National Insurance- What are you paying for?



There are lots of people who will tell you that the national insurance contributions you pay, and your employer also pays on your behalf, are nothing but another form of taxation, that what you get is not related to what you pay and there is no national insurance fund.


They are wrong.  At the end of this article I look at why they might be saying this, but first, a bit of history and a few facts.

A bit of history

After the second world war people were determined not to go back to the poverty they remembered before the war.  So the new anti- poverty scheme, proposed by William Beveridge and adopted by the new Labour government, was very popular.  Under the national insurance scheme everyone would pay contributions.  In return they would be insured against all the risks that mean that they could not support themselves through work, sickness, pregnancy, old age, unemployment and widowhood. Benefits were to be set at a level designed to keep people in a modest but secure standard of living and were to be paid based at the contributions you had paid. There was to be no benefit paid to people in work on the grounds that this would encourage low pay.


Employees paid contributions (Currently these are called class one contributions).  So did employers. (These are called class 1 secondary contributions)  Self employed people also paid, although their payments did not qualify them for unemployment benefits. (Currently they pay class 2 and class 4 contributions). Contributions are normally worked out as a percentage of wages.


The general rule has always been that if your income was below a lower limit you did not need to pay, but you did not earn any benefit.  If your income was above an upper limit this was ignored.  You did not pay any more contribution above the upper limit, but you did not earn any extra .


But the problem was that at the start of the scheme no-one had paid any contributions.  So there had to be a safety net.  This was national assistance.  It was designed as a safety net for those who had not paid enough contributions.  It was to be set at a lower level than national insurance benefits to encourage people to work and contribute.  For obvious reasons it could not be funded out of national insurance.  So it was funded out of general taxation.  It was to be means tested.  This means that the government decided how much you needed to live on (now called the applicable amount) and then it looked at how much income you already had.  If what you needed was less than what you needed to live on you got the difference.  National assistance lives on but has been changed and renamed.  It is now income related job-seeker’s allowance for unemployed people, income related employment and support allowance for people who cannot not work because of sickness or disability, income support for other people of working age who cannot work and pension guarantee credit for people who are over pension age.


Since 1979 governments have run down national insurance benefits and increased means tested ones.  Currently national insurance unemployment and sickness benefits are paid at the same rate as means tested ones.  Basic national insurance retirement pension at around £100 pw for a single person, is well below the means tested pension guarantee credit which is around £135 for a single person.  However out of work national insurance benefits are important for couples where only one is working and for those who have savings.  Although the very poorest do not benefit from the contributions that they have made towards retirement, for many people the national insurance basic pension is the bedrock on which they build their retirement provision.  Further on I look at the extra state second pension which can add to the basic benefit.

Where do your contributions go?

If you asked contributors what their national insurance contributions went on, many of them would put the NHS first.  They would be largely wrong. There are powers to deduct money from contributions but in most cases section 162 of the Social Security Administration Act limited these to 1.05% of the wages on which employees national insurance is paid and 0.9% of the employers contribution on the same wages.  This means that around 10% of all national insurance contributions went to the NHS from 1992 up to 2003.  (There are slightly different rules for the self employed)


But in 2003 the Labour government added an additional 1% to employees’ national insurance contributions.  Unlike most contributions, this one had no upper limit.  They also added to employers contributions. Section 4 of the National Insurance Act 2002 allowed the whole of these extra payments to go to the NHS.


The same section increased the percentage of ordinary contributions that went to the NHS. The 1.05% went up to 2.05% and the 0.9% went up to 1.9% Without fanfare the contribution went to about around 20% and the national insurance fund was about 10% poorer than it was before.


The Government actuary’s Report on the 2011 re-rating and up-rating orders  (appendix 5) estimates that in 2011/12 £82 billion national insurance contributions will go into the national insurance fund and £20 billion will go to the NHS.


In 2011 the coalition government doubled the size of the additional contribution but this extra money was put into the national insurance fund, not given to the NHS.


You can see that the slight of hand by the Labour government increased the contributions to the NHS, but they are still clearly defined and limited.  The bulk of funding of the NHS is through general taxation. NHS paymentsHHh

are taken away before the contributions are added to the fund and do not form part of the fund. So when we look at the surplus that the fund has this will be after these deductions have been made.


Section 162(1) of the Social Security Administration Act prohibits the spending of national insurance contributions on anything but the National insurance fund and the NHS. Section 163 of the Social Security Administration Act says that the national insurance fund can only be spent on national insurance benefits, redundancy payments where the employer fails to make these, and administrative costs.  There is no power to spend it on anything else. Means tested benefits must be funded out of general taxation.

Is there a national insurance fund and, if so, what sort of state is it in?

It should by now be clear that the fund exists, but to avoid all doubt section 161 of The Social Security Administration Act requires the existence of a national insurance fund. The government must report on the state of fund every year and the government actuary must examine it every 5 years. The most recent report is for 2010/11  It shows a surplus of just under £43 billion, about four times what the government actuary thinks that it ought to keep in reserve. (This is lower than the figure I have given in past articles, which was based on projections.)


