SOCIAL SECURITY IN THE UNITED KINGDOM: A MODEL FOR REFORM?
CRS Report for Congress
Social Security in the United Kingdom:
A Model for Reform?
Updated March 27, 2001
Geoffrey Kollmann and Dawn Nuschler
Domestic Social Policy Division
Congressional Research Service The Library of Congress
Social Security in the United Kingdom:
A Model for Reform?
Predictions of future financial problems in the U.S. Social Security program have
helped fuel growing interest in converting all or part of the system into private
accounts. The experiences of other countries have been cited by advocates of
privatization as examples of how to change from a traditional “pay-as-you-go” social
insurance system, in which workers receive retirement benefits that are defined by law
and paid through the government, to one in which workers receive retirement benefits
from their own accumulated savings. It has been suggested that the United Kingdom
(U.K.) is especially relevant for the United States because it is a developed industrial
democracy with a rapidly aging population. The U.K. system is divided into two tiers:
the basic state pension which provides a small, flat-rate benefit to most workers and
the State Earnings-Related Pension Scheme (SERPS) which provides a benefit based
on employee earnings. Although this design is fairly common among developed
nations, in the U.K., employers and employees have the option of leaving SERPS if
they replace it with a private sector arrangement.
Supporters of the U.K. system maintain that it has improved the living standards
of the elderly, lessened the role of government in private lives, increased saving and
investment, reassured workers that retirement benefits will be available to them, and
forestalled the large tax increases that would be needed to pay benefits under the old
system. They contend that its structure could be particularly instructive for the U.S.
because it is a gradual process that maintains basic protection while slowly shifting
part of the responsibility for retirement income to the private sector. Rather than
undergoing potentially wrenching transition problems, the process has built upon the
existing public and private pension structure, facilitated by the provision of incentives
for workers to switch to private arrangements.
Detractors say that the system has adverse social effects because it is
disadvantageous for lower paid workers, part-time workers and women. They
maintain that company pensions are not available to many workers and primarily
benefit full-time, well paid employees. Furthermore, if the pension is based on the
worker’s own contributions, they are forced to bear the risk of inadequate income in
retirement due to poor investment performance or because the market dipped when
they retired. Opponents also claim that these workers do not fare well with personal
pensions because they carry high fixed administrative costs that continue in periods
of unemployment when there is no opportunity to contribute more to the pension;
have been poorly regulated leading to the “mis-selling” of pensions to workers who
would have been better off staying in SERPS or an employer plan; and provide
inadequate retirement income given insufficient contributions or investment returns.
Currently, the U.K. system is undergoing further reforms that aim to make
private pension coverage accessible to a broader segment of the working population
and improve benefits for lower paid workers who remain in the second tier of the
public retirement system. Major changes include the introduction of “stakeholder”
pension schemes and the new State Second Pension to replace SERPS.
Introduction ................................................... 1
History of Social Security in the U.K.................................2
The Current U.K. Social Security System
and Recent Reforms..........................................3
Adopting the U.K. Approach to Social Security........................10
Appendix: Detailed Description of the
U.K. Social Security System..................................14
Financing ................................................. 14
First Benefit Tier — Basic State Pension.........................16
Second Benefit Tier — State Earnings-Related Pension Scheme (SERPS)16
“Contracting Out” of SERPS..................................18
List of Figures
Figure 1. U.K. Social Security System...............................9
List of Tables
Table 1. Key Features of the U.K. Social Security System, 2000/2001.......6
Table A-1. Employee and Employer National Insurance Contribution Rates
in the United Kingdom, 2000/2001.............................15
Social Security in the United Kingdom:
A Model for Reform?
Although the U.S. Social Security system’s income currently exceeds outgo, it
is generally recognized that the system will face financial problems in the next several
decades due to the aging of the population and the retirement of the post-World War
II baby boom generation. The ratio of workers to recipients is projected to fall from
3.4 to 1 today to 2.0 to 1 by 2050. The Social Security Board of Trustees projects
that the system’s expenditures will exceed its income in 2025 and do so until the
Social Security trust funds are exhausted in 2038. On average over the next 75 years,
expenditures are projected to exceed income by 14%.
This phenomenon is not unique. With few exceptions, life expectancies are
increasing throughout the world, and the ratio of workers to retirees is shrinking. In
response, other countries have undertaken various reforms. One approach has been
to switch greater responsibility for providing retirement income from state sponsored
systems to workers’ own savings, a process commonly referred to as “privatization.”
The experiences of these countries, especially Chile, have been cited as examples
of how to change from a traditional social insurance system, in which workers receive
retirement benefits that are defined by law and paid through the government, to one
in which workers receive retirement benefits from their own accumulated savings.
Critics, however, maintain that circumstances in many of these countries were very
different from those prevailing in the U.S., such as being in earlier stages of economic
development or, in the case of Chile, under the control of a military government that
could replace a failing social security system as part of wholesale economic reform
designed to roll back socialism. Given this criticism, it is logical to ask what other
countries privatized in situations that are more similar to ours. The social security
system in the United Kingdom (U.K.) is “partially” privatized in that workers can opt
out of the part of the state provided pension program that is earnings-related. It has
been suggested that the U.K. is especially relevant for the United States because it is
similar to the U.S. culturally, economically, politically, and demographically. The
U.K. and the U.S. have industrial economies, stable, democratically elected
governments, aging populations, and in many respects, a common heritage.
As in the U.S., the U.K. population is aging. Although this is a worldwide
phenomenon, it appears to be somewhat advanced in the U.K. For example, in 1990
the population age 65 and older was equal to 24% of the working age population —
in the U.S. the figure was 19%. However, by 2030 it is projected the figures will be
much closer, 39% and 35%, respectively. While the demographic trend is worrisome
for U.K. policymakers, it is not as acute as for most other European countries, some
of which are projected to have these ratios increase to almost 50% by 2030.
History of Social Security in the U.K.
