(a draft prepared by Tony Lynes as a basis for a National Pensioners Convention factsheet on the National Insurance Fund)
1. The National Insurance Fund operates on a pay-as-you-go basis but has to keep a working balance which the Government Actuary recommends should not fall below two months’ benefit expenditure. The balance predicted for March 2006 is £24.5 billion above the recommended level and it is expected to rise to over £60 billion - about £48 billion above the recommended level - by 2010.
2. The suggestion that the Fund exists only on paper and is not available for spending is unfounded. The money is invested in gilt-edged securities.
3. The Treasury regards NI contributions as a convenient form of taxation, while benefits, including pensions, are seen as part of total public expenditure. The size of the Fund’s balance, therefore, is not taken into account in deciding whether or by how much pensions should be increased.
4. A number of measures have been taken to prevent the Fund’s balance from rising to a level at which pressure to restore the value of benefits would be irresistible. The first of these was the reduction and eventual abolition of the Treasury supplement between 1981 and 1989, followed by the introduction of an ad hoc Treasury grant which was paid only from 1993 and 1998. Restoring the supplement at its pre-1981 level would bring an extra £11.3 billion a year into the Fund, enough to meet the gross cost of a £109 per week basic pension.
5. The policy of compensating employers for a series of “green” taxes by reducing their NI contributions is costing the Fund about £2.4 billion a year, while the proceeds of the taxes, amounting to about £1.8 billion, are purloined by the Treasury.
6. The extra 1% NI contributions introduced in 2003 to provide money for the National Health Service have had the effect of reducing by about £1 billion a year the amount of contributions paid into the Fund.
7. Control of the Fund should be taken out of the hands of the Treasury and transferred to a National Insurance Commission consisting largely of representatives of contributors and pensioners, as recommended in a Catalyst Forum paper in 2003.
How the Fund works
National Insurance is the system through which contributions by working people and employers are paid into a fund - the National Insurance Fund - to finance a range of benefits, including state pensions (but not the means-tested pension credit), incapacity benefit, widows’ benefits, maternity allowance, guardian’s allowance, jobseeker’s allowance and the Christmas bonus. Part of the contributions is not paid into the Fund but goes towards the cost of the National Health Service; but the money paid into the Fund can only be used for the payment of benefits or the cost of administration.
In addition to its share of contributions, the National Insurance Fund receives income from its investments. When necessary, it can also receive a grant from the Treasury - but this has not happened in recent years, as the Fund’s income has been well above the amount needed for the payment of benefits.
In principle, the National Insurance Fund operates on a pay-as-you-go basis, the contributions received in each year being used to pay pensions and other benefits in the same year. In this respect it differs fundamentally from private pension funds, which need to build up reserves to cover their future liabilities.
The Fund does, however, need to keep some money in hand. The Government Actuary, who reports on the state of the Fund each year, wrote in the report on one of his “quinquennial” (5-yearly) reviews, published in 1995:
“As the National Insurance Fund has no borrowing powers, the balance . . . must be sufficient to cover the consequences of an unexpected excess of expenditure or short-fall in income in the short term . . . In addition, a working balance has to be maintained in order to be able to advance money to the Post Office and other agencies for the purpose of paying pensions and other benefits.”
The Actuary recommends that the balance held in the Fund for these purposes should not fall below two months’ benefit expenditure. That recommendation has remained unaltered despite the fact that pensions are now normally paid into people’s bank accounts, not by orders cashable at post offices, which means that the Fund no longer needs to advance money to the Post Office for this purpose and could now operate with a smaller working balance.
In practice, in recent years, the Fund’s income has regularly exceeded its expenditure, leaving it with a much bigger balance than the Government Actuary recommends. The amount needed to cover two months’ benefits in 2005-06 would be £10.1 billion. The balance predicted for March 2006 is £34.6 billion - £24.5 billion above the recommended level.
