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What is a pension?

30 July 2020

This is the first in a series of posts which aim to bring some clarity to pensions.  I aim to explain pensions from first principles to give you an understanding of the relationship between government policy, investment and regulation. The goal is to improve your knowledge to give you a greater sense of comfort about your long-term financial future.

A complex idea
Stop someone in the street and ask them what a pension is and they are likely to tell you it what you get paid after retiring. It provides a replacement income in your later years for the one which used to be provided by your salary and lasts until you die.

Sounds simple? Think about it a bit and you realise it’s quite extraordinary. Money will be provided to you once you become too old to work to ensure you do not become impoverished in your later years. And the income will last until you die, even if you live to be more than 100 years old.

That sparks a new round of questions. Who is going to pay me this money? How much money will there be? If I live to ripe old age, how do I know it won’t run out?

The first question to tackle is: who will pay my pension? In the UK there are three sources for this income – the government, your employers and you.

The UK is unlike other European countries because the bulk of pension provision comes from occupational pensions – that is to say schemes provided by your employer and financial contributions made by both you and the business you work for into these plans.

The state pension can be thought of as a foundation payment. Its aim is to avoid poverty in old age rather than be a principal source of income replacing your salary.

Let’s start by taking a close look at the state pension. While most in the UK think of a universal pension as a standard benefit, this concept is not even 100-years old.

A brief history of the state pension
The universal state pension starts, like so many other welfare benefits, after World War II. As the Institute for Fiscal Studies puts it in their 2015 report The History of State Pensions in the UK: “In the beginning was Beveridge”.

The 1942 Beveridge Report Social Insurance and Allied Services introduced universal coverage based on a social insurance model.

Beveridge’s vision for a pension was for it to be funded by contributions made over the course of a lifetime. The aim was to provide a safety net against poverty rather than a high replacement income.

The National Insurance Act 1946 introduced the state pension taking effect from 1948. But the social insurance model was not adopted.

That’s because contributions are built over many years. There was no time to gather the funds needed to pay a pension to an older generation which had endured The Great Depression and contributed to the war effort.

Instead the system became – and remains today – a ‘pay as you go’ system. Rather than individuals’ contributions being invested so as to pay their own pensions later, money collected today instead pay today’s pensioners.

Missed opportunity
That no government between 1948 and today has revisited the social insurance model is a great shame. The two systems could be run in parallel until the ‘pay as you go’ model could be switched off.

There are many benefits to a social insurance model. It gives each citizen ‘ownership’ of their state pension. This model could be expanded to cover other benefits. Beveridge originally envisaged his system would provide sick pay and cover unemployment. Maybe it could be used to fund social care?

The social insurance model would have also reduced the strains changing demographics places on the ‘pay as you go’ system.

This system works when the older population is smaller than the working population but when those dynamics shifts, it becomes problematic. Today the tax revenues of a smaller cohort of younger workers have to support a larger ageing group of pensioners.

A return to simplicity
Over time pressure grew on governments to do more than provide a flat rate basic pension payment as envisaged by Beveridge. State pensions became an increasingly complex system and included means testing. Successive changes were made by subsequent governments.

Almost two decades ago, the complexity of the state pension was challenged by the Pensions Commission. This review of the UK’s pension system was commissioned by the Labour government in 2002, which was concerned by the dramatic decline in occupational pensions.

In 2016, a simpler flat-rate state pension was reintroduced with the aim of making retirement planning easier. This is protected by the triple-lock – it increases each April by the greater of September’s price inflation, earnings growth or 2.5%.

Now we have established the basic concept of pension and had a brief canter through the history of state pensions in the UK, the next post will address the evolution of occupational pensions.

Charlotte Moore - post author

Charlotte Moore has been a freelance journalist since 2006, with a solid technical understanding of a broad range of financial topics along with a previous incarnation as an investment analyst. Along with journalism, she has experience of producing written material for corporates and is seeking to expand this part of her business portfolio.