Government support for the elderly in the U.K. began in 1908 with the Old Age
Pensions Act. Benefits were paid by the government and were limited to poor people
over age 70. A contributory program was introduced in 1925, with the Widows,
Orphans and Old Age Contributory Pensions Act. Participation by workers was
voluntary, except for manual laborers and others with earnings under a specified
In 1942, economist Sir William Beveridge wrote a report that urged the
government to provide a reliable retirement pension for all workers. Up to that time,
social insurance programs for the elderly had been limited to those whose family
income was below certain thresholds. This means testing carried such a stigma that
some who qualified for benefits preferred destitution to the indignity of being labeled
poor. Beveridge proposed a universal, non-means-tested program, supported by the
contributions of virtually all workers, that would ensure a minimum level of income
for every citizen. The Beveridge report led to passage of the National Insurance Act
of 1946, which created the current compulsory social insurance program.
Responding to concerns that the “basic pension” under National Insurance
provided inadequate income, in 1959 the government created a “second-tier” benefit,
a supplemental earnings-related plan (called a “graduated pension”), effective in 1961.
This program also was criticized for providing inadequate income, particularly since
the amount of the additional pension was fixed at the time of retirement and declined
in value thereafter due to inflation. It was also becoming clear that the workers most
likely to have adequate retirement income were those who also had pensions provided
by their employers (known as “occupational pensions”). In part to narrow the gap
between workers with and without employer pensions, the 1975 Social Security
Pensions Act replaced the graduated pension with a more generous supplemental
earnings-related pension plan (the State Earnings-Related Pension Scheme (SERPS)),
effective in 1978. Because SERPS was intended as a backup for workers without
employer pensions, the Act gave workers and private companies the option of leaving
SERPS if they had a defined benefit employer pension1 that offered retirement benefits
equal to or greater than those provided by SERPS.
Soon afterward, projections of future costs grew rapidly leading to action by the
government to curtail future SERPS benefits and provide workers not covered by an
employer defined benefit plan the alternative of opting out of SERPS into an employer
defined contribution plan2 or an Appropriate Personal Pension3 (APP), effective in
1In a defined benefit plan, a formula determines benefits (e.g., 1% of final pay per year of
service) that the sponsor is obligated to honor (i.e., the investment risk is on the employer).
2In a defined contribution plan, a formula determines contributions (e.g., 10% of annual
earnings), and the employee receives a benefit at retirement that depends on the accumulated
value of the funds in his account (i.e., the employee bears the investment risk). In the U.S.,
a 401(k) plan is an example of a defined contribution plan.
3APPs are similar to Individual Retirement Accounts (IRAs) in the U.S.
During the 1990s, certain features of the system came under increasing criticism.
Incentives were provided for employees to opt out of SERPS, but the private
alternatives to SERPS proved impractical for many workers — employer plans were
not available to many workers and personal pensions were disadvantageous for
workers with low or unsteady earnings. In widely publicized “mis-selling” cases,
many workers purchased personal pensions when it was not in their best interest to
do so. In December 1998, the U.K. government outlined its proposal for a new4
pensions framework calling for the creation of “stakeholder” pension plans (flexible,
fee-limited defined contribution plans) and the State Second Pension to replace
SERPS. The proposal made no changes to the basic state pension. The U.K.
government enacted legislation creating “stakeholder” pension schemes in November
social security system are being phased in starting in April 2001.
The Current U.K. Social Security System
and Recent Reforms
The U.K. social security system5 is a two-tiered, partially privatized system
funded on a pay-as-you-go basis through payroll taxes (National Insurance (NI)
contributions) levied on most workers and their employers. Workers with earnings
above a specified threshold (the “lower earnings limit”) are automatically covered
under the system. Contribution rates and “taxable” earnings differ for employees and
employers, and reduced contribution rates apply if an employee contracts out of
SERPS to reflect foregone future SERPS benefits.6 Employees pay NI contributions
on a portion of weekly earnings (earnings between the “employee’s earnings
threshold” and the “upper earnings limit”) at a rate of 10% if they remain in SERPS
and 8.4% if they contract out of SERPS.7
Employers pay NI contributions on all weekly earnings above a specified
threshold (the “employer’s earnings threshold”) at a rate of 12.2%. If an employee
contracts out of SERPS, the employer pays a reduced rate on the first portion of
taxable earnings (earnings above the “employer’s earnings threshold” up to the “upper
earnings limit”) and the full rate (12.2%) on all additional weekly earnings. The
amount of the reduction depends on the type of private pension the employee chooses
4U.K. Department of Social Security, A New Contract for Welfare: Partnership in Pensions,
5In the U.K., “social security” refers to a broad range of programs and services. The U.K.
social security system provides retirement, survivors, and disability benefits as well as
sickness, maternity, unemployment, work injury, child, and welfare benefits, and health care
services. In this report, the term “social security” refers only to the retirement portion of the
6Employees contracted out of SERPS do not receive a second-tier benefit from the
government. Therefore, they and their employer pay a reduced rate of NI contributions. The
reduction in NI contributions is known as the contracted-out “rebate.”
7Self-employed workers are eligible for first-tier benefits only. They pay a flat rate of £2 per
week ($3) plus 7% of a portion of net annual earnings.
in place of SERPS. The reduced rate is 9.2% if the employee participates in an
employer-sponsored defined benefit plan and 11.6% for an employer-sponsored
defined contribution plan. If the employee opts for a personal pension in place of
SERPS, the employee and employer pay the full rate of contributions (10% for
employee, 12.2% for employer) as if paying into SERPS and the government pays a
“rebate” directly to the individual’s personal pension scheme.
The first benefit tier — the basic state pension — is mandatory and provides
a small, flat-rate benefit based on years of contributions. A worker must pay NI
contributions for at least 90% of his or her working life to receive full benefits. At the
current pension eligibility age, a full career is 49 years for men (ages 16 to 65) and 44
years for women (ages 16 to 60).8 Workers receive credits toward the basic state
pension for periods in education, training, unemployment, disability, caregiving, and
child rearing. Because the basic state pension is indexed to prices, its value relative
to average wages has declined over time.
