A Bloody Mess
How has Britain's privatization
scheme worked out? Well, today, they're looking enviably upon
by Norma Cohen
The American Prospect magazine,
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. Its top priority for
its second term is tackling what it views as an enduring vestige
of socialism: its system of social insurance for the elderly.
Declaring the current program unaffordable in 50 years' time,
the administration proposes the privatization of a portion of
old-age benefits. In exchange for giving up some future benefits,
workers would get a tax rebate to put into an investment account
to save for their own retirement.
George W. Bush's America in 2005? Think
again. The year was 1984, the nation was Britain, the government
was that of Margaret Thatcher-and the results have been a disaster
that America is about to emulate.
For all the fanfare that surrounds the
Bush administration's efforts to present a bold new idea on pension
reform, the truth is that it is not new at all. In fact, the proposal
looks suspiciously like the plan set in train during Thatcher's
first term in 1979 and which has since led Britain to the brink
of a crisis. Since then, the nation's basic pension, which is
paid for out of tax receipts, has shrunk dramatically. The United
Kingdom has the stingiest state pension program of any G8 nation,
and there is growing consensus-even among British conservatives-that
reform is needed. And ironically enough, considering that America
is on the verge of copying Britain's mistake, most experts seek
reform in the direction of a more generous, and simpler, basic
state pension-one similar in design, in other words, to America's
Social Security program.
David Willetts, the Conservative MP who
is the opposition spokesman on pensions (and whose intellectual
agility has earned him the sobriquet "Two Brains"),
is one admirer of the U.S. system. "I like the way they distinguish
between Social Security and means-tested welfare," he says.
"They have higher Social Security benefits to keep elderly
people off welfare." And last year, in a startling reversal
of its decades-old policy, the Confederation of British Industry,
the United Kingdom's premier business group and the functional
equivalent of the U.S. Chamber of Commerce, called for a more
generous state retirement benefit, saying-remember, this is the
nation's leading business lobby talking-that it would even support
raising taxes to help pay for it. (It also called for raising
the retirement age.)
Britain's experiment with substituting
private savings accounts for a portion of state benefits has been
a failure. A shorthand explanation for what has gone wrong is
that the costs and risks of running private investment accounts
outweigh the value of the returns they are likely to earn. On
average, fees and charges can reduce pension lump sums by up to
30 percent on retirement. The nation's savings industry, which
sells those private accounts, has already acknowledged this. Which
brings us to irony No. 2: Just as the United States prepares to
funnel untold billions to its private sector for the management
of private accounts, back in 2002, many U.K. insurance companies,
mindful of tough new rules against giving bad advice, began to
'write to their customers urging them to consider abandoning their
private savings and returning to the state pension system, something
hundreds of thousands of Britons have done already.
And this is the system that the United
States is seeking to emulate?
How Britain's retirement system got to
where it is today is a twisted tale that combines political ideology
with fiscal expediency.
Britain has had pensions since medieval
times; offering them to monks and abbesses was Henry VIII's simple
formula for dissolving Catholic monasteries without a revolt by
their occupants. They were given more widespread use in the late
19th century by some of the more enlightened entrepreneurs. But
it was the aftermath of World War II that saw the widespread inclusion
of pension benefits into workers' benefits packages. Britain's
nationalization of its heavy industries such as coal, steel, and
railroads made pensions as much an element of social policy as
of employment policy. At the time, Britain was suffering a manpower
shortage so acute that, for the first time, it encouraged citizens
of its former West Indian colonies to settle there. 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.
Thatcher (now a baroness) came to power
in May 1979 at a time when much of Britain was ready to hear her
message. The now-infamous poster of workers on the dole queue,
headlined "Labour Isn't Working," coupled with national
disgust over a series of strikes during the 1979 "Winter
of Discontent" that left bodies stacked at morgues in Liverpool
and trash piled high in London's Trafalgar Square, made Britons
eager for change.
