Annex 1 of the Pensions in the National Accounts - A fuller picture of the UK's funded and unfunded pension obligations. Annex 1 covers state pension estimates for the UK Supplementary Table on Pensions 2010 and provides a sensitivity analysis.
This document is an annex to the article ‘Pensions in the National Accounts – A fuller picture of the UK’s funded and unfunded pension obligations’ published on 27 April 2012. It presents detailed results and sensitivity analysis for the state pension estimates which appear in that article in Column H of the 2010 National Accounts supplementary table on pensions. The state pension estimates have been produced for the Office for National Statistics (ONS) by the Department for Work and Pensions (DWP). ONS and the Government Actuary’s Department (GAD) have quality assured the results.
In the supplementary table, as elsewhere in the National Accounts, state pensions do not include social assistance (income-related benefits). State pension estimates in the UK are for the contributory state pension which is made up of two tiers: the Basic State Pension (BSP), which provides a flat-rate pension in retirement, and the additional state pension.
In order to qualify for the full BSP, which is £107.45 per week for a single person in 2012/13, people reaching State Pension Age need to have 30 ‘qualifying years’. Qualifying years are built up by paying National Insurance Contributions while working or, if not in work, through credits. People may also purchase qualifying years by making additional voluntary contributions. If someone has fewer than 30 qualifying years, they receive a partial payment in proportion to the number of qualifying years they have built up.
With the additional state pension, employees (but not the self-employed) add to the BSP by making extra contributions in order to receive additional pension payments. People who care for others can build up entitlements to the additional state pension through credits. The additional state pension was first introduced as the State Earnings-Related Pension Scheme (SERPS) in 1978. SERPS was replaced by the State Second Pension (S2P) in 2002.
The second article in the Pensions in the National Accounts series (Levy 2011) describes how the state pensions estimates for the 2010 UK supplementary table on pensions were produced by DWP from models developed for its long-term projections of state pension expenditure. There are two models: one for BSP and another for AP. In DWP’s models, references to Additional Pension (AP) refer to SERPS and S2P. Estimates for the state graduated retirement benefit scheme (GRAD), a forerunner of SERPS, are produced separately by the BSP model. The BSP model is also used to produce separate estimates for lump sums which people may take if they defer receipt of their state pension for 12 consecutive months or more beyond State Pension Age.
For the 2010 supplementary table on pensions, DWP adjusted the state pension estimates generated by the long-term projections models onto an ‘accrued-to-date’ basis. This is because the long-term projections models take into account future accumulation of pension rights as well as pension rights accrued to date, while the National Accounts supplementary table on pensions shows only rights accrued to date1. Details of the DWP model and the adjustments made to produce estimates for the 2010 supplementary table on pensions can be found in Levy (2011).
This section presents estimates of the total state pension entitlements of UK households from the 2010 supplementary table on pensions. These are also the total obligations or liabilities of the UK government in respect of state pensions. Row 1 of the 2010 table (Table 1) contains the opening balance for 2010, which is also the closing balance for the previous year (31 December 2009). Row 10 shows the closing balance as at 31 December 2010.
|Row||Item||Calculation/source||Basic State Pension (BSP)||Additional Pension (AP)||Total state pension|
|Opening balance sheet|
|1||Pension entitlements||Closing balance at 31 December 2009||2,798||633||3,497|
|2||Social contributions||Sum of Rows 2.1 to 2.4||225||42||270|
|2.1||Employer actual social contributions||Employer % of total accruals estimated using data on employer/employee proportions of National Insurance contributions||50||6||56|
|2.2||Employer imputed social contributions||Not applicable|
|2.3||Household actual social contributions||Household % of total accruals estimated using data on employer/employee proportions of National Insurance contributions||36||5||41|
|2.4||Household social contribution supplements||Row 1 x 5% (nominal discount rate for supplementary table)||138||31||173|
|3||Other (actuarial) accumulation of pension entitlements in social security pension schemes||Balancing item: Row 10 - Row 1 - (sum rows 2,6,7,8,9) + Row 4. Captures 'experience effects'.||108||4||112|
|4||Payment of pension benefits||Payment of pensions during year||54||13||69|
|5||Changes dues to social contributions and pension benefits||Row 2 + Row 3 - Row 4||279||32||313|
|6||Transfers between schemes (net)||Transfers in - Transfers out (payment to leavers)||0||0||0|
|7||Changes due to pension scheme reforms||Changes due to reforms enacted by Parliament or not requiring legislation (past service cost)||162||-124||33|
|Other economic flows|
|8||Revaluations||Changes in financial assumptions||0||0||0|
|9||Other changes in volume||Changes in demographic assumptions||0||0||0|
|Closing balance sheet|
|10||Pension entitlements||Closing balance at 31 December 2010||3,238||542||3,843|
Table 1 shows that at the end of 2009, state pension entitlements were estimated at £3,497 billion. Of this total, 80 per cent was made up of entitlements to BSP (£2,798 billion) and 18 per cent comprised entitlements to AP (£633 billion). The remaining 2 per cent was made up of entitlements to GRAD and lump sums. By the end of 2010, total state pension entitlements were estimated to have risen to £3,843 billion, an increase of 10 per cent.