The second benefit tier — SERPS — provides an additional earnings-based
benefit to employees.9 Participation in SERPS is voluntary as employees have the
option of “contracting out” of SERPS if they have an employer-sponsored, personal,
or stakeholder pension (available starting in April 2001). Changes in the SERPS
benefit formula included in the Social Security Act of 1986 resulted in lower benefits
for workers who reach state pension age after April 5, 1999. In the absence of recent
policy changes (see section on the State Second Pension below), SERPS benefits
would decline gradually from 25% of the highest 20 years of earnings to 20% of
lifetime average indexed earnings. In addition, SERPS benefits are based on the
portion of employee earnings between the “lower” and “upper earnings limit.” The
upper earnings limit is indexed to prices. If wage growth exceeds price growth in the
future as projected, a smaller proportion of earnings would be credited under SERPS
and the value of SERPS benefits as a proportion of earnings would decline for many
Options for contracting out of SERPS were expanded at the same time that
SERPS benefits were reduced for future retirees. Employers have had the option to
contract out of the second tier of the public system since 1961 if they offer a qualified
defined benefit plan. In 1988, contracting-out options were expanded to include
employer-sponsored defined contribution plans and qualified personal pensions
(known as Appropriate Personal Pensions) increasing the private sector’s role in the
provision of retirement income (see Figure 1). Despite the increased options for
contracting out of SERPS, choices remained limited for certain types of workers,
especially low to moderate earners who lacked access to an employer-sponsored plan.
More than one-third of employees do not have this option and persons with low or
unsteady earnings do not fare well with personal pensions because high administrative
8Under the Pensions Act of 1995, the age at which women become eligible for benefits will
increase gradually to 65 over the 2010 to 2020 period.
9SERPS is not available to self-employed workers, who must make private pension
arrangements to supplement the basic state pension. Approximately half of the self-employed
currently contribute to a personal pension.
charges can erode the value of an individual’s account.10 To address second-tier
coverage gaps, further changes are being made to the U.K. system. Reforms currently
underway are designed to allow more individuals to replace SERPS with private
arrangements and enhance benefits for lower paid workers and those with breaks in
employment due to disability or periods caring for children or sick family members.
Major changes include the creation of “stakeholder” pensions and reform of public
second-tier benefits through the new State Second Pension.
Starting in April 2001, employees will have the option of contracting out of
SERPS using new stakeholder pensions designed to benefit primarily moderate and
higher earners who do not have access to an employer plan (as well as self-employed
workers who are not eligible for SERPS). Stakeholder pensions are flexible, defined
contribution plans with an asset-based administrative charge limit. Employers are
required to provide employees access to a stakeholder pension scheme if they do not
offer an occupational pension plan or a group personal pension. Self-employed
workers may purchase them directly from providers. Employers are not required to
make contributions, but they must collect and pay employee contributions.
Employees may stop and restart contributions and transfer into and out of stakeholder
schemes without penalty. Annual administrative charges are limited to 1% of the
account’s value. Stakeholder pensions are intended to be a good option for persons
who change jobs frequently or work intermittently because they are not tied to a
single employer. The ceiling on administrative charges is designed to benefit workers
without an employer plan who find existing personal pensions too costly.
Starting as early as April 2002, SERPS will be replaced with the State Second
Pension designed to improve second-tier benefits for lower paid workers (especially
female, part-time workers who lack private pensions) and extend second-tier coverage
to persons who leave the labor force for extended periods due to disability or family
caregiving responsibilities (caring for children or sick family members). Under the
State Second Pension, workers with annual earnings below a specified amount — the
new “low earnings threshold” — will be credited with earnings equal to the “low
earnings threshold” which will be indexed to average wage growth. In addition,
qualified caregivers and disabled persons with little or no earnings for the year will be
treated as if they had earnings equal to the “low earnings threshold” to protect their
entitlement to benefits. Initially, the State Second Pension will provide an earnings-
related benefit. After stakeholder pensions have become established, it will be
converted to a flat-rate benefit providing an incentive for workers who earn more than
the “low earnings threshold” to opt out of the State Second Pension in favor of
Table 1 summarizes key features of the U.K. social security system in 2000/2001
and recently enacted reforms.
10Personal pensions were sold to many workers who would have been better off remaining in
SERPS or an employer plan. Many of these “mis-selling” cases involved older and lower paid
workers. Given the effects of compounding, personal pensions are more advantageous for
younger, higher paid workers who have longer periods to invest and can make regular
contributions in amounts large enough to counteract high administrative fees.
Table 1. Key Features of the U.K. Social Security System,
CoverageTwo-tiered, partially privatized system funded by
National Insurance (NI) contributions paid by
most workers and their employers
All workers with a minimum level of earnings are
automatically covered under the system.
Benefits are paid to men at age 65 and to women
at age 60 (between 2010 and 2020, the retirement
age for women will increase gradually to 65).
Employee ratesUnder SERPS: 10% of earnings from £76.01 to
£535 per week ($109 to $770)
Contracted out of SERPS:* 8.4% of earnings
from £76.01 to £535 per week ($109 to $770)
Employer ratesUnder SERPS: 12.2% of earnings over £84 per
Contracted out of SERPS:*
— with an employer-sponsored defined benefit
plan: 9.2% of earnings over £84 per week up to
and including £535 per week ($121 to $770);
12.2% of all additional earnings
— with an employer-sponsored defined
contribution plan: 11.6% of earnings over £84 per
week up to and including £535 per week ($121 to
$770); 12.2% of all additional earnings
— with an Appropriate Personal Pension:
employees and employers pay NI contributions at
the full rate (10% for employees, 12.2% for
employers) and a rebate is paid directly to the
individual’s account by the government
Self-employed workersSelf-employed workers (none of whom are eligible
for SERPS) pay a flat rate of £2 per week ($3)
plus 7% of net annual earnings between £4,385
and £27,820 ($6,314 to $40,061).
First tier: Basic state pensionParticipation is mandatory.
Provides a small, flat-rate benefit to employees and
the self-employed based on the number of years of
contributions (regardless of earnings).
