Optimal Design Of Means-Tested Retirement Benefits

Moderate levels of means-testing for state pension benefits can be a useful way of providing every UK household with a sufficient income in retirement while containing public expenditure on pensions. That is the conclusion of research by Professor James Sefton and Dr Justin van de Ven, published in the November 2009 Economic Journal.

Their findings contrast with the strong stance against means-testing taken by the Pensions Commission, which took the view that means-testing significantly reduces saving levels. The researchers conclude: ''Rather perversely, given the Pensions Commission's recommendations, the only sure way to reduce aggregate savings is to give everyone a
large state pension, and thus remove the need to save!''

Their study explores the advantages and drawbacks of means-testing state retirement benefits. It finds that:

  • A pension withdrawal rate of 40-60% strikes a sensible balance between the costs of providing benefits and the savings disincentives.
  • There is an unmet preference for greater social insurance that can be provided by more means-testing of pensions, or a more redistributive tax system.
  • There should be real concerns that savings will be depressed further if state retirements benefits are indexed to wages instead of prices.

With all political parties now accepting that radical steps need to be taken to cut back the government budget deficit, the spotlight is yet again falling on public pension expenditure.

In September 2009, the government announced that it would delay the introduction of its flagship private pension savings scheme by four years to 2016; in October, the Conservatives stated that they would bring forward planned increases in the state retirement age; and the Institute of Directors has suggested that not only should the
pension age be raised more quickly that currently planned, but that it should be raised to 70 rather than 68.

This research takes a fresh look at the use of means-testing of pension benefits as a way of limiting public expenditure while ensuring that every citizen has sufficient income in retirement. Its case is based on three observations:

  • First, targeting pension benefits tends to reduce public expenditure.
  • Second, means-testing pension benefits affects private incentives.
  • Third, pensions must be paid for, and so should be seen in context of the wider tax and benefits system.

When the fiscal burden of pensions is met through distortionary taxation, then these three observations imply that the decision over means-testing is essentially a trade-off. Yes, means-testing of pension benefits reduces private incentives to save – as its critics have been correct to point out – but it also reduces the fiscal burden of pensions, allowing for lower taxes during the working lifetime.

The second half of this story – that means-testing of pensions can improve incentives to work through its influence on income tax rates – has been overlooked in much of the recent UK debate about the future of pension provision. The research suggests that withdrawal rates of between 40-60% of public pension benefits for every pound of private pension represent a reasonable compromise between these conflicting concerns.

A further implication of the study is that households are likely to prefer more redistribution than is currently implicit in the UK tax and benefits system. Given this general finding, the preference for moderate means-testing of pensions is perhaps unsurprising. A direct corollary of this finding, however, is that if the government were to adopt a more progressive income tax system, then households would prefer less means-testing of pensions. What do these results imply for the consensus that has built up around the findings of the Pensions Commission?

First, the results indicate the need to question the strong stance taken by the Pensions Commission against means-testing. Though the researchers agree that very high levels of means-testing (as was seen before the introduction of the Pension Credit in 2003) do significantly reduce saving levels, their findings imply more generally that moderate levels of means-testing can be a useful way of providing every household with a sufficient income while containing costs.

They conclude that further means-testing does not necessarily reduce the overall aggregate level of saving. In fact, because under means-testing, high-income individuals are less likely to receive any state pension benefits, it could actually increase aggregate savings.

''Optimal Design of Means Tested Retirement Benefits'' by James Sefton and Justin van de Ven is published in the November 2009 issue of the Economic Journal.