In DWP’s BSP and AP models, the initial outputs show forecast expenditure every year from the date of the accounts (December 2009 or December 2010) until 2114. However, for the National Accounts supplementary table on pensions, a single figure representing the present value of obligations/entitlements is required for the opening and closing balances. In order to produce these present value figures, future expenditure flows must be discounted using a discount rate (see Box 1) and summed to give a single figure. Eurostat, the European statistical agency, requires that the same discount rate (3 per cent real or 5 per cent nominal) be used in all EU countries for all government-managed pension schemes including state pensions.
Figures 1 to 3 show the effect of discounting future flows of expenditure. Discounted values show the value in today’s terms of payments that will be made in future years.
For BSP (Figure 2), annual expenditure before discounting is expected to peak in the 2050s. Also, it is higher for the December 2010 estimates than for the December 2009 estimates because the introduction of the triple lock policy in June 2010 meant that BSP would be uprated faster than previously assumed1. Once the future expenditure flows are discounted, the amounts are much lower (reflecting their present day value) and the peak of annual expenditure is in 2033 rather than in the 2050s; but the December 2010 estimates remain higher than the December 2009 estimates due to the introduction of the triple lock policy.
For AP (Figure 3), a reduction after discounting can also be observed. However, expenditure is lower for the December 2010 estimates than for the December 2009 estimates because of the effect of the change from Retail Prices Index (RPI) to the Consumer Prices Index (CPI) during 2010 for uprating AP payments. It is also noticeable that for December 2010, expenditure in present value terms peaks early, in 2013, and declines thereafter.
However, readers should note that the shape of the curves after discounting depend on the level of the discount rate: altering the level of the discount rate will not only change the height of the curve, but also change the point at which expenditure is expected to peak, since this depends on the relationship between the rate at which pensions are uprated and the rate at which payments are discounted. Section 4 examines the impact of changing the discount rate on the present value of accrued-to-date obligations (expenditure).
GRAD (Figure 4) behaves in a similar way to AP – with lower expenditure for the December 2010 estimates than for the December 2009 estimates because of the effect of the change from RPI to CPI in 2010, and with an early peak and subsequent decline in expenditure. However, for GRAD this decline is exacerbated by the fact that accruals ended in April 1975, so the numbers of pensioners with GRAD is forecast to decline sharply after 2020.
The discount rate (r) is the rate which is used to convert future payments into a ‘present value’ at a particular date. For example, the present value (PV) at time (t) of a payment (P) payable one year in future (at t+1) is calculated as:
PVt = Pt+1/ (1+r)
In the case of pensions, there is a stream of payments for many years into the future which are discounted to calculate the present value.
Total state pension entitlements were estimated at £3,843 billion at the end of 2010, an increase of 10 per cent with respect to the end-2009 figure. The main article of which this document is an annex points out that many of the estimates of unfunded pension liabilities (including state pension liabilities) that have been published in the UK in recent years have been difficult to interpret because they do not show why the figures change from one year to the next. By contrast, the information in the supplementary table helps to explain changes in entitlements/liabilities over time.
Rows 2 to 9 of Column H of the supplementary table (Table 1) show the changes in households’ state pension entitlements during the year 2010:
Rows 2.1 and 2.3 contain actual National Insurance Contributions (NICs) to state pensions, which are the same as those currently shown in the UK National Accounts. These add to the opening balance shown in Row 1, increasing entitlements. However, the actual contributions figures are not the same as the extra expenditure on state pensions to which people become entitled as a result of paying NICs (see Row 3 below).
Row 2.4 is the ‘unwinding of the discount rate’ or re-valuation of liabilities between the start and end of each year, which is calculated by multiplying Row 1 by the nominal discount rate. This adds to the opening balance, increasing entitlements.
Row 4 shows the payment of pension benefits during the year, derived from DWP’s models. These are subtracted from the opening balance, reducing entitlements.