The main reason for this is the policy adopted by the Conservatives in 1980 and pursued by both Conservative and Labour governments since then, of breaking the link between pensions and average earnings, so that, while the Fund’s income from contributions rises roughly in line with earnings, pensions and other benefits normally rise only in line with prices. By 2010, if present policies continue, the Actuary’s figures show that the balance can be expected to rise to over £60 billion, about £48 billion above the recommended level.
Is it a real fund?
It is often suggested that the Fund exists only on paper and is not real money available for spending on pensions and other benefits.
Such suggestions are entirely unfounded. The Fund does exist. On days when more money is received than is paid out, the surplus is transferred to a National Insurance Fund Investment Account, managed by the National Debt Commissioners (CRND) who invest it in government securities. The CRND’s website explains how this works:
“HM Revenue and Customs transfers money to the National Insurance Fund Investment Account on days when it has a net inflow of cash and draws from the Investment Account on days when payments exceed receipts.
“The Fund's investment policy is discussed in broad terms with HM Revenue and Customs, with the actual choice of investments being made by CRND. It is normally necessary to keep a high level of liquidity to cover daily movements, which can amount to more than £500 million deposits or withdrawals in any day, and to maintain a spread of gilt-edged securities with maturities of up to about 20 years with the aim of achieving a high level of income while at the same time protecting the capital value of the Fund.”
There is no doubt at all, therefore, about the Fund’s existence. It exists and is invested, in the same way as any other pension fund, though in a narrower range of “gilt-edged” government securities.
Can the money be spent?
The purpose of keeping a balance in the Fund from year to year, as we have seen, is that, at any time when more money is being paid out in benefits than is received in contributions and investment income, the overspend can be met by drawing on the accumulated balance. This not only happens on a daily basis; expenditure may also exceed income over the year as a whole, as it did in four of the past 20 years: 1989-90, 1991-92, 1992-93 and 1996-97. It is clear, therefore, that when the need arises there is nothing to prevent the Fund from cashing in some of its investments to meet current benefit expenditure.
However, it is one thing to say that the money can be spent and quite another thing to suggest that the government should plan to spend it by taking into account the balance in the Fund when fixing the following year’s benefit rates. From the Treasury’s point of view, National Insurance contributions are a very convenient form of taxation, which most people view more favourably than income tax. National Insurance benefits, on the other hand, including pensions, are seen by the Treasury as simply part of the total of public expenditure; and it is the total that matters, not whether the money comes from contributions, income tax or some other source. The fact that the Fund has money to spare, therefore, is not taken into account in deciding whether or by how much pensions should be increased each year.
The Treasury view needs to be challenged, in the interests of both contributors and pensioners. Working people and employers are compelled to pay contributions to meet the current cost of benefits on a pay-as-you-go basis; but a significant part of their contributions - an average of over £3 billion a year since the Labour government was elected in 1997 - is not being used for that purpose. Despite the fact that the Fund now has a balance of nearly £25 billion more than the Government Actuary considers necessary - a figure which is expected to nearly double by 2010 - pensioners are told that bigger pensions cannot be afforded.
But the money held in the Fund is only part of the story. At least as significant is the amount of money of which the Fund has been deprived by a succession of measures which have attracted remarkably little notice. If governments had adopted a policy of simply holding down the level of benefits while allowing contributions to rise in line with earnings, the balance in the Fund would be many times greater than it actually is. The strategy adopted over the past 25 years, therefore, has been to maintain the ever-increasing flow of contributions while holding down the level of benefits and, at the same time, preventing the balance in the Fund from rising to a level at which pressure to spend it by restoring the value of benefits would be irresistible. Some of the methods used are described below.
The Treasury supplement
From the earliest days of National Insurance before World War I (pensions were not then part of the insurance scheme), a substantial part of the annual cost of benefits was borne by a contribution from the Exchequer, paid out of general taxation. The exact proportion varied over the years. Under the Social Security Act 1973, the Treasury supplement was fixed at 18% of the combined contributions of insured persons and employers. In the 1980s, however, the Conservative government decided that, with the earnings link broken, the Treasury supplement could be reduced and eventually abolished. The first reduction took place in 1981. By 1988 the supplement had fallen from 18% to 5% of contributions, and the following year it was abolished.
