementary, earnings-related schemes run by major firms or professional associations. With the advent of state responsibility for universal pensions after the Second World War, some governments came to view earnings-related pensions as the means to secure higher pensions for all. By the early 1970s, a variety of earnings-related schemes were extended and consolidated by governments in many parts of Europe, but in Britain this never happened. Quite why is the subject of the account offered below.

The European pension panic in the 1960s

After the Second World War, universal social protection became a central component of public policy all over Europe. In Britain, the post-war Labour government implemented the famous Beveridge Report. Universal social security, including contributory pension schemes, was established in France and Germany, while Sweden and the Netherlands created tax-funded citizens' pensions. In some respects, developed European economies faced similar challenges when confronting the pension problem when the war ended. First, most already possessed some form of state pension scheme for the working classes, but the value of pre-war schemes had been undermined by inflation during and after the conflict. At the same time, the demands of post-war reconstruction had to take priority over wages and welfare benefits. Hence post-war basic state pensions were low. Second, as in Britain, occupational pensions, offered by employers in both private and public sectors, were widespread. These could be quite generous, particularly for skilled or white-collar workers. Earnings-related pensions expanded at this time: competition for skilled labour was fierce thanks to wartime and post-war labour shortages, and generous pension schemes helped to attract and retain key employees. In many respects, national governments after the war were faced with a fait accompli. It was not politically possible to write off established professional or occupational pension rights, so it became imperative to work around them.

However, as prosperity returned, it became apparent that not all were sharing in its benefits. Pensioners in particular were losing out: enquiries from the late 1950s rediscovered poverty among the elderly, poverty that state welfare was supposed to have eliminated. Pressure from the left then promoted change. In Germany, a state-run system of earnings-related pensions was introduced in 1957. All employers paid the higher contributions required by the new state scheme, but the German government continued to encourage firms to offer their own pensions as well. Unlike the UK equivalent, German occupational schemes operated on a book-reserve model: employees' contributions were retained as internal investment within the firm, thus providing a valuable source of reconstruction finance. Here, earnings-related state and earnings-related occupational pensions existed side by side. In Sweden, the desire to supplement existing citizenship pensions stimulated prolonged debate in the late 1950s about who should run a supplementary scheme - employers or the state? Eventually, a state-run earnings-related pension scheme was introduced in 1960. This was similar to the German model, but was centrally administered and offered greater redistribution from rich to poor. Although both these state schemes were ostensibly PAYG, surplus contributions were initially used to fund industrial infrastructure. Indeed, the contributions to the Swedish scheme enabled earnings-related pensions to be paid from interest earned by the investment of state reserves well into the 1980s.

In the Netherlands, by the early 1950s, private, occupational, earnings-related, funded pensions - many amalgamated in sectoral funds to cover specified industries and employments - were expanding rapidly. The government wished to encourage these schemes, to supplement the state citizenship pension. The accumulating funds, paid for by sponsoring firms and subscribing workers, were invested internally in the Dutch economy until the early 1990s. The continuous extension of what was ostensibly private provision pooled risk within sectors while investment growth offered higher pension rates to an ever-growing proportion of the working population. A similar strategy - raising pension rates by extending occupational schemes - was also adopted in France. In 1963, a national collective agreement between employers and unions universalised compulsory earnings-related complementary pensions in the private sector; this covered the whole working population by the early 1970s. Unlike the Dutch scheme, however, the French complementary pension scheme was not funded, and ran on a PAYG basis - although one year's invested contributions were retained as 'reserves'.

These European schemes varied very widely. They held, however, some significant features in common. First, all used contributions (through either public or private agency) to manage domestic demand and to secure internal investment in some form: even the French scheme held reserves that were employed in this way. Second, all were managed by representatives of employers and workers - with the state in the German and Swedish schemes forming a third party. German private company pension funds were also subject to joint management. Pension contributions were widely viewed as deferred salary: as owners of these funds, workers had a right to determine how they were invested and to manage claims - both as contributors and as future pensioners. Representation by the interested parties fostered confidence in each scheme's operation.