Thatcher's vision was the dismantling
of much of what Britain's Conservative Party calls "the nanny
state." Individual choice and individual opportunity were
to be the hallmarks of this dismantling. No longer would the state
seek to shield people from the force of the markets; people would
have to learn to stand on their own two feet. Britain was to be
a nation of homeowning, share-owning entrepreneurs who did not
want the state snooping into their business or asking more of
them than good citizenship.
From the start, the new Tory government
set out to make tax cutting the centerpiece of its fiscal policies.
However, it was clear that this could not be accomplished without
benefit cuts. As former Chancellor of the Exchequer Nigel Lawson
notes in his memoirs, the single most important cut was directed
at retirement benefits. 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. This is
one key change that the Bush administration is contemplating today
for Social Security.
In Britain, by most accounts, the change
caused little political fanfare at the time. Ros Altmann, a Harvard-trained
specialist in pension economics and a governor at the London School
of Economics, says that neither the voting public nor most politicians
understood the true implications of altering the link to wages.
But those who pushed for the change knew what they were doing:
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.) "Two percent
doesn't sound like much:' Altmann notes. "But with the effects
of compound interest, that amounts to nearly a 50-percent reduction
in the value of benefits over 30 to 40 years." As a result,
the basic state pension in the United Kingdom-the equivalent of
U.S. Social Security-is today lower than that in all but four
other European countries: Portugal, Greece, Belgium, and Ireland.
It is also substantially below that of its U.S. counterpart.
The American observer may find it odd
that Britain's voting public was prepared to put up with so low
a basic state pension. Why did voters never demand more generous
old-age benefits? The answer lies in the fact that the United
Kingdom has one of the most generous employer-backed pension systems
in Europe. Aggregate assets in U.K. pension finds far outstrip
the value of similar finds on the continent. Indeed, in a report
issued last October, the Pensions Commission acknowledged this
very point. "The UK pension system appeared in the past to
work well because one of the least generous systems in the developed
world was complemented by the most developed system of voluntary
private funded pensions;' the commission wrote. "This rosy
picture always hid multiple inadequacies relating to specific
groups of people, but on average the system worked?'
Thus, with most Britons assured that their
private pensions would protect them, the Tories faced little opposition
as they kept at reducing state pensions. The Labour Party, then
in opposition, was relatively acquiescent, in part because just
a few years earlier, a bipartisan group had agreed on a new legislative
centerpiece that was designed to ensure that old-age pensions
retained their purchasing power. This legislation established
a new and more generous second tier of the basic state pension,
which was to be known as 5ERP5 (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.
That additional pension was known as the
guaranteed Minimum Pension (GMP) because, unlike the basic state
pension, it set a floor under the smallest benefit a worker could
expect in retirement. But it contained an interesting wrinkle:
Employers who provided their own schemes for their workers could
be allowed a reduction of roughly 60 percent of their payroll
taxes if they guaranteed to provide a pension at least as good
as the GMP.
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.
The narrative of how this came to pass
will sound familiar to those who have been following the current
debate in America. At the start of 1984, then-Chancellor Nigel
Lawson (now Sir Nigel; his daughter Nigella has more recently
won great culinary fame on American television) had begun to express
his alarm at projections for the cost Of sEaPs over the next 50
years. A colleague in the cabinet, Social Security Secretary Norman
Fowler (also now a "Sir," albeit one lacking a daughter
famous in the States), advocated abolishing it altogether. In
his memoirs, Lawson describes SERPS as "a doomsday machine"
and calls its provisions "irresponsible generosity."
Both men were strong advocates of personal pensions. However,
what Lawson does not say is that while the 5ERPS expenditure was
likely to peak in the year 2030 (projections for that year appeared
in all discussions about the need to curtail it), it was projected
to fall off after that. But-here's another wrinkle that should
sound familiar to American ears-by focusing on projections for
2030, the sense of impending crisis prevailed in the media.
