When independence is achieved, Scotland will inherit the legacy of the UK pension system. This legacy consists of one of the lowest state pensions in the developed world and a heavy reliance on people having a second pension – either through workplace pension schemes or private personal pensions.
Retirement security in the UK has been seriously undermined by a combination of low state pensions and the virtual extinction of workplace defined benefit (DB) pensions, which have been replaced by workplace defined contribution (DC) schemes. DB pensions provide a second pension related to earnings and thus offer greater certainty of retirement income. DC pensions, however, depend upon the investment returns achieved on the savings built up during the years of paying contributions.
The challenge for any ambition to create an earnings-related pension system is to restore DB pensions along with the introduction of a State Earnings Related Pension (SERP) to replace the flat rate state pension inherited from the UK. DB pensions have largely disappeared from the private sector because employers are unable to provide the funding guarantees which underpin the promise of an earnings-related pension. DB schemes have often been closed because the investment risk is too heavy a burden on businesses.
Why DB pensions have disappeared
There are two simple underlying reasons for this. Employer sponsored DB schemes eventually reach a point where there are more pensioners than contributing employees. By this time, income from pension contributions has long ceased to provide sufficient cash flow to cover pension benefits and operating costs. So, as time goes by, reliance on investment returns grows and so do the risks borne by employers. Secondly, DB pension schemes close when companies fail, which means employer sponsored DB schemes face a longevity problem.
Restoration of DB pensions cannot be achieved by relying on employer sponsored schemes. The solution is to establish a new National Pension Fund (NPF) which is ultimately guaranteed by the Scottish state. Such a guarantee can be provided if Scotland has its own currency and, therefore, need not rely on borrowing on the money markets to finance public spending.
A National Pension Fund is different
A NPF would be open to all citizens. This means that the ratio of pensioners to workers is predictable as it is based on the demographics of the nation. This demographic predictability provides the foundation for a funding model in which the annual cash flow from pension contributions can be matched to the annual outflow of pension benefits. This is a “Pay as You Go” (PAYG) funding model.
The rate of contribution (C) can be calculated based on the desired level of pension relative to earnings – the “replacement rate” (R), and on the ratio of pensioners to workers in the economy (P/W).
Calculation of the PAYG contribution rate for a NPF
C=R x (P/W)
If the chosen R is 50% of earnings and there are three workers to every pensioner, the PAYG contribution rate (C) is as follows: C=R x (P/W) = 50% x 1/3 = 1/6 (16.7%). Contributions of 16.7%, split between all employers and all workers, will provide the cash flow to pay all pension benefits which fall due over the same period.
Establishing a NPF
The NPF would be established by law – in a similar way to how auto-enrolment and the UK NEST pension scheme were established by the Pensions Act 2008. NEST is one of several multi-employer collective defined contribution (CDC) schemes in the UK. It is a DC based scheme; the NPF will be a defined benefit, earnings-related scheme.
On the NPF launch date, all new employees joining the workforce after leaving full-time education, and their employers, will be required by law to contribute to the NPF. None of the first cohort will retire for 40 years or more; no pensions are drawn from the fund until then. The fund will grow quickly and exponentially, and will provide an important source of investment funds to support the Scottish economy by investing in businesses and infrastructure.
Here is a simple model to illustrate the potential size of the NPF.
70,000 new workers start employment each year over 40 years. Average earnings Scottish £20,000 per year, contribution rate 15%. After 40 years the fund will have grown to Scottish £172bn.
Option to transfer in
Once the NPF is established, existing workers could be offered the opportunity to transfer their currentsecond pension(s) into the NPF. There is a strong incentive for workers with DC pensions to transfer, as this will give them access to a DB pension when they retire. The value of the pension(s) transferred into the NPF would be converted into a credit for contributions.
Calculation of a contributions credit (K) based on the value of transferred pension fund(s) (V)
K=V/ (E x C)
EXAMPLE Pension transfer value is Scottish £45,000, Earnings (E) are Scottish £30,000 and the contribution rate (C) is 15%. The contributions credit would be 45,000/ (30,000 x 15%) = 45,000/4,500 = 10 years’ contributions.
If this person transferring into the NPF is aged 40, there are 25 years to retirement at age 65, so the final pension would be based on a total of 25 + 10 = 35 years of contributions.
State Earnings Related Pension (SERP)
The SERP is the other key element of the new system. This, plus the NPF earnings related pension, can be designed to deliver a total pension at any chosen replacement rate. If R was set at 90% of earnings the SERP could deliver 40% and the NPF 50%. The contribution of SERP and NPF to total pensions, and the replacement rate, are all a matter of choice based on public consultation.
While contributions into a NPF will be required, SERP can be non-contributory, and national insurance contributions (NICs) abolished. This reduction in overall taxation can be compensated elsewhere in the tax system. One possible option would be to abolish tax relief on pension contributions. However, the detailed design of a future Scottish taxation system is a separate subject.
How the UK state pension can be integrated
This leaves the issue of existing UK state pension rights. First, the Scottish Government would take over the responsibility for payment of UK state pensions already being made to retired workers. For those still working, they will have accrued rights to part of the UK state pension based on the number of years of paying NICs. This group can be offered three options.
One is to convert their UK NICs into entitlement to the new SERP and transfer in their second pension(s) into the NPF – e.g. 20 years paying NICs can be converted into 20 years’ entitlement to a SERP; future years are accrued in SERP. Future entitlement to the SERP is then credited based on the years of contributions into the NPF – meaning that SERP is a non-contributory state pension scheme.
The second option is to retain the accrued UK pension entitlement and existing second pension(s) and continue to contribute for a flat rate Scottish pension based on the same contribution rate as for the NPF. Contributions would need to continue in order to maintain any existing second pension(s). This is in effect an opt out of the SERP/NPF based earnings-related pension system.
Finally, there is a hybrid option, which is to keep the accrued UK state pension but transfer second pension(s) into the NPF, pay NPF contributions and earn future years’ entitlement to a partial SERP.
There will be a transition period
The NPF outlined here will not reach full maturity for 40 years (or perhaps a little later), as the membership will consist of a mix of auto-enrolled workers and others who have opted in. After 40 years, all the membership will have been auto enrolled; the NPF will have become a universal pension scheme open to all citizens. The future ratio of pensioner members to working members can then be more reliably predicted, based on national demographic data. The final article will discuss a range of issues relating to the transition period and how the pension system might evolve towards its final form. Before that, the next articles will outline the structure of the NPF funds, how they will invest and what the operating and governance structures might look like.
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