The surplus has come down considerably since the crisis of 2007, as you might expect, with fewer contributions and more payments being made. A House of Commons Library briefing on 14/6/12 showed that the 2008/9 surplus was over £50 billion and that the figure had grown steadily over recent years.  However According to the Government Actuary’s Report on the 2011 re-rating and up-rating orders (appendix 9) predicts an increase in the surplus to £57 billion by 2014/5.  The rate of increase in surplus seems to be growing.


There seems to be no lack of money to pay national insurance benefits, despite government insistence that it has to make further cuts in national insurance sickness benefits!


But it could be suggested that there may be transfers in and out of the national insurance fund are so numerous that they make the existence of a fund a sham.  However this seems not to be the case. In the early years the Treasury put money in to the fund.  You might think this reasonable since the government has decided that some people should be treated as having made contributions when they have not made them.  These include people with responsibilities for children and other dependents.  This recognises that some people make a social contribution rather than a financial one.  The government also uses reductions in contributions to incentivise employers and we might expect the government to make up this shortfall.  But the House of Commons Library briefing on 14/6/12 shows that there have been no payments this century.


I’ve explained that the fund is formally ring fenced, But I have also shown how money is being taken out to fund the NHS and employer incentives.  Tony Lynes in his briefing for the Southwark Pensioners Action Group adds a few more examples of pilfering from the fund.  It is also the case that, while the fund used to invest its surpluses in Gilts, it now gives soft loans to the government.  But I suggest that this still amounts to no more than pilfering rather than an argument for the non-existence of a fund.  The Financial Times recently reported that in a period when the stock market had grown by something like 55%, individual funds in which people could invest their private pension money had only grown by about 30% because of charges and overheads.  We call this wrong, but we do not say that the person had no fund.


National insurance benefits are funded on a pay-as-you go basis, as are schools, the health service and many other public services.  But to point this out is to make a point about the way the fund is used, not one that can be used to say that the fund does not exist.

What do you get for your money?

National insurance pays for a number of benefits, but I want to focus here on retirement pension, which is by far and away the most important; the benefit that the most money is spent on. There are two components, the basic pension and the state second pension

Basic state retirement pension

The amount of basic state retirement pension is set by Parliament.  After years where it was increased by the increase in the Retail Price Index, it is now increased by the higher of the average increase in earnings, the Consumer Price Index and a fixed percentage.  The rate for a single person in 2011/12 is £102.65.  You can get an addition for a legal partner of £61.20 if they do not have their own pension.


The conditions have varied over time but a pensioner retiring on 1 January 2011 would need to have paid enough national insurance contributions in 30 years of their working life to get full basic benefit. In many earlier years you had to have contributed for about 85% of your working life to get full basic pension. Otherwise a reduced pension is paid. The reduction in conditions was justified by the Labour government on the grounds that it protected those with caring responsibilities but could not be credited with contributions.  Whilst this reduction dilutes the contributory principle I think it is still fair to say that contributions match payments.

State second pension

Originally everyone got the same, no matter how much they had contributed, but in 1964 an attempt was made at increasing pension in line with contributions.  It was called Graduated Pension and for each £7.50 a man paid in contributions or £9 for a woman, they earned an extra 2.5p per week in pension when they retired, uprated for inflation.


This rather pathetic scheme was replaced in 1978 by the State Earnings Related Pension, (SERPS) The architect of SERPS was Labour’s Barbara Castle.  The idea that the more you contributed, the more you should get is not, at first sight, a socialist one, but did recognise the growth of company and private pensions.  The government recognised that there were some employers who were never going to be able to offer decent pensions and perhaps realised that the then emerging private individual pensions were not going to be a good deal.


If your employer could show that they offered a better pension scheme than SERPS they could opt employees out of it. This meant that they and employees paid lower national insurance contributions but that the employees did not build up entitlement to additional pension.  Self employed people do not build up entitlement to the additional pension either.


But everyone else with a job contributed.   Entitlement has been changed and reduced over the years. The more you contributed over your working life the more you got, but the basic idea of SERPS was that you contributed all your working life you would get 25% of the difference between the upper and lower national insurance limits (later reduced to 20%), uprated by inflation.  So entitlement was directly related to what you paid, as it had been for Graduated Pension.


From 2002 SERPS was replaced by State Second Pension.  The formula is quite complex and income at some levels accumulates more entitlement than others.  There is also the possibility of being credited with contributions in certain situations. It is interesting that a search of government web sites reveals very little about state additional pension.  Most searches for explanations bring up lots of private pension company sites, who obviously see SSP as an important competitor.  The clearest explanation I have found is on the Scottish Life web site.


Contributors keep the entitlement that they have built up over the various schemes and someone retiring today might have entitlement from all three additional pension schemes.