To receive full benefits, a worker must pay NI
contributions for at least 90% of his or her
working life (currently, 49 years for men, 44 years
The basic state pension is £67.50 per week ($97)
for a single person, £107.90 per week ($155) for a
Second tier: SERPSProvides an additional benefit to employees only
(the self-employed are not eligible for SERPS).
Participation is voluntary — employees may
contract out of SERPS if they participate in an
employer-sponsored defined benefit or defined
contribution plan; an Appropriate Personal
Pension; or a stakeholder pension (starting in April
2001). About one-fifth of employees are covered
As of March 1999, the average SERPS benefit
was £29.68 per week ($43) for men, £16.85 per
week ($24) for women. The maximum SERPS
benefit was £125.30 per week ($180).
Stakeholder pensionsEffective in April 2001, stakeholder pensions may
be used to contract out of SERPS.
Stakeholder pensions are group provided, defined
contribution plans designed to benefit primarily
moderate and higher earners without access to an
employer-sponsored plan (including self-employed
workers who are not eligible for SERPS).
Employers are required to provide access to a
stakeholder pension scheme in the workplace if
they do not offer an occupational scheme or a
group personal pension. Employers are not
required to make contributions, but they are
required to collect and pay employees’
contributions. Self-employed workers can
purchase stakeholder pensions directly from
providers including insurance companies, banks,
and other financial institutions.
Participants may stop and restart contributions and
transfer into and out of stakeholder schemes
Annual administrative charges are limited to 1% of
the account’s value.
State Second PensionPlanned as a replacement for SERPS as early as
The State Second Pension will provide an
earnings-related benefit initially. After stakeholder
pensions have become established, the State
Second Pension will be converted to a flat-rate
Designed to benefit primarily low earners and
persons who leave the labor force for an extended
period due to disability or family caregiving
*Employees contracted out of SERPS do not receive a second-tier benefit from the
government. Therefore, they and their employers pay a reduced rate of NI contributions.
Note: See the Appendix for a detailed description of the current U.K. social security system
and recent reforms.
Figure 1. U.K. Social Security System
Basic State Pension
(Effective in 1946)
g/wWage and Salary WorkersSelf-Employed Workers
SERPS*(Effective in 1978)Contracted-Out ArrangementsStakeholder Pension**
(Effective in 2001)
Employer DB Plan(Effective in 1978)Employer DC Plan(Effective in 1988)PersonalPensionPension**
(Effective in 1988)(Effective in 2001)
KEY:*As early as April 2002, the new State Second Pension will replace SERPS.
SERPS = State Earnings-Related Pension Scheme
DB = Defined Benefit**Starting in April 2001, stakeholder pensions will be available to all persons including
DC = Defined Contributionself-employed workers (who are not eligible for second-tier benefits) and non-earners.
Adopting the U.K. Approach to Social Security
Proponents of the U.K. system tout its beneficial effects at both the national and
personal level. They argue that the reform of the national pension system in large
measure rescued the U.K. from the financial straits currently facing other European
countries because it has fostered both lower government spending on entitlements and
increased national savings. Without such reforms, they say, forecasts showed that,
to support the old system, payroll taxes would have had to double in the 21st century.
They point out that the assets of employer pensions have grown from 36% of the
U.K.’s Gross Domestic Product (GDP) in 1983 to 77% of GDP in 1994. They
attribute recent forecasts of the U.K.’s eventual retirement of its National Debt to the
savings fostered by the current design of the national pension system. This forecast
of low debt also allows the U.K. to easily meet the requirements under the European
Monetary Union agreement that participating countries must have a budget deficit of
no more than 3% of GDP.
Proponents acknowledge that the U.K. system is a hybrid rather than a fully
privatized system, but they maintain that this is one of its strengths making it an
appropriate model for the U.S. system. The system is balanced, with the government
still providing some benefits and continuing oversight and regulation to ensure that
workers are protected from some of the dangers of marketplace risk. This continued
government involvement and oversight makes the system amenable to change when
necessary. For example, since contracting out was enacted, the government has
ordered that private providers pay restitution to workers whom they misled into
purchasing personal pensions. In addition, the government has required that
employers provide protection against inflation both for annuitants and for accrued
pension rights for workers who leave the firm. Another measure of balance is the
diversification of risk between political and market forces provided by the mixture of
public and private pensions. Recently, in response to criticism that the current mix
of pension provision is inadequate, the U.K. government enacted legislation creating
“stakeholder” pension schemes and the new State Second Pension to replace SERPS
in an effort to improve retirement income for workers at all levels of income.
Proponents contend that the transition made to the current system should serve
as an example to other countries and effectively invalidates the argument that
switching to privatized systems causes inordinately difficult transition problems.
Among the lessons they cite are the use of the existing framework (employer-provided
pensions and private savings arrangements), the provision of incentives for workers
to voluntarily contract out of the earnings-related state plan, and the continuing
existence of a basic safety net to ensure a level of protection for all workers. They
argue that intergenerational equity has been maintained by providing acceptable
tradeoffs for younger workers to help bear the costs of continuing to maintain the
benefits of current recipients while they move from a financially (and therefore
politically) insecure public retirement system vulnerable to benefit cuts and/or
contribution increases to a portable system of private pensions whose assets they
believe to be more real and which they effectively own.
At another level, proponents laud the beneficial effects of the U.K. reforms on
individuals. During the 1980s and 1990s, the income of pensioners in the U.K. grew
proportionately faster than any other demographic group, and the percentage of
pensioners living in poverty fell dramatically. During the period, the income of
pensioners increased by two-thirds in real terms compared to a two-fifths increase in
real average wages. Proponents say that younger workers and future generations
have been spared the crushing burden of what would have been huge unfunded
liabilities had the system not been reformed.
Proponents further contend that the standard of living for future retirees will be
higher than if the old system had remained in force because of the higher rate of return
inherent in private investments. They state that because SERPS is a pay-as-you-go
system (as is Social Security in the United States), it can at most pay the average
worker a rate of return equal to the rate of growth of average wages, whereas the rate
of return on the equity of a funded occupational or personal pension plan historically
has been considerably higher (from 1986 to 1995, the annual gross rate of return for
median private pension funds in the U.K. was 13.3%). They argue that the enormous
popularity of personal pensions illustrates this point. When workers in the U.K. were
first allowed to opt out of SERPS using personal pensions in 1988, the Department
of Social Security predicted that about half a million workers would do so initially.