Finally, all complementary earnings-related pension schemes offered substantial improvements in old-age income security. In Sweden and Germany the state ran and underwrote their operation. In the Netherlands and France legislative enactment underpinned industrial agreements: both schemes were essentially private with funds belonging to the social partners, but the security of each individual contributor was guaranteed. Should the worker change job or should an employer go bankrupt or merge with another business, pooled risk guaranteed that previous pension contributions and future old-age security would not be forfeit. Hence proper pensions could be offered to all, without impeding labour mobility, while accommodating industrial mergers and acquisitions. This helped promote public confidence. Thus throughout Europe security for the contributor was promoted and confidence in the systems assured: a necessary adjunct to popular participation in and support for the new pension regimes.

The British response

In the early 1950s, British pension provision bore some resemblance to the systems found across the Channel. Funded by National Insurance Contributions, social insurance offered a low, flat-rate basic pension. Then, as now, this was below subsistence and contributors without other resources 'topped up' with means-tested National Assistance. A growing proportion of the middle-class population supplemented state provision through private occupational pensions and a variety of funded and tax-sponsored public-sector schemes. In spite of pensioner poverty, the Treasury sought to reduce the tax-payer's contribution to social insurance.

The incipient introduction of universal earnings-related pensions in Germany provoked political debate in the UK: the left claimed that the British welfare state was 'falling behind' and the Conservative government was failing to act. The Labour Party proposed a National Superannuation Scheme following a plan drawn up by Professor Richard Titmuss at the London School of Economics. Included in the manifesto for the 1959 General Election, this promised to create a national funded pension scheme, offering compulsory, earnings-related supplementary pensions for all workers. A national superannuation fund would be invested in equities under state management. The Conservative government knew that demographic change and inflationary pressure were due to double state expenditure on pensions between 1960 and 1970, just as Exchequer contributions to National Insurance were being cut from 33% to 14%. So new legislation on the eve of the 1959 election introduced a graduated state pension, with earnings-related contributions securing a higher pension on retirement. As the aim was less to raise pensions than to increase revenues to shore up future National Insurance Fund balances, contributions raised were well in excess of earnings-related pensions paid. In fact the main object was to shift pension costs onto the private sector by encouraging occupational schemes to expand: any employer who could promise an equivalent pension to the state scheme could contract out of the additional earnings-related contribution. Thus, by offering financial incentives for employers to abandon the state scheme, the new British scheme was quite unlike its German or Swedish equivalents.

As inflation swiftly eroded the value of the new Conservative pension, reform remained on the cards following the 1964 election. However, opposition to Labour's original plan for universal funded superannuation proved very strong. Obviously major employers and the financial services industry were against such a proposal: it threatened their business. More surprisingly perhaps, the Trades Union Congress (TUC) wanted a higher basic state pension not earnings-related provision. In the years of voluntary (and later statutory) incomes policies in the 1950s and 1960s, trade unions negotiated higher occupational pensions in partial compensation for wage restraint. This was particularly true in the nationalised industries, where official policy to hold back wage demands had been more strictly observed. The TUC did not want gains secured by industrial bargaining negated by the extension of equivalent pension rights to everyone. As a result, the incoming Labour government decided to retain contracting out. However, the most persistent opposition to Labour's proposals was within Whitehall itself. Treasury criticism was both virulent and effective; it delayed legislation for several years. In the event, the National Superannuation Bill, by this stage sponsored by Richard Crossman, fell when Harold Wilson brought the general election forward from the autumn to the summer of 1970 when the Bill was barely through its committee stage.

The objections of the Treasury to a state-run funded pension scheme were copious. First and foremost, this was 'nationalisation by the back door'. Of course this was Labour's intention: the object being to increase state influence over industrial policy by raising levels of public investment in British industry. This represented the opposite political trajectory to the one promoted by the previous Conservative government, whose efforts to privatise pensions had received strong Treasury support. Second, the superior transferability and the index-linking of Labour's pensions would make the provision of equivalent protection more difficult for private employers; contracting out would diminish and private schemes would disappear. This would displace private investment and undermine London's capital markets, potentially damaging industrial modernisation. Third, the scheme would raise National Insurance Contributions which, the Treasury argued, would stimulate inflationary wage demands, raise production costs, damage exports, upset the balance of payments and thus threaten sterling's position on international financial markets.

