Until recently, when someone who had been saving in a pension scheme reached retirement age, their pension pot – the fund built up through their own and maybe their employer’s contributions – would be used by their pension company to buy an annuity provided by that company. The annuity would then pay out a pension until the pensioner died. But in his budget this year the Chancellor of the Exchequer announced that not only would the retiree’s pension pot no longer have to be used to buy a particular company’s annuity, but it would not have to be used to buy an annuity at all. The person reaching retirement age would be able to use the pension pot to buy whatever they liked. Steven Webb, the Minister for Pensions, in an interview, said that he was relaxed about someone reaching pension age and using their pension pot to buy themselves a Lamborghini, but that he believed that people would use their pots sensibly and that free financial advice would be available to help them to do that.
We can understand the motivation behind this policy change. As things stood, someone reaching retirement age might have found themselves having to purchase a poorly performing annuity when some other use for all or some of their pension pot might have been more efficient for them – for instance, for paying off a mortgage, for settling debts, or for passing on to other family members if the retiree knew that they would die in the near future and would therefore have no need of a pension.
The problem with the policy change is that at the moment we have a State pension that is partly based on a contribution record and partly means-tested, and that if someone decides to spend or give away their pension pot then they might find themselves eligible for means-tested Pension Credit when they would not have been eligible for it if they had bought an annuity with their pension pot and were receiving a pension from that annuity. As the new Single Tier State Pension (STP) is rolled out this problem will slowly disappear. This is because the STP is based entirely on the number of years for which National Insurance Contributions have been paid but is otherwise unconditional and nonwithdrawable, so however much additional pension income or savings a pensioner has the STP will remain the same. Once the STP is fully rolled out, pensioners’ decisions in relation to their pension pot will no longer have implications for the level of public expenditure on pensions (although they will still have an effect on expenditure on Housing Benefit, which pensioners will be more likely to need if they have spent their pension pots and not turned them into annuities).
Somewhat surprisingly, at a recent discussion on pensions policy organised last week by the Social Policy Association at the London School of Economics, Dr Kristian Niemietz, Senior Research Fellow at the Institute for Economic Affairs, recommended both that there should be maximum freedom in relation to someone’s pension pot and that more of the State’s pension provision should be means-tested. The problem with this suggestion is that in the context of greater freedom in relation to the pension pot, a means-tested State pension raises substantially the level of moral hazard – that is: if I know that my State pension will be higher if I have less other income then I am more likely to spend my pension pot as that will result in a higher pension from the State.
Now that pensioners have been granted the freedom to use their pension pots as they wish, it is unlikely that that freedom will ever be withdrawn. We are therefore entering a world in which any means-testing of the State pension will create moral hazard. This suggests not only that the STP needs to be rolled out more quickly than is currently planned, but also that the Labour Party’s promise to means-test the Winter Fuel Allowance should be put on hold, and that cross-party agreement should be sought on making the State pension genuinely universal: that is, no longer dependent on a full contribution record (although it might therefore be important to apply a residence test, as other countries’ universal pension schemes and the UK’s universal Child Benefit already do).
Policy-making in the pensions field needs to be joined-up. There are two ways to avoid moral hazard. A means-tested State pension requires that retirees should be forced to purchase annuities with their pension pots. Freedom in relation to what the pension pot is used for requires a universal, unconditional and nonwithdrawable pension – a Citizen’s Pension.
The Chancellor’s recent announcement therefore requires a Citizen’s Pension.