Demand turned out to be much greater than projected. By 1995, almost 6 million
people had taken out a personal pension. Many American workers already have
Individual Retirement Accounts (IRAs), which are very similar to U.K. personal11
pensions. Given the familiarity Americans have with supplementary private
retirement programs and the high rates of return the equity markets have provided to
such plans over the past 20 years, proponents say it seems likely that a move to a
semi-privatized system would be popular among U.S. workers.
Critics of the U.K. system tend to focus on what they consider to be its adverse
social effects including growing disparities in retirement income between low and high
paid workers, full and part-time workers, male and female workers, and informed and
uninformed workers. They are concerned that the features of the system tend to
create a more unequal society, in which some people win and some people lose —
and by increasing margins.
While conceding that pension income has risen on average during the past 2
decades, critics point out that the increase was not equally distributed. For example,
between 1979 and 1997 the median income of the wealthiest pensioners increased
80% in real terms compared to 34% for the poorest pensioners. Critics contend that
these disparities will only worsen as the new pension system matures.
Several reasons are cited for this forecast. First, due to the various
deliberalizations mentioned earlier, the lowest paid workers, who probably will be
totally reliant on National Insurance benefits, will have their standard of living steadily
11The Investment Company Institute reports that one in three U.S. households owned
Individual Retirement Accounts as of June 1999.
eroded. Second, the most reliable predictor of adequate income in retirement is
eligibility for an employer pension. Demographically, employer-sponsored pension
coverage is more concentrated on male, higher paid, full-time, full-career workers.
Third, the adequacy of personal pensions depends heavily on the ability of the workers
to make regular contributions over a lifetime with a particular premium on
contributions at earlier ages in amounts large enough to minimize administrative costs
which are fixed and continue through periods of unemployment. For lower paid
workers, these administrative charges may be quite high, up to 30% of the total
investment. It is said that it is possible for a worker with discontinuous employment
to lose all of his or her contributions to administrative charges.12
Fourth, government regulators have confirmed that personal pensions have been
marketed and sold to many people who lack investment expertise and would be better
off financially had they stayed in their employer pensions or in SERPS. The “mis-
selling” of personal pensions is said to have affected 1.5 million workers, mostly older
and lower paid, who were persuaded by overzealous sales agents to switch to risky,
inappropriate plans based on unduly optimistic estimates of rates of return. The
government has ordered companies to reimburse these workers at an estimated cost
of $3.2 billion to date with total costs projected to reach $20 billion.
Fifth, critics argue that many people choose to contract out essentially because
the government bribed them to do so through rebates and tax incentives. As
mentioned above, many workers were induced to opt out when it was not to their
advantage, but critics contend that for many others, the incentives were a windfall and
very costly to the taxpayer. Also, higher paid workers are said to be particularly
advantaged because they receive more benefit, both in money amounts and in
proportion to their earnings, from the preferential tax treatment given to pension
contributions and income (i.e., the tax preferences are regressive).
Sixth, critics maintain that the current system is particularly disadvantageous for
women because they tend to have lower earnings, shorter careers, and longer
lifespans. Employer pensions are of most benefit to employees who have a lifelong
record of full-time employment in a well paid occupation. Among married mothers
who work, a large proportion do so in part-time labor. Only 12% of part-time
workers were members of an employer pension in 1987. In addition, U.K. actuarial
tables use gender-based life expectancy tables in computing annuities resulting in
lower pension payments for women due to the longer period over which they are
expected to receive benefits.
Critics are also uncomfortable with the displacement of risk from the government
and the employer to the individual worker. Under defined contribution and personal
pension plans the value of the pension depends on the cost of annuities at the time of
retirement and the performance of the stock market during the period of investment.
They point to the example of how a worker retiring and buying an annuity on October
23, 1987 would have received a pension 30% lower than if he had retired a week
12The new stakeholder pension scheme is designed to alleviate these problems.
Although much of their concern is directed at personal pensions, critics also warn
that reliance on employer pensions presents problems as well. Much of their appeal
is the provision of a predictable, practically inflation-proof benefit of which the
employer bears the investment risk. These features exist largely because of
government-imposed requirements, and employers are starting to complain about their
onerousness. Although not widespread, there is evidence that there is a strong
tendency for employers to choose a defined contribution design when given the
opportunity (such as the creation of a new plan). Critics are concerned that, in the
future, workers will be increasingly uncertain of their eventual benefits and bear more
investment risk. They say it is unlikely that U.S. employers would be willing to accept
such a degree of regulation and oversight.
Critics also complain about the features of some defined benefit employer plans
that can lead to maldistribution of benefits. The design of employer pensions in the
U.K. is generally free from legislative restrictions. Most defined benefit plans are
based on final salary, which critics say give an incentive to managers to award
themselves large salary increases in their last year of employment. Such plans also
disadvantage workers whose earnings peak at mid-career, or who retire or leave the
firm early. For workers who change employers, currently the terms of transfer do not
ensure that a person with a given number of years of service in a defined benefit plan
will carry that same number of years into a new plan. Older workers, for whom
employer benefit costs are higher, may run the risk of involuntary employment
As for the effects on the economy, critics say that claims of increased national
savings ignore the substantial transition costs of providing incentives to contract out
of SERPS. According to government estimates, the costs (in terms of foregone
revenue) associated with the contracting out of SERPS into personal pensions were
three times greater than the savings.13 Furthermore, critics are concerned that the
growing discrepancies in retirement income and the erosion of the “floor of
protection” provided by National Insurance may lead to increased welfare costs to the
government in the long run.
13Liu, Lillian. Retirement Income Security in the United Kingdom. Social Security Bulletin,
v. 62, n. 1, 1999.
