TCS Daily


Social Security's Battle of Britain

By Tim Worstall - January 24, 2005 12:00 AM

Ah, what joy! The good Professor Krugman returns to the fray on the subject of the British pension system and its relevance to the debate over Social Security reform in the United States. How could any self respecting hack who had written on his last, um, exposure of the system fail to respond?

His article draws heavily on a piece by Norma Cohen, by her day job the pensions expert at the Financial Times in London, here presenting her views at the American Prospect. I have no particular problems with Ms Cohen's piece as, after all, I am the person who both predicted and welcomes greater, not lesser, bias in media viewpoints. I disagree with her tone, with many of her implicit conclusions, think she has glossed over certain important points and failed to draw the appropriate conclusions; yet despite all that I think it is a very fine piece of political and partisan polemic. Just about all the necessary information is there, few facts are left out or mis-stated, yet the reader is driven to one preferred conclusion, which is what polemical writing is all about after all. I'm also not surprised at the general tone or direction of the article... I'm not convinced that anyone reads American Prospect for their paeans and encomiums to the joys of laissez-faire capitalism.

There is the occasional minor solecism (it's Lord Lawson, not Sir Nigel; "contracting out" always existed in the SERPS system, it was not introduced in 1986) but it is the interpretation of all of these facts that I want to argue with.

        "A conservative government sweeps to power for a second term. It views 
        its victory as a mandate to slash the role of the state. In its first term, 
        this policy objective was met by cutting taxes for the wealthy."

Well, yes, I suppose you could put it that way. I would rather prefer to put it that tax rates for the wealthy were slashed, as were tax rates for the lower paid. Consider, in 1979 the top rate of income tax was 83%, with a 15% surcharge for unearned income. Yes, seriously, the bright sparks running the UK in the '60's and '70's really thought that was a good way to raise money, encourage investment, dynamism and all those other things we want in an economy, make absolutely certain that the rich, those with the money to invest, have no incentive whatsoever to do so. (It was actually worse than that, one of Roy Jenkins' budgets raised that top rate on investment income to 130% retro-actively. You were guaranteed a loss on whatever you had invested in the last year without even the opportunity of not investing. Woy, as he was affectionately known, went on to be President of the European Commission which might explain a few attitudes there.)

Those rates were cut and of course, as Arthur Laffer pointed out on his napkin, the amount of tax collected rose and the amount paid by those wealthy also rose. (Actually, I've just committed the same error as Ms. Cohen. Wealth is a stock, income is a flow, but we all know what her rhetorical flourish is about, them, and the changes that were made meant that they paid more in actual, y'know, money, the stuff that can be used to pay for the exigencies of Government.)

I was also a little surprised to see an article of this length that did not mention the actual beginning of our State Pension System, the 1908 Old Age Pensions Act. Rather she concentrates on the second tier of it, the so called SERPS:

        "This legislation established a new and more generous second tier of the 
        basic state pension, which was to be known as SERPS (State Earnings-
        Related Pension Scheme) and which promised to deliver every worker 
        an additional pension, over and above the basic-level pension and equal to 
        a percentage of the average of his or her best 25 years of wages.

        [...]

        "Thus was established the principle of 'contracting out,' the British 
        term for allowing citizens to divert money from state schemes and to 
        invest instead in private plans -- the term of art, in other words, for 
        privatization. The practice was finally put into place in force with a piece 
        of legislation that passed in 1986."

This sounds like a reasonable history but when one looks at the report of the Pension Commission we find that this is not quite accurate. For:

        "The option of contracting-out into occupational schemes provided 
        by employers existed from the beginning of SERPS, but it was expanded 
        in 1987 to allow individuals to opt-out into Approved Personal Pensions."

And that is a little nugget that surprised me. It has always been possible for SERPS contributions to go into private pension plans. We cannot really talk about the whole process, that which started in 1986/7 as privatization at all, for private options were always available. Interesting, no? There is also a great deal made of the "mis-selling scandal" which followed this opt-out to Approved Personal Pensions:

        "The public outcry over the 'mis-selling' scandal forced the government 
        to act. It established a review panel and ordered that all those who had 
        been made worse off by taking out a personal pension be 
        compensated by the seller. Over the next eight years, roughly 1.7 million 
        people sought and received compensation that ultimately cost the 
        insurance industry £12 billion. In addition, hundreds of millions were paid 
        out in fines and penalties. It was the biggest financial scandal in the United 
        Kingdom to date
."

Now while it is not expressly stated the implication is of course that those who opted out of SERPS had in some way lost that 12 billion quid (around $20 billion), that it was the very fact of opting out that lost them the money. This isn't exactly true as is noted but not enlarged upon a little earlier:

        "Worst of all, many workers left good occupational plans and faced 
        being worse off, not better off, in retirement by depending on the 
        privatized schemes
."