And so, in 1985, the Conservatives pushed
through what would become the landmark legislation of social-security
privatization. The new law curtailed some SERPS benefits; allowed
employees the choice of either joining SERPS or setting up a personal
pension scheme; and, crucially, allowed those choosing a personal
pension to contract out of SERPS altogether. It was these last
two elements, when combined, that led to one of the greatest financial
scandals in recent memory and that, together, have undermined
confidence in long-term savings in Britain.
The new rules on personal pensions and
contracting out did not take effect until 1988. But in the months
leading up to their launch, the government spent substantial sums
on advertising aimed at encouraging Britons to take them up. The
Thatcherite government was so eager to pursue its ideological
agenda that it spent taxpayers' money on it; the 1985 act had
included a payment into the fund giving an additional 2-percent
tax rebate to those taking out a new personal pension between
1988 and 1993.
When contracting out began, predictions
from the Government Actuary's Department forecast that no more
than 500,000 people would take up personal pensions. A former
official told the Financial Times at the time, "We all told
the secretary of state that personal pensions were really only
good for the very young or for very high earners." But in
the first five years, the number of private pensions sold would
turn out to be 10 times those two segments of the population.
The legislation, and the accompanying public-relations blitz,
worked: The "take-up," as the British call it, of personal
pensions was successful beyond the ministers' wildest dreams and
was hailed as one of the triumphs of the Tory government. By the
end of the 1988-89 tax year-the first year in which they were
available-more than 1 million private pensions had been sold,
twice the government projection. By the end of the following tax
year they totaled 3.9 million, rising to 4.3 million at the end
of the 1991 tax year.
It wasn't until a July 1992 gathering
of ministers and civil servants at Chevening, the chancellor of
the exchequer's country residence, that the government got its
first official warning that all was not well. On the opening day
of a strategy session called by then-Social Security Secretary
Peter Lilley, ministers were alerted to the costs now associated
with persuading people to opt out of occupational and state pension
schemes into personal pension plans. The warning came from David
Clark, then deputy secretary for pensions, in a paper to the assembled
group. A minister recalled to me, "The paper said that, in
some sense, personal pensions have been a tremendous success,
but there are a few time bombs ticking away there."
A report written two years earlier by
the National Audit Office confirmed what Clark had told the disbelieving
ministers. The government had sent out £9 billion in rebates
from 1988 to 1993 to people who had agreed to contract out; but
the same time, the massive shift to private
pensions was going to cut SERPS costs by only £3.1 billion.
In other words, the government was spending much more than it
was saving by bribing people to leave SERPs. What had once been
a £1.6-billion surplus in the National Insurance Fund vanished
completely. 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.
Finally, Britain's financial services
regulator, the Securities and Investment Board, reacted. Over
the objections of the insurance industry, it undertook random
samples of paperwork from personal pension clients of most large
providers and discovered that a staggering percentage of pensions
had been sold to those who would be worse off in retirement as
a result. 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
In retrospect, it is no surprise that
personal pensions became controversial; the insurance industry,
which would benefit most from their creation, was also the most
influential in crafting their design. For advice, Fowler relied
heavily on a small group that included the highly influential
insurance executive Sir Mark Weinberg, who had launched three
insurance companies. According to Fowler's former aides, no one
influenced Fowler more than Weinberg. "In the main, Weinberg
was the only person in the industry who Fowler had direct contact
with," one former staffer says.
Today, another financial scandal looms,
and this one could be bigger. It involves the United Kingdom's
occupational schemes, long the backbone of retirement provision
(they are the British equivalent of traditional U.S. pension plans).
The drop in real interest rates and the
accompanying disappearance in high returns on equities have left
most British occupational pension schemes in deficit. Employers
sponsoring some 70 percent of all defined-benefit plans-in which
the retirement pay is a percentage of the final salary-have shut
their doors to new members. Instead, as with American 401(k) plans,
employers are offering defined-contribution plans in which company
contributions, per worker, are very much lower than those of the
schemes they replace. They're unlikely to ever deliver anything
like the old-style retirement benefits. What has made this abandonment
particularly acute is that the United Kingdom was so confident
of the strength of its occupational plans that Tory and Labour
governments alike insisted that no insurance scheme would be necessary.