Row 6 comprises transfers of pension entitlements into the additional state pension when individuals cease to contribute to contracted out private pension schemes; this figure was negligible in 2010, so it shows as zero in Table 1.
Row 7 contains an estimate of changes in ‘past service cost’ i.e. benefits accrued in previous years due to legislation enacted during the year (or official announcements that do not require legislation). This figure is positive for BSP in 2010 – implying an increase in entitlements between the beginning and the end of the year – because of the change in uprating to the ‘triple lock’. It is negative for AP in 2010 – implying a decrease in entitlements – because of the change in uprating from the RPI to the CPI measure of inflation.
Rows 8 and 9 show any changes in entitlements due to changes in financial and demographic assumptions respectively. However, in 2010 these contain zeros because the discount rate is stable, as prescribed by Eurostat, and there were no changes in assumptions about growth or wages, indexation of benefits, inflation or life expectancy during the year. In future versions of the supplementary table, there are likely to be entries in these rows. For instance, every two years Row 9 will show changes that reflect revised ONS projections of life expectancy1.
Row 3 captures the increase in entitlements for people who do not make NICs through work (for instance people of working age who are unemployed, looking after children or caring for elderly relatives); these people are credited with qualifying years which allow them to build up state pension entitlements. It also captures, for working people, the difference between the actual value of NICs made by them or their employers and what they will receive in state pension payments as a result of these contributions, for instance because they contribute for longer than the maximum 30 ‘qualifying years’ or because of uprating. In addition, it contains a small ‘residual’ (differences in the outcome because some actual changes turn out to be different from those assumed in the model).
The 10 per cent increase in entitlements/liabilities during 2010 was not because of any changes in financial assumptions (including the discount rate) or in demographic assumptions. Part of it was due in part to increases contributions (Row 2) and related increases in entitlements (Row 3) minus payment of benefits (Row 4). In other words, the entitlements built up during the year by working people outweighed the reduced entitlements during the year due to payment of benefits to pensioners. However, a substantial part of the increase in contributions (£173 billion) was not due to actual cash flows but to re-valuation of liabilities (Row 2.4). Another part of the 10 per cent increase in entitlements/liabilities during 2010 was explained by the changes in uprating, which produced an increase of £162 billion in BSP entitlements and a decrease of £124 billion in AP entitlements, leading to an overall increase of £33 billion in Row 7.
3.1 Changes before 2009
The latest available estimate of state pension liabilities, before the publication of the 2010 supplementary table on pensions, was produced by GAD for Great Britain as at 31 March 2005; this estimate put total liabilities at £1,347 billion, based on the legislation in force at that date. HM Revenue and Customs (HMRC) published a UK-equivalent figure of £1,354 billion as at 31 March 20052. This article shows that the figure as at 31 December 2009, estimated using DWP’s models, was £3,497 billion. Thus, there was a big change in the estimate of entitlements/liabilities between March 2005 and December 2009. One reason for this was the passage of the Pensions Act 2007 during this period (see Box 2).
|Basic State Pension (BSP) £ bn||Additional State Pension (AP) £ bn||Total state pension £ bn||% of total change||Corresponding row in Supplementary Table|
|DWP estimate for UK as at 31/12/2009||2,864||633||3,497|
|Exclude NI adjustment||72||16||88||4%|
|Change to 2006-based population projections (used in GAD's model for March 2005 estimates)||26||7||33||2%||9|
|Use of previous economic assumptions||-154||51||-102||-5%||8|
|Effect of discounting - changing the value of the discount rate assumption from 5% to 6.1%||660||115||775||36%||8|
|Effect of discounting - moving the discounting back for March 2005 estimate||513||102||615||29%||2.4|
|Payment of benefits between March 2005 and December 2009||-141||-30||-171||-8%||4|
|Removing the effect of additional accruals between March 2005 and December 2009||126||24||150||7%||2.1. 2.3 and 3|
|Applying uprating rules in force before Pensions Act 2007||466||0||466||22%||7|
|Applying the State Pension Age rules in force before Pensions Act 2007||-24||-6||-30||-1%||7|
|Scheme rule changes (for BSP, this is due to changes in Pensions Act 2007; for AP, other changes)||105||-1||103||5%||7|
|GAD estimate for Great Britain as at 31/3/2005||1,017||330||1,347|
ONS asked DWP to investigate the change between 31 March 2005 and 31 December 2009. The results of DWP’s analysis are shown in Table 5. The main reasons for the change were:
The difference between the discount rate used by GAD for the 2005 estimates (6.1 per cent) and the 5 per cent nominal discount rate used for the 2010 supplementary table, as well as the effect of moving the discounting back from December 2009 to March 2005 (or the unwinding of the discount rate). These produced increases of 36 per cent and 29 per cent respectively (65 per cent in total).
