PensionReforms' summary and comments
The complex system of retirement income support in the UK includes two separate elements of income testing:
-  the Guarantee Credit, currently payable from age 60 (formerly called the Minimum Income Guarantee (MIG)) and
-  the Savings Credit, payable from age 65 that aims to reward those who have made some private provision for retirement.

A full explanation of the UK's system is given in the report covered by PensionReforms here.

This 2005 report study looks at how retirees would be treated, and how they might react, by reducing the 'taper rate' (rate of reduction in state-provided subsidies) under the then MIG with the 'gentler' then Pension Credit (PC).  Understandably, the results of this analysis depend on whether retirees have private savings.

There are four key groups identified:
"1. Households on very low incomes, who do not save any wealth under the MIG - comprising 17 percent of the population in 2004. The behaviour of these households is affected only slightly by replacing the MIG with the PC. These households do not save for retirement and choose to exit the labour market before state pensionable age because of their low labour incomes (relative to welfare benefits), rather than in response to the effects of means tested pensions.

"2. Households (other than those described under 1) for which a marginal increase in savings would be subject to a 100% taper under the MIG - comprising 12 percent of the population in 2004. Substitution effects dominate with the introduction of the PC, and these households choose to increase their savings for retirement (by £11,000 on average between ages 60 and 64), and to choose a later retirement age (an additional 18% to 20% choose to be employed between ages 60 and 64).. The responses of this population group consequently appear to most accurately reflect the suppositions of those who argued for a move away from the MIG.

 

"3. Households (other than those described under either 1 or 2) with sufficient savings under the MIG to generate incomes close to the upper threshold for which benefits can be received under the PC - approximately corresponding to the third population quintile (31% of the population).  These households are unambiguously better off under the PC.  In the absence of behavioural responses, some of these households would receive a state retirement benefit under the PC where they would not under the MIG, and the PC implies a smaller cost of consumption during the working lifetime than the MIG.  Hence, both substitution and income effects motivate these households to reduce their retirement savings (by £6,500-£7,300 on average between ages 60 and 64), and to take earlier retirement (between 4% and 7% fewer choose to be employed between ages 60 and 64) under the PC relative to the MIG.  The behavioural responses of these households draw a clear contrast with those described under 2.

"4. Households that earn sufficiently high incomes, so that they lie beyond the thresholds of means tested pension benefits under either the MIG or the PC - comprising the fourth, and in particular, highest population quintile (approximately 40% of the population). As could be expected, these households do not appear to be much affected by the policy counterfactual considered here."

Overall, the report suggests that the change in the long term will see an additional 0.5%-1.4% of poorer households' choosing to work between ages 60-64 and that, overall, there would be "an insubstantial fall in aggregate population savings".

The effect on government spending will probably be neutral according to the report so, in PensionReforms' view, it isn't easy to see how "the reduction in pensions means testing will reduce the reliance on the welfare state."

"Our analysis, however, implies that lower income households will actually impose a smaller burden on the public purse under the PC than they would have under the MIG, because of their responses to the improved incentives to save.  This net benefit to the government budget is almost exactly offset in our analysis by the responses of middle income households, who save less and retire earlier under the PC.  The finding of budgetary neutrality is important as it suggests that the policy reform is welfare improving, since all households are at least as well off under the PC as they would have been under the MIG, and some are made strictly better off."

The report then suggests that introducing a Citizen's Pension equal to the MIG, "exaggerates the behavioural responses of households in the first and second quintiles, increases the consumption (both pre and post retirement) of households above the second quintile, and imposes a higher cost on the public purse."

Surprisingly, the report concludes that having lower taper rates does not "impose a substantial additional burden on the government budget" if "plausible assumptions about elasticities of labour supply and intertemporal substitution" are used.

"Indeed, we find that expected lifetime utility is higher under the PC [40% withdrawal rate] than the MIG [100% withdrawal rate] when taxes during the working lifetime are adjusted to obtain budget neutrality. Furthermore, we find that when means testing is eliminated from the pension system entirely, the tax adjustments necessary to maintain budget neutrality imply a fall in expected lifetime utility. Hence, the Pension Credit appears to provide a reasonable compromise."

PensionReforms wonders about that conclusion that seems to be driven, at least in part, by the report's model.  If the Citizens Pension is tax-free (as the model assumes), then replacing the income test with the Citizens Pension must increase government spending and increase taxes.  But if the Citizens Pension were taxed as ordinary income, that would be similar to the PC's 40% taper rate.

But, as the report itself concludes "The above findings should, however, be treated with caution.  As the sensitivity analyses that are presented reveal, the results depend heavily upon the assumed contextual environment." (File size 568 KB; 72 pp)  372