The abolition of the Treasury supplement proved premature. One reason for this was the unexpectedly large number of people taking out personal pensions and claiming contracted-out rebates from the National Insurance Fund. In three of the four years following the abolition of the supplement, the Fund’s income failed to match its expenditure, leaving it with a balance below the target of two months’ benefits. The same Conservative government that had abolished the supplement was thus obliged to reintroduce it in the form of an ad hoc Treasury grant payable in any year when it was needed to keep the Fund at an adequate level. The grant was paid in the years 1993-98. Since then, however, during the period of Labour government, the Fund’s year-end balance has exceeded the recommended level by a large and steadily increasing margin without the need for any contribution from the Treasury.
To sum up: the Treasury supplement, calculated as a fixed percentage of contributions, was phased out between 1981 and 1988; it was reintroduced in the form of a variable grant, paid from 1993 to 1998; since when the Treasury has contributed nothing to the Fund and, if present policies continue, will not need to do so for many years ahead.
The loss of the Treasury supplement has had a catastrophic effect on the Fund. Reintroducing the supplement now at its pre-1981 level of 18% of contributions would bring in an extra £11.3 billion a year. Together with the Fund’s predicted surplus of £3.4 billion for 2005-06, this would be enough to meet the gross cost of a £109 basic pension, without taking into account the resulting savings in pension credit.
Another reason for restoring the Treasury supplement is that it would make the financing of National Insurance fairer. A large part of the cost of retirement pensions and other benefits is accounted for by rights acquired not by the payment of contributions but through the system of credits and home responsibilities protection. It is right that these benefit entitlements should be funded from general tax revenue, via the Treasury supplement, rather than from contributions levied only on earned incomes (and, in the case of employees’ contributions, only on earnings below the upper earnings limit of £630 a week).
The NI Fund’s income from employers’ contributions has been deliberately and substantially reduced as a result of a series of “green” taxes: the landfill tax introduced in 1996, the climate change levy in 2001 and the aggregates levy in 2002. The purpose of all these taxes was to make companies pay for the environmental damage caused by their activities. The greater part of the proceeds of each tax was to be returned to employers as a whole by a reduction in their NI contributions of 0.2% of earnings for the landfill tax, 0.3% for the climate change levy and 0.1% for the aggregates levy. The government was thus able to claim that the taxes were “revenue neutral”, encouraging environmentally responsible behaviour without imposing an additional burden on industry as a whole, while at the same time promoting job creation by reducing the costs of employment.
These aims were entirely laudable, but the method used to achieve them has had an entirely unjustified effect on the NI Fund. If the Fund was to bear the cost of compensating employers, through the reductions in their contributions, it should also have been credited with the proceeds of the taxes. Instead, the Treasury has been allowed to pocket the proceeds, while the entire burden of the taxes has fallen on the Fund.
In fact, as the replies to recent Parliamentary questions tabled by Paul Flynn MP have shown, employers have been substantially over-compensated by the Fund, the loss of contribution income in each year being far greater than the revenue derived from the taxes. In the case of the landfill tax, the Fund lost £550 million in employers’ contributions in 1997-98, the first year of the contribution cut, and £610 million in the second year, although the tax yielded only £352m and £323m in those two years (comparable figures for the loss of contributions in later years are not available because of a change in the way employers’ contributions were calculated). The climate change levy, similarly, cost the Fund £1,035m in 2001-02, rising annually to an estimated £1,275m in 2005-06, though the levy has yielded only about £800m per year. The aggregates levy is expected to cost the Fund £425m in lost contributions in 2005-06, while the yield of the tax is expected to be about £300m.