Changes in uprating rules for BSP as a result of the measures in the Pensions Act 2007 which replaced uprating by RPI with uprating in line with earnings; the model projected this change to be implemented from 2012/13. This produced increases with respect to the March 2005 estimate of 22 per cent. On the other hand, the changes to BSP scheme rules as a result of the Pensions Act 2007 had less impact (a 5 per cent increase). The cost reduction as a result of the increases to State Pension Age in the Act was also relatively minor (1 per cent with respect to the March 2005 estimate).
The Pensions Act 2007 also produced a cost saving in terms of reduced payments of Pension Credit, since the changes were designed to move people off the guarantee credit element of Pension Credit and onto contributory state pensions. Therefore much of the increase in state pension obligations in 2007 would have been offset by a decrease in obligations to pay Pension Credit. However, Pension Credit is a form of social assistance, so it is not included in the National Accounts supplementary table on pensions and it is not shown here.
The Pensions Act 2007 introduced a package of measures including, from 6 April 2010:
the restoration of the link between BSP and earnings (replacing uprating by RPI), to be implemented sometime between 2012 and 2015,
an increase in State Pension Age for both sexes from 65 to 68 between 2024 and 2048,
a reduction in the number of qualifying years for full BSP to 30 (from 44 for men and 39 for women) for those reaching State Pension Age on or after this date,
the ending of the requirements (a) for people to have at least one-quarter of the full number of qualifying years to receive any BSP and (b) for at least one year to come from paid contributions rather than credits, and
the introduction of a new system of carer credits.
This section presents the results of analysis of what happens to the accrued-to-date estimate of pension entitlements (or liabilities) as at 31 December 2010 when the assumptions used to produce the estimate change. Each assumption in turn is varied, while holding the other assumptions constant. The changes are reported with respect to a ‘central estimate’, which is the estimate of entitlements (or liabilities) at 31 December 2010 shown in Row 10 of Table 1.
Table 6 looks at the impact of varying the nominal discount rate away from the 5 per cent level used for calculating estimates in the supplementary table on pensions. Increasing the discount rate by 0.25 per cent to 5.25 per cent leads to a 6 per cent decrease in total state pension entitlements (by £231 billion), while increasing the discount rate by one percentage point to 6 per cent leads to a 21 per cent decrease in total state pension entitlements (by £815 billion). Reducing the discount rate has an even greater impact on the estimates. For example, reducing the discount rate to 4 per cent leads to a 31 per cent increase in total state pension entitlements (by £1,174 billion).
|Basic State Pension (BSP)|
|Nominal discount rate (%)||4.0||4.25||4.50||4.75||5.00||5.25||5.50||5.75||6.00|
|Change in pension entitlements (£ billion)||1018||726||461||220||0||-200||-383||-551||-704|
|Change in pension entitlements (%)||31||22||14||7||0||-6||-12||-17||-22|
|Additional Pension (AP)|
|Nominal discount rate (%)||4.0||4.25||4.50||4.75||5.00||5.25||5.50||5.75||6.00|
|Change in pension entitlements (£ billion)||145||104||66||32||0||-29||-55||-80||-102|
|Change in pension entitlements (%)||27||19||12||6||0||-5||-10||-15||-19|
|Total state pension|
|Nominal discount rate (%)||4.0||4.25||4.50||4.75||5.00||5.25||5.50||5.75||6.00|
|Change in pension entitlements (£ billion)||1174||837||532||253||0||-231||-443||-637||-815|
|Change in pension entitlements (%)||31||22||14||7||0||-6||-12||-17||-21|
Table 6 also shows breakdowns for the main components of the state pension: BSP and AP. The impact of changes in the discount rate is greater for BSP than for AP because the central estimate of BSP entitlements is much larger than the central estimate of AP entitlements (see Table 1).
Table 7 shows the impact of varying long-term uprating assumptions for BSP and AP payments with respect to the central estimate of entitlements as at 31 December 2010. The uprating approach in each case is different: in the case of BSP, uprating is based on the triple lock policy (see Section 2.1), while for AP it is in line with the CPI measure of inflation (assumed to be 2 per cent in the long term). The analysis shows the impact of varying uprating in each case.