If you are not up to the calculations some idea of how valuable the state additional pension could be is that in 2012 the maximum additional state pension you can get from SERPS and state second pension is set at £159.52 per week.  Of course you would have to be earning quite a lot to have accumulated this level of pension and most higher earners will be opted out into final salary schemes.  But, when you add on basic state pension a single person could get £260 per week, and a couple double this.


The Conservative government under Mrs Thatcher decided to let individuals who wanted to opt out individually do so.  They offered national insurance rebates, which sunk the national insurance fund into deficit for a time.  At the time the conventional wisdom was that if you were in the first half of your working life then it was probably better to opt out of SERPS and invest in a private pension, since there was a longer time for gains to accumulate, but if you were in the second half of your working life it was better to stay in SERPS.  This advice was given in a period of stock market boom.  It is not clear whether it still holds, but in any case the new government has now withdrawn the choice.  People will no longer be able to use money purchase private pensions to opt out of the state second pension from April 2012.


So the bulk of national insurance contributions are not a tax.  They are a payment of insurance towards pensions and other benefits.  But there are parts of the scheme that are tax.  The 1% surcharge added by the Labour Government for the NHS, which runs over the normal upper limit, is clearly a tax, since it leads to no benefit entitlement and the amount goes to something normally funded by general taxation.


The same might be said for the further 1% added by the current government but, since it stays in the national insurance fund, it could be said to be a socialist move, designed to ensure that rich pay more whilst not getting any extra benefit.


We could also argue that the class four, income related contributions made by self employed people are a tax, since they get no direct benefit from them.  But on the other hand, they get entitlement to a range of benefits for their class two contributions.  They get all the benefits that an employed opted out worker would get except job-seekers allowance, but pay far less in class two payments than most employees would.  So it could also be said that class four contributions are a crude way of evening the situation up.

Why do national insurance benefits get talked down?


You might think that, with final salary pension schemes closing all over the place, and the discrediting of money purchase schemes, state retirement pension, especially the state second pension, would come to the fore.  But it has not.


This may be because it has few champions.  Welfare rights campaigners and social welfare academics tend to focus on the very poor. Trade Unions focus on the opted out schemes they have obtained for their members.  Organisations like Age UK focus on those who have already retired. Economists often don’t understand the scheme. Those who know the most, the pension companies, have an interest in keeping silent.  The Labour party was once the champion of state retirement pension but until recently only Frank Field was prepared to argue in the party for a return to national insurance principles.


Since the all political parties have remained silent on national insurance benefits.  Not surprisingly many people don’t know they have any entitlement. Few could work out what their likely entitlement was and say how it will be worked out.   I suspect that this is deliberate on behalf of governments. If you don’t know you have it or you think it has already been taken away then you don’t fight to keep it.


For the last few years both Labour and coalition governments have followed a policy of eroding the state second pension with the idea of making it a flat rate pension.  The poorest get more but the more well paid get less.  The level might pan out at about £130-140 a week per person when second pension and basic pension are combined.


A good idea?  – not when you look at it closely.  Remember that the means tested pension guarantee is currently £135 for one person.  Most people are entitled to get their income topped up to that. So they would be no better off.


The key beneficiaries would be those who are not entitled to the means tested guarantee payments because they have savings above the limits and those in couples where the other member has a state pension as well. (The means tested rates for couple are less than double the single person’s rate) There would also be benefits for people who had work or private pensions as well as their state second pension.


But these groups are likely to be small.  We are talking about people who are on low incomes who are less likely to have lots of savings and where it is more unlikely that both partners will have good national insurance records.  Plus, when someone is earning work or private pension benefits they are unlikely to be contributing to the state second scheme as well. The government will incur very little expenditure


The price of these meagre gains is that those who would have got higher amounts of state additional pension lose out.  Effectively the state competition with private pensions is gone.  From April 2012 people with no work scheme will have to pay for a state second pension that, in many cases they will not benefit from.  They will be forced to take out private sector pension schemes.  I suspect that this is what governments have wanted.


It should be fairly obvious that the NEST scheme, where there is a 4% contribution from the employer and a 2% contribution from the employee, will benefit few but the government and the pension provider.  Under the current system the meagre pension pot will be of little benefit to most of the lower paid and will do little to replace what higher earners have lost.   Employers may use the scheme to replace their current money purchase schemes where payments of 5% and above by the employer are common.


To try to deal with this the Prime Minister has borrowed the idea of a Citizens Pension from the Green Party.  Seductively, he floats £140 as its level.  Most people do not realise that most of them are guaranteed nearly this amount anyway.  The advantage of a flat rate scheme, possibly not linked at all to national insurance contributions, is that you can say  “I’m sorry we can’t afford to increase the level because the economy is going badly, or it is Wednesday, or we don’t like pensioners”, or for some other reason.  You might even do away with the employer’s national insurance contribution and put all of the burden on the employee.  But you can only get away with this if people have forgotten that they have already paid for a decent pension.  Hence the silence.  Let’s remind people that they are paying good money for pensions and other benefits and stop pretending that national insurance is just another tax.

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