CONTRACTING‐OUT AND LIFETIME REDISTRIBUTION IN THE UK STATE PENSION SYSTEM*

Publication Date01 Feb 1993
DOIhttp://doi.org/10.1111/j.1468-0084.1993.mp55001002.x
AuthorEdward Whitehouse,Richard Disney
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 55, 1(1993)
0305-9049 $3.00
CONTRACTING-OUT AND LIFETIME
REDISTRIBUTION IN THE UK STAlE
PENSION SYSTEM*
Richard Disney and Edward Whitehouse
I. INTRODUCTION
This paper presents empirical evidence as to the lifetime redistributive
impact of the state pension scheme in the United Kingdom (UK) for a cohort
of men. The basic data are simulated individual lifetime earnings profiles for
over 30,000 men derived from Family Expenditure Survey (FES) data. The
focus of the present paper is the impact of contracting-out on the redistribu-
tive potential of the pension scheme. In the UK, individuals can choose to
remain contracted-in to the State Earnings Related Pension Scheme (SERPS),
or to contract-out into an approved occupational pension scheme or, since
the Social Security Act 1986, an approved money purchase scheme such as a
Personal Pension, thereby paying a reduced rate of National Insurance
contribution.
The ability of individuals to contract-out of the state pension scheme must
be expected to circumscribe its lifetime redistributive impact. In general,
lifetime redistribution among members of any generation can occur for
purely stochastic reasons (accidental death), or through systematic factors
such as differential mortality between various occupations and industries, as
well as the particular rules of the scheme governing eligibility for benefits,
levels of benefits, or levels of contributions. For example in the UK, National
Insurance contributions, which finance pensions, are broadly earnings-
related (see Section II below) whereas benefits are two tier, with a flat-rate
component as well as SERPS. The progressivity of the benefit formula is,
however, almost wholly outweighed by the regressive impact of differential
mortality (Creedy, 1982; Creedy and Disney, 1985; Creedy, Disney and
Whitehouse, 1992).
Given residual and predictable lifetime redistribution among cohorts
stemming from the pension formula, contracting-out allows those who expect
to lose from the redistribution (i.e. earn a lower return on their contributions)
* The authors would like to thank the ESRC, under research grant XC 14 25 0015, and the
Carnegie (UK) Trust for financial support; the Department of Employment for allowing access
to Family Expenditure Survey data; and John Creedy for helpful advice.
25
26 BULLETIN
to opt out, so long as the rate at which the contracted-out rebate is set is not
so actuarially unfair as to outweigh the loss. Indeed Hemming and Kay (1981)
suggest that the contracted-out rebate (i.e. reduction in the National Insur-
ance contribution rate) has typically been set at a rate which is highly favour-
able to the intra-marginal occupational pension fund, and this too will have
encouraged contracting-out.'
In similar vein, Disney and Whitehouse (1992) show that the rebate plus
extra 'incentive' offered to optants for the new approved money purchase
schemes, such as Personal Pensions, provide substantial intra-marginal gains
to many individual optants. Thus although contracted-out pension schemes
are themselves constrained by statutory requirements (such as sex-neutrality
in calculating annuity rates on the 'protected rights', and in the provision of
dependants' allowances) and cannot thereby offer fully individual-specific
insurance contracts, the attraction of the contracting-out strategy to the
potential loser in the state scheme remains.
The building blocks of the present paper are the construction of lifetime
earnings profiles for a sample of men, for whom individual National Insur-
ance contributions and pension entitlements are then simulated using the
parameters of the current UK pension scheme. The current pension scheme
and the simulation methodology for the earnings profiles are described
briefly in Appendices A and B respectively.
Measuring the lifetime redistributive impact of the UK pension scheme
(that is, the variance in returns to contributions among individuals, given
revenue neutrality) is not a straightforward issue, and is discussed in the next
section of the paper. Since the intention is to focus on the return to con-
tracted-out versus contracted-in individuals, we wish to sift out the consider-
able complexity of overall redistribution stemming from the interaction of
spouses' pension entitlements. We therefore focus only on men, who are
assumed to receive their full basic state pension plus their supplementary
entitlement. The results of the analysis of returns under various assumptions
are then discussed in Section III, with a brief conclusion to follow.
H. MEASURING REDISTRIBUTION
The UK pension scheme is financed by the scheme of National Insurance
(NI) contributions, notionally levied on employees and employers. Con-
tracted-in employees pay the full rate of NI contributions, and, subject to
obtaining an adequate contribution record, are entitled to receive both the
basic flat-rate pension and the earnings-related 'tier', SERPS. Individuals who
are contracted-out of the NI scheme pay a reduced rate of contribution and
Of course, since occupational pension schemes vary in the composition of their contri-
butors and benefit recipients, the amount of rebate needed to finance the pension equivalent to
the state scheme, which such schemes are required to provide, known as the Guaranteed Mini-
mum Pension (OMP), will vary among schemes.

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