For BSP, increasing uprating by 1 per cent leads to a 31 per cent increase in entitlements, while reducing uprating by 1 per cent leads to a 22 per cent reduction in entitlements. For AP, increasing uprating by 1 per cent leads to a 16 per cent increase in entitlements, while reducing uprating by 1 per cent leads to a 13 per cent reduction in entitlements.
|Basic State Pension (BSP)|
|Change in uprating (%)||-2||-1||+1||+2|
|Change in pension entitlements (£ billion)||-1,233||-712||1,008||2,469|
|Change in pension entitlements (%)||-38||-22||31||76|
|Additional Pension (AP)|
|Change in uprating (%)||-2||-1||+1||+2|
|Change in pension entitlements (£ billion)||-131||-71||85||217|
|Change in pension entitlements (%)||-24||-13||16||40|
Although Table 7 shows the effect of changes in long-term uprating assumptions of +/-2 per cent, changes of this magnitude are unlikely to occur without a significant change in the long-term economic environment, such as persistently higher/lower inflation and/or (nominal) earnings growth. In such circumstances, it is improbable that the nominal discount rate would remain at the same level, as we have assumed in this analysis. It would probably be adjusted to reflect the new economic conditions. This can be explored in the model. As an example, if BSP uprating is increased by 2 per cent and the nominal discount rate is increased from 5 per cent to 7 per cent, the discounted value of the BSP entitlements is materially unaltered compared with the central estimate of entitlements as at 31 December 2010.
Table 8 shows the impact of varying the earnings growth assumption for AP with respect to the central estimate of AP entitlements as at 31 December 2010. As explained in Levy (2011), earnings growth is used in the AP model to revalue entitlements up to State Pension Age. Table 8 shows that a change of +1 per cent in the earnings growth assumption leads to a 13 per cent increase in AP entitlements, while a change of -1 per cent leads to a 10 per cent decrease in AP entitlements. The table also shows the impact of +/-2 per cent change in earnings growth assumptions, but, as noted above, this would be unlikely to occur without a significant change in the long-term economic environment, such as persistently higher/lower inflation and/or (nominal) earnings growth, which would affect the choice of nominal discount rate.
|Change in earnings growth assumption (%)||-2||-1||+1||+2|
|Change in pension entitlements (£ billion)||-95||-53||69||159|
|Change in pension entitlements (%)||-18||-10||13||29|
|High life expectancy||BSP||AP||Total state pensions|
|Change in pension entitlements (£ billion)||304||35||341|
|Change in pension entitlements (£ billion)||9||6||9|
|Low life expectancy|
|Change in pension entitlements (£ billion)||-298||-31||-331|
|Change in pension entitlements (%)||-9||-6||-9|
The mortality rates used by DWP in the BSP and AP models are taken from the ONS’s 2008-based National Population Projections, specifically the central or ‘principal’ projection. ONS also produces variants around this central projection, including one based on the assumption that life expectancy increases more rapidly than expected in future (the ‘high life expectancy’ variant) and another based on the assumption that life expectancy increases less rapidly than expected (the ‘low life expectancy’ variant). Table 9 shows the effect of using mortality rates based on the high and low life expectancy variants rather than on the principal projection. This produces changes in pension entitlements of +/-9 per cent for BSP and +/-6 per cent for AP.
The sensitivity analysis presented in this section shows that changes in the assumptions used to produce estimates of pensions entitlements (or liabilities) produce important changes in the results. The greatest impact on the discounted values of pensions accrued to date comes from changing the discount rate and uprating assumptions.
ONS commissioned DWP to produce estimates of state pensions for the 2010 experimental supplementary table on pensions, which is part of new international requirements for the National Accounts. Pension obligations in the supplementary table are estimated on an accrued-to-date basis, showing amounts due for service to date, excluding rights which will be built up in the future.
At the end of 2010, UK state pension obligations were estimated at £3,843 billion, an increase of 10 per cent compared with the estimate of £3,497 billion at the start of the year (31 December 2009). These are the first official figures for the government’s accrued-to-date state pension liabilities since 31 March 2005, when they were estimated at £1,354 billion. The main reasons for the increase between March 2005 and December 2009 were discount rate and discounting changes and changes in uprating rules for the Basic State Pension as a result of the Pensions Act 2007. The impact of increases to State Pension Age under the 2007 Act had little impact.
Although the supplementary table on pensions contains a single estimate of households’ state pension entitlements (or the government’s state pension liabilities) for the end of each year, this article has shown that varying the modelling assumptions can have a major impact on the estimates. As with the analysis of changes between March 2005 and December 2009, the sensitivity analysis shows that the greatest impact on the discounted values of pensions accrued to date comes from changing the discount rate and uprating assumptions.
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Office for National Statistics (2011): Pension Trends Chapter 5: State pensions