THE BRITISH STATE PENSION: CONTRIBUTIONS, BENEFITS AND INDEXATION1

DOIhttp://doi.org/10.1111/j.1468-0084.1982.mp44002001.x
AuthorJohn Creedy
Publication Date01 May 1982
OXFORD BULLETIN
of
ECONOMICS and STATISTICS
THE BRITISH STATE PENSION:
CONTRIBUTIONS, BENEFITS AND
INDEXATION1
John Creedy
I. INTRODUCTION
The British state pension scheme introduced in 1978 is the most
complex in the world. The scheme includes many innovations which
make its financial and redistributive implications extremely difficult
to assess. The purpose of the present paper is therefore quite limited. It
concentrates on a single cohort of indviduals who are assumed to
contribute to the state scheme over the 45-year period from age 20 to
age 65 years. Particular attention is paid to the methods used to adjust
earnings and contributions for the general growth of earnings and
prices, and to the rule whereby the pension is based on an average of
the best 20 years' earnings (suitably adjusted).
The outline of the present paper is as follows. First, the relevant
details of the British state scheme are described in Subsection 1(i). This
describes only those features of the scheme which are examined later.
Section II then considers the experience of a single cohort of indi-
viduals relative to the working population as a whole, and explains
some inherent problems with the British scheme. The results of a
number of simulation exercises, concerning financial and redistributive
implications, are presented in Section III. An alternative scheme is then
considered briefly in Section IV.
The scope of the analysis is restricted in a number of ways. It con-
siders only single males (ignoring the benefits for wives and widows)
and only those who live until retirement age. Furthermore, it includes
only those who are employed during most of each year, and who are
full members of the scheme (not partially contracted out).
I am very grateful to Jill Peters for computing assistance. I have also benefited from
comments of members of the Government Actuary's Department and the Department of
Health and Social Security on an earlier draft of this paper.
97
Volume 44 May 1982 No.2
98 BULLETIN
(j) The State Pension: Prices and Earnings
Contributions to the state pension are made as part of National
Insurance contributions. They are directly proportional to gross earn-
ings and are applied between two limits, referred to as the lower and
upper earnings limits. No contributions are paid on earnings above the
upper limit, and they are voluntary where earnings are below the lower
limit.2Pensions consist of two tiers. There is a flat-rate component equal to
the lower earnings limit, and an earnings-related component which is
calculated as one-quarter of the difference between pensionable earn-
ings and the lower earnings limit, for pensionable earnings up to the
upper earnings limit.3 The same earnings limits therefore apply to both
contributions and benefits, and the legislation requires that the ratio
of the upper to the lower limit is between 6 and 7-. Indexation of the
limits is not clearly specified in the legislation. Initial plans were for the
limits to be adjusted by either the growth of earnings or prices (which-
ever turned out to be the larger). At the introduction of the scheme in
1978 the legislation specified adjustment using a price index, but the
1980 legislation specified adjustment by 'at least' the rate of increase
of average prices. However, in practice the limits have been increased in
line with prices. Pensions in payment are adjusted in line with prices.
In the calculation of pensionable earnings, those above the upper
limit in any year are not eligible for inclusion. At the date of retirement
the eligible earnings in each year (for which sufficient contributions
were paid) are first adjusted using an index of average earnings. The
average of the best 20 years' (eligible and adjusted) earnings is taken as
the value of pensionable earnings. This means that when average
earnings rise faster than prices, the 'base' on which individuals pay
earnings-related contributions is continually being reduced as more
people reach the upper limit, where the latter is adjusted using a price
index.The relationship between any individual's contributions over working
life and pensionable earnings will be very complex; depending partly on
the pattern of relative changes in average earnings and prices over the
years, and on the extent of earnings variability. The latter depends both
on the extent of the individual's movements within the distribution of
his cohort from year to year, and on the general pattern of the change
in average earnings of the cohort over the life-cycle. The latter in turn
depends on the extent to which earnings change as a result of the
2There are of course employers' contributions between the same limits, and a controversial
employers' surcharge which goes directly to the Exchequer. Reduced contributions are paid by
those who are partially contracted out.
This applies to the mature scheme, where individuals have contributed for at least 20
years. Until then the earnings-related proportion will be 1/80 multiplied by the number of
years of membership.

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