Finally, there were unanswered questions associated with the proposed National Superannuation Fund's investment. Such a vast sum was sure to upset equity prices, which would be inflated, forcing the rate of gilt-edged up, thereby raising the cost of government borrowing for future expenditure on Labour's other projects - new universities, road building and general modernisation. It would also set an unfortunate example: ' ... if government is going to join the rush to get out of gilt-edged' one Treasury official commented dryly ' it is difficult to see who can be expected to stay in'. If, on the other hand, this new fund were to be invested in government securities, then in time its future obligations would become another additional burden on the public accounts. As public expenditure constraints tightened pending the sterling crisis of 1967, the problems involved in such a venture were resistible, particularly as the new scheme would benefit the better off more than the very poor. Under the circumstances, the Treasury preferred the TUC solution: following the 1966 General Election, social security benefits for long-term claimants and the state pension were raised, thereby tackling the issue of old age poverty without moving Britain down the path followed by other European states.

In the absence of new legislation, the 1959 Act bedded down. Encouraged to contract out, employers extended their private occupational schemes, which covered nearly 50% of all workers by 1967. Unlike today, the Treasury proved very reluctant to impose any regulatory controls over their management: such intervention, it was claimed, might discourage employers from creating or sustaining them. Regulation would drive out private provision. Hence the obligations imposed on employers remained light. In 1960 only 50% of occupational schemes were insured. Many were very small: 75% of the 40,000 private schemes in existence had fewer than 50 members. Index-linking was not obligatory, nor was cover for widows. However, the advantages of these schemes lay not with the numbers they covered but with the funds they provided for the financial service sector. By the mid-1960s, annual contributions under private schemes offered significant sums for internal investment and underpinned the burgeoning London market for financial products and services. Retirement security was based on a virtually unfettered private sphere. Overseas commentators admired the way Britain provided indirect public subsidies for pensions that funded economic investment. However, the small size of many occupational schemes (and their consequent vulnerability), their failure to cover blue-collar workers outside the public sector and the penalties incurred by those who changed jobs were widely regarded as major weaknesses. In contrast to European alternatives, security for future pensioners came well down the list of policy priorities in Britain.

This position only changed with the advent of the State Earnings Related Pension Scheme in the following decade. On the return of Labour to power in 1974, Barbara Castle dusted down Crossman's old scheme and, while retaining contracting out, extended pension security by underwriting occupational schemes against inflation and collapse while introducing the first universal earnings-related pension. This experiment was short-lived: rising inflation increased state liabilities and, in 1986, the new scheme was cut back. At the same time, financial incentives to take out a personal pension were introduced for individuals who chose to contract out of the state scheme. Ever since, both Conservative and Labour governments have used all means in their power to persuade the public of the merits of private protection. Clearly, however, rather than interpreting this as a recent privatisation initiative, we should see it as a reversion to a well-established policy strategy.

Conclusion

For many European countries, current pension problems have translated, in varied ways, into problems of public funding. These problems have been made worse by the large numbers taking early retirement during industrial restructuring in the 1980s and the demands of European Monetary Union, which place severe constraints on state expenditure. Popular support for established schemes conflict directly with the strictures set by the European Stability and Growth Pact creating particularly difficult problems in Germany - where recent reform to introduce voluntary personal funded pensions, similar to Britain's Stakeholder, have encountered widespread public disinterest and non-participation. In France, where the main problem lies in cutting back tax-funded pensions for public-sector workers (who have their own separate schemes), powerful trade-union opposition prevented the previous Jospin government tackling the question. The succeeding right-wing Raffarin administration proposes new reforms and is provoking a similar militant reaction.

Forecasts detailing future public liability for pension expenditure make Britain's position appear exemplary. On paper at least, British government will be spending far less on pension provision than its European neighbours. As recently as 1994 the World Bank praised British policy on this account and suggested that it offered an example for others to follow.