Appendix: Detailed Description of the
U.K. Social Security System
The U.K. social security system is a two-tiered, semi-privatized public pension
system with a fairly complex contribution and benefit structure. The system is funded
through payroll taxes (National Insurance (NI) contributions) levied on workers and
employers. NI contribution rates and the amount of earnings on which contributions
are paid differ for workers and employers. Reduced NI contribution rates apply for
persons who contract out of the earnings-related part of the system in favor of private
arrangements. The first benefit tier — the basic state pension — is mandatory and
provides a small, flat-rate benefit to most workers. The second benefit tier — the
State Earnings-Related Pension Scheme (SERPS) — provides an additional benefit
based on earnings to employees (self-employed workers are not eligible for SERPS).
Participation in SERPS is voluntary. Employees may opt out of the second tier of the
system if they participate in an employer-sponsored plan, a qualified personal pension
or, as of April 2001, a stakeholder pension (see Figure 1).
During the past decade, the U.K. system has drawn criticism from some
policymakers concerning the limitations associated with existing contracting-out
options, particularly given the reduction in SERPS benefits for future retirees. Many
workers do not have access to employer-sponsored plans and personal pensions are
impractical for those with low earnings or unsteady work patterns. Some
policymakers expressed concern that, without further adjustments to the public
retirement system, the income gap between the wealthiest and the poorest pensioners
would continue to widen. Currently, the U.K. government is phasing in a series of
new reforms — including the introduction of “stakeholder” pensions and the new
State Second Pension — that aim to make private pensions accessible to a broader
segment of the working population and improve second-tier benefits for those who
remain in the state system, especially lower paid workers.
The basic state pension and SERPS are financed on a pay-as-you-go basis from
NI contributions paid by workers and employers. The programs are assessed
periodically to determine if NI contribution rates are sufficient to maintain program
solvency. General revenues may be used if funding shortfalls occur. Employees who
remain in SERPS pay 10% of weekly earnings between £76 and £535 ($109 to $770).
Employees pay a reduced rate of 8.4% if they contract out of SERPS. Because
employees who contract out of SERPS do not receive a second-tier benefit from the
government, they pay lower NI contributions to reflect the state’s reduced liability.
The reduction in NI contributions is known as the contracted-out “rebate.”
Employers pay 12.2% of all weekly earnings over £84 ($121) for employees who
remain in SERPS. If an employee contracts out of SERPS, the employer pays a
reduced rate on the first portion of “taxable” weekly earnings (earnings between £84
and £535 ($121 to $770)) and the full rate of 12.2% on all additional weekly earnings.
A reduced rate of 9.2% applies if the employee participates in an employer defined
benefit plan and 11.6% if the employee participates in an employer defined
contribution plan. If the employee has an Appropriate Personal Pension in place of
SERPS, the employee and employer pay NI contributions at the full rate as if they
were paying into SERPS (10% for employee, 12.2% for employer) and the
government makes a payment directly to the individual’s personal pension scheme to
reflect the contracted-out rebate.
Table A-1. Employee and Employer National Insurance
Contribution Rates in the United Kingdom, 2000/2001
Contracted out of
Earnings from £76.01 to £535 per week10%8.4%
Employee’s earnings threshold: £76 per week
Upper earnings limit: £535 per week
Earnings over £84 per week12.2%with an employer defined
Employer’s earnings threshold: £84 per weekC9.2% of earnings
threshold” up to and
including the “upper
12.2% of additional
with an employer defined
C11.6% of earnings
threshold” up to and
including the “upper
12.2% of additional
Note: If an employee contracts out of SERPS using an Appropriate Personal Pension, the employee
and employer pay NI contributions at the full rate (10% for employees, 12.2% for employers) and
a payment is made directly to the individual’s account by the government to reflect the “rebate” on
NI contributions. The amount of the rebate, which ranges from 3.8% to 9.0%, is based on the
worker’s age with higher rebates paid to older workers.
Self-employed workers, who are not eligible for SERPS, pay a flat rate of £2 per
week ($3) plus 7% of net annual earnings between £4,385 and £27,820 ($6,314 to
$40,061). The self-employed are not required to contribute to a second pension.
Approximately half currently contribute to a personal pension.
First Benefit Tier — Basic State Pension
Workers with earnings above a certain level must pay NI contributions to earn
entitlement to the basic state pension which provides a small, flat-rate public pension
based on years of contributions (regardless of earnings). The basic state pension is
available to both employees and the self-employed. Benefits are paid to men at age
65 and to women at age 60 (between 2010 and 2020, the retirement age for women
will increase gradually to 65). To qualify for the full basic state pension, a worker
must pay NI contributions for at least 90% of his or her working life (currently, 49
years for men, 44 years for women). Individuals may receive credits for periods in
education, training, unemployment, disability, caregiving and child rearing. Reduced
benefits (a percentage of the full basic pension based on the number of qualifying
years) are payable, however, workers must have enough qualifying years to receive
at least 25% of the full basic pension (below that amount no benefit is payable).
There is no option for early retirement with reduced benefits. Benefits are increased
for each year a worker defers retirement beyond the state pension age.
Basic state pensions have been indexed since 1950. During the 1950s and 1960s,
pensions were indexed on an ad hoc basis. Between 1975 and 1981, pensions were
automatically adjusted by the growth in either prices or earnings, whichever was
greater. Since that time, they have been indexed automatically to price growth
resulting in a decline in pension values relative to average earnings. In 1978, the
maximum basic state pension replaced about 25% of the average wage. In 1998, it
replaced 16% of the average wage. If earnings continue to rise faster than prices as
projected, the value of the maximum basic state pension as a percentage of average
wages is projected to fall to 10% by 2030 and 7.5% by 2050.14
The basic state pension provides only a minimal level of benefits: £67.50 per
week ($97) for a single person and £107.90 per week ($155) for a couple.15 There
are an estimated 11 million recipients. Spending for the basic state pension is an
estimated £33.8 billion ($49 billion).