But the crisis within the occupational
pension system has laid bare just how inadequate Britain's public
pension schemes have been. Now, some 65,000 British workers have
lost all or part of their pensions as a wave of insolvent employers
are discovered to have left their pension schemes severely underfunded.
Some do not even have the cash to pay the GMPs that were promised
in exchange for tax rebates. A 1995 attempt at reform fizzled.
Those who have lost out have discovered that they have nothing
to fall back on except the basic state pension, which is now so
miserly because of changes put in place during the first year
of the Thatcher reign that those relying solely upon it for their
retirement income are defined as destitute. And that GRIP, which
was meant to supplement the basic state pension? "The Guaranteed
Minimum Pension turned out to be neither guaranteed nor a minimum;'
says Ros Altmann of the London School of Economics. "These
people would have been better off keeping their money under the
This, then, is the situation in Britain
* According to the Department for Work
and Pensions, in 2004 alone, 500,000 people abandoned private
pensions and moved back into the state system. Government actuaries
expect another 250,000 to contract back in this year.
* In 2004, the Association of British
Insurers, the trade association representing the companies that
sell the private accounts, made a collective decision not to risk
any more allegations of mis-selling. It urged all of its member
firms to warn those who had taken tax rebates to open private
accounts that they might have made a bad choice. The advice was
particularly aimed at older workers with fewer years until retirement.
* Many insurance companies-the sellers
of the private accounts-have been writing their customers urging
them to contract back in to the state system.
* And, of course, even the U.K. version
of the U.S. Chamber of Commerce has endorsed the idea of raising
taxes to increase benefit levels.
Pension policy threatens to become a key
issue in the British elections in May. To be fair, the United
Kingdom is hardly alone in facing a pension crisis. With sharp
increases in life expectancy among the elderly and plunging fertility
rates, every nation in the world will face similar challenges.
Moreover, the demographic patterns are similar even in less-developed
nations; Mexico, for instance, is forecast to have old-age life
expectancy similar to that of the United States in a few decades'
But whatever the solution to that challenge,
there is little disagreement within the United Kingdom that the
path chosen by successive governments over the past 25 years is
not the right one. 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. While noting that there is no
political support for the first choice, the commission concluded
that each of the three other choices, on its own, is too painful.
Only some combination of them is likely to help Britain's elderly
obtain retirement with dignity. Adair Turner, chairman of the
commission, a vice chairman of Merrill Lynch in London, and the
former director general of the United Kingdom's biggest business
lobbying group, says, "There are no other choices."
And so, at the exact moment that America
contemplates replicating this disaster, many in Britain-some conservatives
included-are looking more and more kindly on American Social Security
as a model for reform. The National Association of Pension Funds,
a group of employers who sponsor the nation's largest schemes,
is urging government not to expect the private sector to shoulder
the burden of keeping the nation's elderly from poverty. Chief
executive Christine Famish notes that it's "actually cheaper
for the state to carry the risk;' adding that in looking for a
system that offers the best combination of modest guaranteed retirement
benefits delivered at low cost, the U.S. Social Security program
seems the best model. "It doesn't have to make a profit,
and it delivers efficiencies of scale that most companies would
die for,' she says.
And that is how the British eye, wearied
after beholding decades of privatization "reform," views
the American system, which has served the United States so remarkably
well for seven decades but which supposedly is now in dire crisis
and must be overhauled by the time the forsythia bloom. It's a
point of view Americans would do well to take in.
Norma Cohen is senior corporate reporter
at the Financial Times and is currently responsible for coverage
of pension issues. This article was made possible by a grant from
the Center for American Progress.
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