Behind the statistics, however, another story is emerging. British governments have made every effort to raise public faith in personal pensions, but new regulations to safeguard marketing strategies and to secure consumer participation, enforced by the most powerful regulator in Britain, are failing in their objective. Levels of savings remain insufficient for future pension requirements. Public confidence, already undermined by financial scandal and evidence of gross mismanagement, has been further hit by the worst global financial depression since the 1930s. As the middle classes observe the consequent decline of their financial investments, so the attraction of state-sponsored private pension products dwindles. The prospect of future mass pensioner poverty looms.

Historical and comparative perspectives offer three broad conclusions. First, official support in Britain for private earnings-related pensions was justified in the 1960s in terms of the advantages offered to inward investment and Britain's industrial modernisation. However, in contrast to other European economies like Germany, British industry has not so much modernised as disappeared in the intervening years. Private pension finance has, particularly since the 1980s, instead been vested in global financial markets, largely in equities. The returns have been astounding and some pensioners have benefited, but this strategy has not done much for British manufacturing. In contrast, Swedish, German and French pension funds and reserves were used for internal investment; even the Dutch only transferred their substantial funds to global equity markets in the early 1990s. How far the promotion of private funded pensions has worked in Britain's general economic interests is therefore open to question.

Second, as adequate voluntary private pension cover peaked in Britain in 1967 (and has hovered somewhere below 50% ever since), it is high time that the government abandoned policies premised on its expansion. In the absence of security, public participation in a voluntary pension market remains low. Efforts to promote security by increasing state regulation raise costs, reduce market transparency and confuse the financial services industry and its customers. Faced with growing financial obligations, British firms are freezing - or closing - occupational pensions, or are transforming them from schemes guaranteeing a proportion of salary on retirement into schemes offering only a market return on accumulating individual contributions. Greater state regulation has added to corporate financial burdens while failing to win back public confidence. As the Treasury argued in the 1960s, it discourages employers from offering occupational pensions in the first place.

Finally, as the examples of both the Dutch and the French private sectors illustrate, it is possible to harness private occupational provision to future pension security, while also raising public confidence by guaranteeing public accountability. Although Dutch pensions have been damaged by recent downturns on global financial markets, the system of pooling funds and collective management allows future pension adjustments to be equitably negotiated between the interested parties. In similar vein, when Prime Minister Balladur encouraged the reform of complementary pensions in the French private sector in 1993, joint negotiations permitted the creation of a solution acceptable to all sides. Equity is conspicuously absent from the present British system. Whether due to fund mismanagement, market failure or entrepreneurial bankruptcy, the diminution (or even disappearance) of pension funds leaves the membership stranded. It is a lottery; no protection exists for the worker in middle life whose pension savings suddenly dwindle in value. Nor can state regulation offer protection. It is not possible to warn the public of potential financial failure without hastening the exodus of investors, thereby rendering a bad position worse, to the detriment of all concerned.

What is striking about the contrast between British and continental pension systems is the strength of the public-private divide that pertains to the Anglo-Saxon world. The Netherlands and France offer different models of a public-private partnership, both infinitely simpler and more transparent than the regulatory confusion that currently confounds both purchaser and provider in the British pension market. If New Labour wants to create a Third Way, it could do worse than look to continental Europe for models that demonstrate how this might work. For nearly 40 years, British governments have tried unsuccessfully to find a commercial solution to the pension crisis. Continuing failure guarantees that increasing numbers of elderly will resort to means-tested supplements, thereby raising public expenditure and contradicting the original object of the exercise, which was to contain them. A new approach is needed and very soon.

The author wishes to thank the ESRC under the Future of Governance Programme and Zurich Financial Services for funding the research on which this paper is based.

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• Whiteside, Noel
• Public services and social policy

About the author

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Noel Whiteside is Professor of Comparative Public Policy at Warwick University and Zurich Financial Services Fellow. She writes on pension policy in historical and comparative perspective, research funded by the ESRC Future of Governance Programme and Zurich. Her co-edited book Pension Futures in the Twenty-First Century: Redrawing the Public-Private Divide will be published by Oxford University Press in the autumn of 2003. n.whiteside@warwick.ac.uk.

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