Second Benefit Tier — State Earnings-Related Pension
Under National Insurance, an additional earnings-related benefit (SERPS) is
payable when a worker reaches the state pension eligibility age. As originally
designed, SERPS provided a benefit equal to 1.25% per year of coverage (up to a
maximum of 20 years) times the average indexed amount of the 20 highest years of
earnings between the “lower” and “upper earnings limit.” Therefore, SERPS
14Liu, Lillian. Retirement Income Security in the United Kingdom. Social Security Bulletin,
v. 62, n. 1, 1999.
15The Minimum Income Guarantee (MIG), a means-tested benefit for the elderly, provides
slightly higher benefits. On a weekly basis, the MIG provides £78.45 ($113) for single
persons ages 60-74 (£121.95 ($176) for couples); £80.85 ($116) for single persons ages 75-
79 (£125.35 ($181) for couples); and £86.05 ($124) for single persons age 80 and older
(£131.05 ($189) for couples).
provided a maximum replacement of 25% (1.25% x 20 years = 25%) of the best 20
years of average indexed earnings. Combined with the basic state pension, a full-
career worker with average earnings received a replacement rate of about 40%
(combined benefits replaced about 40% of a worker’s earnings in the year before
SERPS benefit formula changes, included in the Social Security Act of 1986 as
a means to reduce future public pension costs, resulted in lower benefits for workers
who reach pensionable age after April 5, 1999. In the absence of policy changes
described below, SERPS benefits would decline gradually from 25% of the highest
Furthermore, benefits are based on a worker’s earnings between the “lower” and
“upper earnings limit.” The upper earnings limit is indexed to prices. If wages grow
faster than prices as projected, a smaller proportion of earnings would be credited
under SERPS and the value of SERPS benefits as a proportion of earnings would
decline over time.
As of March 1999, the average SERPS benefit was £29.68 per week ($43) for
men, £16.85 per week ($24) for women. The maximum SERPS benefit was £125.30
per week ($180). Currently, SERPS spending is an estimated £4.7 billion ($6.8
As early as April 2002,17 SERPS will be replaced with the State Second Pension.
The State Second Pension is designed to benefit primarily lower paid workers (by
providing a higher benefit than SERPS)18 and persons whose careers are interrupted
by periods of disability or caring for children or sick family members (by providing
earnings credits during non-work periods to protect their entitlement to benefits).
Under the State Second Pension, workers with earnings between the annual “lower
earnings limit” (the level of earnings at which individuals are automatically covered
under the system) and a new, higher “low earnings threshold” will be treated as if they
had earnings equal to the low earnings threshold.19 Similarly, caregivers and disabled
persons with little or no earnings for the year will be treated as if they had earnings
equal to the low earnings threshold if they meet certain requirements.20
16The revised benefit formula provides for 1% per year of coverage (instead of 1.25% per
year) up to 20 years. In addition, benefits would be based on earnings for all working years
since 1978 (the year SERPS benefits were introduced) instead of the highest 20 years of
17In July 2000, the Child Support, Pensions and Social Security Act of 2000 established the
State Second Pension as a replacement for SERPS. The earliest implementation date for the
State Second Pension is April 2002. The actual implementation date depends on the readiness
of operational systems needed to administer the program.
18Because SERPS benefits are based on earnings, career low earners do not build up
substantial second-tier benefits.
19The “low earnings threshold” is £9,500 ($13,680) in 1999/2000 terms. In the future, it will
be indexed to average wage growth.
20Caregivers may qualify for the earnings credit if they receive a Child Benefit for a child
The State Second Pension will be implemented in two stages. In the first stage,
it will provide a benefit based on earnings. Different accrual rates (40%, 10%, and
20%) will apply to three bands of earnings such that persons who have annual
earnings between the “lower earnings limit” and an “upper threshold” of £21,600
($31,104) will receive a benefit higher than they would have received under SERPS
with the largest proportional increases going to the lowest earners. Persons with
earnings of £21,600 and higher will receive a benefit equal to what they would have
received under SERPS.
In the second stage, which is to be implemented after stakeholder pensions have
become established (an estimated 5 years), the State Second Pension will be
converted to a flat-rate benefit based on the “low earnings threshold” for persons who
have a significant number of working years left. At that point, everyone who remains
in the State Second Pension will be treated as if they had earnings equal to the “low
earnings threshold” regardless of actual earnings. The conversion to a flat-rate benefit
is designed to encourage moderate and higher earners to make private second-tier
arrangements such as an employer plan if available or a stakeholder pension.
The government estimates that 18 million people will benefit from the State
Second Pension including 14 million low and moderate earners, 2 million caregivers,
and 2 million disabled persons. The majority of low earners expected to benefit are
female, part-time workers who do not have private pension arrangements.21
“Contracting Out” of SERPS
Currently, workers may opt out of SERPS through membership in their22
employer’s pension plan or an Appropriate Personal Pension. Starting in April
2001, employees will have the option to contract out of SERPS using newly
established stakeholder pensions. Most workers who contract out of SERPS join an
employer-sponsored defined benefit pension plan in which case their contributions and
their employer’s contributions to the social security system are reduced by the
equivalent of the estimated amortized cost of the pension. Originally, the plan had to
offer a guaranteed minimum pension roughly equivalent to what SERPS would have
provided, but this requirement was replaced by more general requirements on the
under age 6 in their care; are entitled to Invalid Care Allowance; or receive Home
Responsibilities Protection (a person is treated as being precluded from regular employment
by responsibilities at home if they are caring for a sick or disabled person). Disabled persons
who are entitled to Incapacity Benefit or Severe Disablement Allowance may qualify for the
earnings credit if they have paid NI contributions for at least one-tenth of their working lives
since 1978 (when SERPS benefits were introduced) by the time they reach the state pension
21U.K. Department of Social Security. The Changing Welfare State: Pensioner Incomes.