In total, therefore, the three taxes are currently costing the Fund well over £2 billion a year in lost contributions. Over the whole period since they were introduced, up to 2005-06, the climate change levy has cost the Fund over £5.8 billion, the aggregates levy £1.6 billion and the landfill tax an amount which cannot be precisely calculated but is unlikely to be less than £6 billion - a total of at least £13 billion, rising by (at a rough estimate) £2.4 billion a year, of which about £1.8 billion (the annual yield of the three taxes) is purloined by the Treasury.
This is plainly indefensible. The Fund should be fully compensated for the losses it has already sustained and an annual payment should be made to compensate it for future losses of contribution income from employers.
The NHS allocation
Since 1948, a proportion of NI contributions has been allocated to the National Health Service. Originally, the whole of the contribution income was paid into the National Insurance Fund, from which the appropriate amount was transferred to the NHS. The current legislation, however, provides for the contributions to be paid into the NI Fund after deducting the appropriate NHS allocation.
In 2002 the government decided to increase the contribution rates of employees, employers and the self-employed by 1% of earnings (including earnings above the upper earnings limit) from the year 2003-04, using the money raised in this way to increase the NHS allocation. The impression given at the time was that the NI Fund would not be affected, since the additional contributions would go directly to the NHS. Nothing was said to alter that impression during the parliamentary debates on the National Insurance Contributions Bill 2002 which provided for the 1% increase.
It was the Government Actuary who, in his report on the 2003 changes in benefits and contributions, pointed out that the 1% contribution would have an adverse effect on the Fund. The reason for this was that the NHS allocation in respect of employers’ contributions was to be increased by 1% of all earnings, not just earnings above the £89 threshold on which contributions were payable. As a result, the additional amount of employers’ contributions allocated to the NHS in 2003-04, under the 2002 Act, would be about £1 billion more than the additional 1% contribution, leaving £1 billion less available to be paid into the NI Fund.
The exact amount that the Fund stands to lose in subsequent years is not known, but it will rise with each increase in the contribution threshold (now £94 a week). It is safe to assume, therefore, that the Fund is losing about £1 billion each year. Nobody would dispute that the NHS needs the money and few people objected to paying the extra 1% contribution for this purpose, but there might have been less support for the proposal if the government had come clean about its intention to extract an extra £1 billion a year from the Fund, leaving less money available for improvements to state pensions.
A National Insurance Commission
Before 1 April 1999, responsibility for policy in relation to National Insurance contributions and the National Insurance Fund rested on the Secretary of State for Social Security. From that date, responsibility was transferred to the Treasury, which has shown a total disregard for the underlying principles of social insurance and of the need to preserve (or restore) public confidence in the system. The present arrangements are entirely unsatisfactory. But what should replace them?
A paper published by the Catalyst Forum in 2003 put forward the following proposal:
“To give National Insurance the protection that it deserves there should be a separate and largely autonomous financial institution, with a governing National Insurance Commission consisting largely of representatives of contributors and pensioners which would be responsible for fixing benefit and contribution rates and for proposing structural changes, such as the introduction of new benefits or the modification or abolition of existing benefits. Structural changes in the pension system would have to be endorsed by the relevant government departments, including the Treasury, and by Parliament. . . . Should a government ever wish to impose changes in benefits or contributions contrary to the views of the Commission, they would have to lay before Parliament a full statement of their reasons, to which the Commission would have the right of reply. As a result the use of the Fund’s resources for purposes unrelated to the proper functioning of National Insurance or the removal of rights based on past contributions would lay the government open to serious and embarrassing criticism.”
An arrangement along these lines, firmly taking control of the National Insurance Fund out of the hands of the Treasury, is essential if the British system of social insurance is to continue to command public support. Without such support, it can have little prospect of surviving in the longer term. The alternative - a system of benefits awarded at the whim of whatever government is currently in power and subject to a permanent Treasury veto - would, in our view, be a disaster.