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DISCUSSION PAPER PI-0409

What is a Promise from the Government Worth? Measuring and
Assessing Political Risk in State and Personal Pension Schemes
in the United Kingdom

David Blake

ABSTRACT

TThere are three key types of political risk facing state and personal pension
schemes: those induced by demographic, economic and pure political factors.
The state scheme in the UK has been susceptible to all three types since 1980
with the result that the annual real internal rate of return (IRR) on the second-pillar
state pension (SERPS) for the average male worker fell from 5.1% to 1.5% over
the quarter century of its existence. The Blair government replaced SERPS with
the Second State Pension (S2P) Scheme which was designed to benefit its natural
supporters, low-paid workers, at the expense of middle- and higher-paid ones. S2P
which assumes that all eligible workers earn at least the Low Earnings Threshold,
regardless of their actual earnings, combined with the Pension Credit, has raised
the prospective IRR to low-paid workers to 6.2%. The flat-rate, first-pillar Basic State
Pension (BSP) has also experienced a fall in its IRR of 3 percentage points as a result
of the indexation basis changing from earnings to prices, but the government’s 2006
Pensions Bill proposals to relink the BSP to earnings, while also raising the state
pension age to 68, go some way to restoring the BSP’s IRR to its original level.
Women have fared relatively badly since their state pension age will have risen by
8 years, once the government’s reforms have been fully implemented. Personal
pensions are not immune from political risk either, although to date they have been
less susceptible than the state scheme: the abolition of the tax credit on UK dividends
in 1997 lowered the IRR on personal pensions by up to 16 basis points, for example.
Given that company final-salary schemes in the UK have all but closed to new
members, leaving state and personal (or company) defined contribution pension
schemes as the only alternatives available for building up pension entitlements, it
is hard to see where British workers can turn in future for retirement income security.