That was the mis-selling scandal, not the opt-out from SERPS. That a hungry commission-only sales force from the pensions industry fanned out across the country and in their eagerness sold not just the opt-out plans but also convinced a good number of financial illiterates to leave extremely good defined benefit schemes to join these new defined contribution ones. Sheer idiocy on everyone's part but very little to do with whether private pension plans are better than state ones. I'll agree that the change gave the opportunity to the less than ethical but to say it proves the invalidity of the basic idea is absurd. One might as well state that the existence of Henry Blodgett proves that this internet thingamajig will never work (anyone want to explain that to Jeff Bezos or Sergey Brin?). One might also note the comments about changing the basic State Pension from wage indexing to price indexing:

        "So the Tories' very first budget, passed by Parliament in 1979, included 
        a fateful change in the formula for basic state pensions. For years 
        before that, state pensions had risen in line with wages; but the 1979 
        budget decreed that in the future, they would rise in line with inflation."

Which rather goes to show that perhaps putting your trust in Governments is not the solution either. Before we go onto discuss Professor Krugman's comments on the subject, just a few more nuggets (yes, I know, long articles on pensions are so boring, but I promise some fun later).

        "As a result, the basic state pension in the United Kingdom -- the equivalent 
        of U.S. Social Security"

Now isn't that an interesting comment? The Basic State Pension is the equivalent of US Social Security, meaning that all of the above about SERPS, opting out and the rest does not apply to SS, as, in fact, they're not the same thing. There is also throughout the piece a hankering after, a sense that there was some paradise of past pension provision that was good, the impression given that company provided defined benefit ones were the best. That they had their problems is admitted :

        "For employers in certain industries such as retailing and banking, dependent 
        on large numbers of relatively low-wage workers in a labor-restricted 
        economy, pensions were a low-cost insurance policy against high staff 
        turnover that could drive up wage bills. The system was, to be sure, 
        complex and not without its inequities. But it was not in crisis."

"Not without its inequities" is to my mind a rather mild description. From the Pensions Commission report:

        "Indeed while DB schemes deliver significant advantages for many 
        people, and while their decline is resulting in both a decline in 
        generosity and a shift in risk to individuals (discussed later in this chapter), 
        it is important to note that DB final salary schemes have always entailed 
        a significant redistribution from low earners to high earners."

No, this really isn't what we want from a pension system now is it, the poor subsidizing the rich?

The final word on the whole problem is spot on:

        "The Pensions Commission recently completed the most 
        comprehensive review ever of the U.K. system and concluded that there 
        are only four possible solutions for the difficulties ahead: cutting state 
        retirement benefits, increasing taxes, increasing savings, or delaying 
        retirement."

Well, yes, isn't that where we came in? Isn't this one of the very things under discussion? Trying to increase savings by increasing the income that some of those savings earn? Quite the most remarkable thing about Ms Cohen's screed is that she manages to get through all those words without mentioning that taxes have been raised recently in the UK. Unfortunately the tax that was raised was on pension savings. Gordon Brown, our seemingly permanent Chancellor of the Exchequer, decided to remove the tax privileges that pension plans (whether defined benefit or contribution, private, personal, or corporate) got on dividend income. Whereas before this bright idea, dividends going into pension savings received back the tax that had already been paid on them. This no longer happens, meaning a 5 billion pound cut in annual incomes to pension plans. Something one might think should be mentioned, eh? Might have a minor effect on how well people are providing for their retirement you might think?

Quite the most enjoyable line is this one:

        "They were slowing the rate of growth in pension increases, because 
        in the United Kingdom, wages have historically risen by 1.5 
        percentage points to 2 percentage points ahead of inflation each year. 
        (Wages rise ahead of inflation in America as well.)"

Pardon? Wages rise faster than inflation? Well, doesn't that put something of a hole in the left's standard rhetoric? That the average worker is always falling behind? That Joe Six-Pack can never get ahead as his wages don't rise as fast as prices? Who'd a thunk it? 50% of Bob Herbert's and the EPI's output for the past few years made redundant by one little line.

As Professor Krugman quotes both Ms. Cohen and the Pensions Commission report I'll assume that he's read both (you can too if you wish but I suggest concentrating on the Executive Summary and Chapter 3 of the 350 page odd report) and armed with the above we can now have a look at what he says:

        "Strong words, but her conclusions match those expressed more discreetly 
        in a recent report by Britain's Pensions Commission, which warns that at 
        least 75 percent of those with private investment accounts will not have 
        enough savings to provide 'adequate pensions.'"

Indeed, as above, that's exactly what we're all talking about. How do we raise savings rates? Although quite how this is connected with privatization is beyond me. For again, as above, we could argue that no privatization has happened at all, the Basic State pension is still there, SERPS always contained the option of opting-out. But let's allow this point and move on:

        "Britain's system was backed by extensive assets, so the 
        government didn't have to engage in a four-decade borrowing spree to 
        finance the creation of private accounts."

