An uncomfortable retirement: The state pension is under fire from all sides, including Labour, reports Mary Campbell

THE Labour Party seems to be quietly ditching the centrepiece of its pensions policy: the commitment to the universal state pension, indexed to average earnings.

On 3 March at a Fabian conference, Donald Dewar, Labour's social security spokesman, floated the idea of restricting future increases in state pension for those with other pensions. Today, the Labour-sponsored independent Commission on Social Justice, chaired by Sir Gordon Borrie, publishes a document that questions many of Labour's traditional views on pensions (The Pensions Dilemma, by Paul Johnson, available from the Institute for Public Policy Research, pounds 2.95).

Three long-term trends - ageing populations, increased unemployment and changing work patterns - have provoked a crisis in pensions policy throughout the Western world. For demographic reasons, Britain has been experiencing these changes earlier than other nations. The central issue is how a smaller number of wage earners can support a larger number of increasingly elderly pensioners.

Time was when almost all pensioners were poor. Raising the universal state pension (which is not means-tested) targeted those in need. This is no longer the case. Although more than half of the poorest 10 per cent of the population, in income terms, are pensioners, many other pensioners are rich. The state pension costs pounds 27bn a year. Even a small rise costs billions, much of which goes into the pockets of people who do not need it.

In 1980 the Conservative government decided to switch the indexing of pensions from earnings to prices, which go up more slowly. This will ultimately reduce the universal pension to a vestigial role, down from 20 per cent of average male earnings in 1978 to 6 per cent in 2040. Poor pensioners are increasingly left to the tender mercies of means-tested benefits, while rich pensioners whoop it up on private or occupational pensions.

Some Tories want to 'privatise' the state pension altogether. The Borrie commission pamphlet considers this idea - of converting from the current 'pay-as-you-go' scheme to a 'funded' scheme - at some length, and rejects it.

With PAYG, today's state pensions are paid out of current national insurance contributions. So today's earners pay the pensions of yesterday's earners, relying in turn on the next generation of earners to pay their pensions. By contrast, occupational and private pensions invest each individual's contributions so that they build up through a working life.

Yet however attractive a 'funded' scheme might be in principle, to achieve it would cost perhaps pounds 300bn, because today's earners would have to pay the continuing pensions of the previous generation while simultaneously saving for the whole of their own.

Allowing the universal state pension to wither in importance may be unavoidable. But before we allow this to happen, even by Mr Dewar's backdoor method, we should come clean about the implications.

The state pension is paid out of the Department of Social Security budget and classified as a social security benefit. But this is misleading. Whereas the NI contributions we make towards sickness benefit and unemployment benefit are insurance premiums against something we hope will not happen, our pension is income earned by a lifetime of saving. It is surely wrong for the individual to be penalised because the state chooses to spend his or her NI contributions rather than invest them (in the private sector, this would be illegal).

By letting the state pension wither away, the Government is already forcing those in work to pay more than once for their pensions. For, as Paul Johnson says, today's earners are paying for much higher state pensions than they are themselves going to receive.

There may be an underlying equity to this: those currently in work have high incomes relative to the much-increased army of the unemployed. But we must be clear that if today's earners want a half-decent pension when their time comes, they must save for a private or occupational pension on top of their NI contributions.

Allowing the universal state pension to wither means that other sources of future pension income must be built up. For those who have hardly ever earned, means-tested benefits will have to continue to be the mainstay. The trick for all political parties as they prepare their pensions policies for the next election will be to keep this group to a minimum and target their means-tested benefits tightly, so as not to create disincentives for everyone else to maximise their savings.

It will not be easy. The old large-scale employers with their comfortable pension schemes will not cover nearly as many workers as before. More people work part-time, more work for small businesses, move jobs, and move in and out of employment. The outdated assumption that wives would benefit from the pension contributions of their husbands is being destroyed by increased divorce, cohabitation and separation. Society is so fluid and complex that a heterogeneous approach to pensions will be the only answer.

Take divorcees. In 1985, 3 per cent of women over 60 were divorced; this is expected to rise to 13 per cent by 2025. There will also be more retired women who have separated from the fathers of their children after long-term cohabitation. Without action to give such women a share in the pensions they have indirectly helped to earn, millions more elderly women may become at least partially dependent on the state. The Government is examining this issue; surely a lesson of the Child Support Agency problems is that it should act quickly while the numbers affected are few.

The Johnson pamphlet includes one proposal that could help to ease this problem: limiting to the basic rate tax relief on pension contributions. At present, contributions to pensions are tax-deductible at the individual's marginal tax rate; the pension is then taxed when it is paid out. Johnson says: 'Since the vast majority pay only basic rate tax in retirement they can get relief at 40 per cent on their contributions, but only pay tax at 25 per cent on their benefits.'

Changing this would not only save the Exchequer pounds 600m a year in tax relief, but would also make it worthwhile for families in which husbands are taxed at the top rate to put their spare cash into pensions for wives.

(Incidentally, the pamphlet makes one other important suggestion on tax: to phase out the anomalous tax-free status of the lump sum which can be an element of private pensions on retirement. This provision apparently costs the Exchequer pounds 1bn a year.)

After those whose lifetime earnings will confine them to dependence on state benefits, comes another group, which never earns enough, or consistently enough, to make it worthwhile to pay the administrative costs of an individual personal pension. These are typically people who move jobs a lot, or work part-time, or for small businesses. They are an increasing proportion of the workforce. For these groups the Borrie commission proposes compulsory contributions to approved industry or regional pensions, along lines that already exist on a small scale.

If politicians do move towards a de facto switch of pensions to the private sector, there are two other issues they will have to address urgently. One - now well publicised - is better regulation, preferably backed by an industry insurance scheme, to provide against fraud as well as other risks. The other is inflation-indexing.

Most private sector pensions do not include any cushioning against high inflation during 15, 20 or more years' retirement. The Government must legislate to require at least the first tranche of each individual's pension to be fully indexed against inflation.

An important feature of all pensions for those on the borderline of poverty will be State Earnings Related Pensions (Serps). These are additional state pensions, built up by employees who are not contracted out into private sector schemes. They are expected to cost about pounds 15bn by the year 2030, more than 40 per cent of the cost of the basic pension. They will be important to that intermediate group who were not earning enough to make it worthwhile to opt out.

Yet even if all these changes to pensions policy are made, politicians at the turn of the century may still face another significant problem, that of disappointed expectations among today's middle classes. For their parents, the state pension has been sufficient to provide a base on which to build with an occupational pension or income from savings. Today's earners will not have that solid foundation.

Nor have most of them taken on board just how much they will need to invest throughout their lifetime to keep up their standard of living after retirement. This is substantial. For example, in one large public sector scheme, someone who retires at 65 on a salary of pounds 40,000 might get an inflation-indexed pension of pounds 20,000 a year, plus a tax-free lump sum of pounds 60,000. But to get this the employee and employer have between them contributed about 25 per cent of salary (before tax relief) each year for 40 years. The problem is not one of increased poverty, but of too-high expectations: previous generations did not expect to maintain the same standard of living when they stopped earning.

In practice, most pensioners in future will be much better off than their forebears. Occupational pensions cover more than half the population. Around 5 million people have at least some investment in a personal pension. More and more pensioners own their own homes outright and will have substantial inheritances. Two-person households will increasingly have two full state pensions as the increased contributions record of women feeds through.

Johnson's pamphlet and other recent work have shown that the pensions dilemma is not insoluble. If anything, the debate needs to shift to the other extra cost of an ageing population: health care, specialised housing and home helps.

(Photographs omitted)