22Employers are permitted to contract out employees who are members of an employer pension
plan that meet the qualifying criteria. In effect, the option of contracting out is the employees’
as they decide whether to join or remain in such plans. If they do not, they must participate
in SERPS or an Appropriate Personal Pension.
structure of the plan effective April 1997. Since 1988, workers have had the option
of choosing an employer-sponsored defined contribution plan or an Appropriate
Personal Pension. In either case, the contribution rate must at least equal the
contracting-out rebate or the amount that would produce the minimum pension
requirements. Employees can make additional voluntary contributions to increase the
value of the pension. For the first 5 years, the government encouraged workers
without an employer pension to opt out of SERPS into an APP by providing rebates
on part of their National Insurance contributions plus a 2% bonus and the option to
reenter SERPS. From 1993/1994 through 1996/1997, the 2% bonus was reduced to
1% for those age 30 and over. Initially, the government estimated that about 500,000
people would contract out of SERPS in favor of personal pensions with the number
eventually expected to reach 2 million. By 1995, almost 6 million workers had opted
for personal pensions (5.4 million having left SERPS and the remainder having left
occupational pension plans).23
The tax system provides another incentive to contract out of SERPS. Worker
and employer contributions to both employer and private pensions are tax deductible,
and no tax is payable on income or capital gains of the pension funds. Pension
benefits are fully taxable although the tax code provides additional tax breaks for
The government requires that, except for civil service and military pensions,
employer pensions must be fully funded for workers to be allowed to contract out of
SERPS. All but 5% of the investments of the pension fund must be outside the
company and can revert to the company only in limited circumstances. Unlike
employer-sponsored defined benefit plans in the U.S., they must preserve the value
of the benefits of employees who leave the firm before retirement by indexing the final
salary by the rate of inflation, up to 5% per year. In addition, unlike in the U.S., the
government requires that employer defined benefit pensions provide beneficiaries
annual increases in benefits indexed to inflation, up to 5% per year. (In the U.S.,
there is no government requirement that employer-provided pensions must index
benefits to inflation. Most plans do not adjust benefits after retirement, and those that
do usually do so at a rate well below that of inflation.)
Currently, there are two types of personal pensions. An “Appropriate Personal
Pension” is a personal pension taken out in place of SERPS. An “ordinary” personal
pension is an individually-arranged personal pension usually taken out by the self-
employed (who are not covered under SERPS) or as an addition to SERPS or an
employer pension. With either type of personal pension, a worker may withdraw up
to 25% of assets as a tax-free lump sum upon retirement. Otherwise, the assets must
be used to purchase an annuity from a life insurance company which pays the retiree
an agreed upon income for the rest of his or her life. Flat payment annuities or
annuities indexed to inflation are available. The part of the personal pension that
replaces SERPS, however, must be indexed to inflation, up to 5% per year. Because
some workers retire at a time when annuities are very expensive, rules allow them to
defer their purchase until age 75.
23Congressional Budget Office. Social Security Privatization: Experiences Abroad. January
Starting in April 2001, stakeholder pensions will be available as an alternative to
SERPS.24 Stakeholder pensions are fee-capped, defined contribution plans designed
to benefit primarily moderate and higher earners who do not have access to an
employer-sponsored plan and for whom existing personal pensions are not a good
value (including the self-employed who are not covered by SERPS). Designed as a
low cost, portable private pension option, stakeholder pensions are intended to benefit
persons who change jobs frequently or work intermittently. They will be sold in the
workplace by insurance companies, banks and other financial institutions. Self-
employed workers will be able to purchase them directly from providers.25
By October 2001, employers with five or more employees are required to offer
persons with at least 3 months’ service access to a stakeholder pension scheme if an
occupational scheme or a group personal pension is not offered (employees are not
required to join the stakeholder scheme).26 Employers are not required to make
contributions, but they must process employee contributions through the payroll27
system. Employees may change payroll deductions every 6 months. Minimum
contributions may be set no higher than £20 ($29). Contributions of up to £3,600 per
year ($5,184) are allowed regardless of earnings with higher contribution amounts
subject to existing personal pension age and earnings-related limits (ranging from
17.5% of annual earnings for persons age 35 and under to 40% of annual earnings for
persons age 61 and older).28 Employees may stop and restart contributions and
transfer into and out of stakeholder schemes without penalty. Under stakeholder
24In November 1999, stakeholder pension schemes were established by the Welfare Reform
and Pensions Act of 1999. Both occupational and personal pension schemes may acquire
“stakeholder” status if they meet certain requirements and are registered as a stakeholder
scheme with the Occupational Pensions Regulatory Authority (OPRA).
25Stakeholder pensions will be available to non-earners as well (including children) subject to
an annual contribution limit of £3,600 ($5,184). Employees in occupational schemes may
contribute to a stakeholder pension at the same time if their annual earnings do not exceed
£30,000 ($43,200). The government estimates that about 90% of employees contributing to
an occupational scheme will qualify for stakeholder pensions.
26Employers are exempt if they provide an occupational scheme which all staff are eligible to
join within 1 year of employment (excluding new employees within 5 years of retirement and
those under age 18); provide a group personal pension for all staff to which they contribute
at least 3% of employee earnings; or all staff have earnings below a specified amount (the
“lower earnings limit”).
27Employees may make contributions directly to the scheme.
28Under new pension rules, the £3,600 non-earnings-related contribution limit also applies to
personal pensions. Previously, contributions to personal pensions were linked entirely to
earnings (contribution limits were specified as a percentage of income based on the age of the
worker). As a result, persons without income (nonworking spouses, caregivers, etc.) were
precluded from contributing to a personal pension. Similarly, workers who had been
contributing to a personal pension were not allowed to continue making contributions during
temporary periods out of the labor force. Under the new guidelines, individuals may
contribute up to £3,600 per year ($5,184) to a personal pension regardless of earnings.
Higher contribution amounts are allowed subject to existing age and earnings-related limits.
For personal and stakeholder pensions, earnings-related contributions may continue for up to
pension schemes, annual charges are based on a percentage of fund assets up to a
ceiling of 1%. It is said that given the ceiling on charges, investment options will
likely be limited. If more than one investment fund is offered, the stakeholder scheme
must designate a default investment fund.
Additional Information on Stakeholder Pensions and the State Second Pension is
Available at the Following U.K. Web Sites:
U.K. Department of Social Security:[http://www.dss.gov.uk]
Occupational Pensions Regulatory Authority:[http://www.opra.gov.uk]