The mind boggles. Have we actually been looking at the same source documents? The extensive assets were the extensive private assets in private pension funds. What has this to do with government borrowing? The State pension schemes (both Basic and SERPS) being pay as you go systems, were entirely unfunded. The Commission report makes this entirely clear. (Although it does not mention one of the side effects of bringing in a new such scheme in the late 1970's. Such systems are cash flow positive in their early decades and in 1976 the UK had gone cap in hand to the IMF for an emergency loan. One doesn't have to be unusually cynical about the motives of politicians to think that perhaps some of the motivation for SERPS was revenue now, problems later.)

        "And the Thatcher government hadn't already driven the budget deep into 
        deficit before privatization even began."

Absolutely correct, they hadn't. They had managed to repair the public finances immeasurably in the previous years. As we noted above they did this by cutting tax rates, sparking a revival in tax revenues and well, basically showing that the Laffer Curve is at least true sometimes and in some places. My, aren't we learning some interesting things today? Tax cuts can increase revenues! It's not a result that generally agrees with the oracular pronouncements of the Professor but there we are, facts are facts are they not?

        "Many Britons were sold badly designed retirement plans on false pretenses. 
        Companies guilty of 'mis-selling' were eventually forced to pay about 
        $20 billion in compensation."

I think we've dealt with that haven't we? The mis-selling was not a direct result of private pension plans but of people being enticed to leave very good private plans for less good private plans, defined benefit for defined contribution.

        "'Reductions in yield resulting from providers' charges,' the Pensions 
        Commission says, 'can absorb 20-30 percent of an individual's pension 
        savings.'"

Selective quotation can be such a wonderful thing, can it not? I've been guilty of it myself, no doubt. Allow me to provide the context:

        "There are however big barriers to the success of a voluntary pension 
        saving system, some inherent to any pension system, some specific 
        to the UK. Most people do not make rational decisions about long-term 
        savings without encouragement and advice. But the cost of advice, 
        and of regulating to ensure that it is good advice, in itself 
        significantly reduces the return on saving, particularly for low earners. 
        Reductions in Yield arising from providers charges can absorb 20-30% of 
        an individuals pension saving, even though they have fallen to a level 
        where provision to lower income groups is unprofitable. This poses a 
        fundamental question: in principle can a voluntary market for pensions 
        work for low income, low premium customers?"

I think that changes the meaning a little doesn't it? We are no longer talking about the privatization, opt-out of SERPS. It would appear that we are making a general point about the costs of advice and of the cost of regulation. It is indeed a problem: can a voluntary market for pensions savings exist that caters to low income groups? As everything that is being talked about in the US concerning SS is about a forced savings system, what do the two things have to do with each other? I'm also less than surprised that those who work in financial markets wish to be paid for their efforts. I'm told (although as yet have no direct experience) that literary agents also demand some portion, in the 15-20% range, of the returns they achieve for their authors. Guess that book leave was just a waste of time and effort then eh, Professor?

        "The Confederation of British Industry - the equivalent of the U.S. Chamber 
        of Commerce - has called for an increase in guaranteed benefits to 
        retirees, even if taxes have to be raised to pay for that increase."

Well strike me down with a wet haddock! A business organization is suggesting that costs traditionally borne by business should instead be borne by the taxpayer at large! Isn't this something along the lines of private profit, public costs, something that is ever raged against? I'm sure that a poll amongst the Chief Financial Officers of large American companies would find a majority in favor of Hillarycare... any health system at all as long as the taxpayer, not the shareholders, pick up the tab.

I'm afraid that neither Ms Cohen nor Professor Krugman have quite managed to grasp the real point at issue. There are, in an echo of what Bill Clinton was stating a decade ago, only so many things that can be done:

        "Cutting state retirement benefits, increasing taxes, increasing savings, 
        or delaying retirement."

Can we cut retirement benefits? A rather unlikely idea given the power of the AARP. Delay retirement? That would be my (in my excessively libertarian manner) choice, return SS to what it was, an insurance policy against outliving your savings. The age at which you can collect is set by the average age at death of the previous age cohort. Also a complete non-starter politically. We need to increase savings, get a little of that free lunch that exists in the difference between investment returns and a pay as you go pension system. The alternative, raising taxes, is simply too awful to contemplate. Not just because that is what was done a couple of decades ago and here we all are talking about it again, but because, well, have a look at page 5 of Chapter 3 of the Pension Commission report. The European Union average in 2050 of public expenditure on pension provision will be 13.3 % of GDP. If you want to take lessons from across the ocean that might be a good one, tax and spend is not the way you want to run a pension scheme.

Tim Worstall is a regular TCS contributor. More vituperation can be found at www.timworstall.com

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