The Facts about National Insurance

Introduction
The purpose of this briefing paper is to clarify a number of basic points surrounding workings of the National Insurance Fund, in order to give campaigners a better understanding of the issue when arguing for improvements in basic State Pension.

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 benefits, widows’ benefits, maternity allowance, guardian’s allowance, jobseeker’s allowance and the Christmas bonus. In 2004-05 the Fund received £78bn, of which around £42bn was spent on basic State Pension.

Employees contribute 11% of income between £94 and £630 a week and 1% above £630. Employers pay 12.8% on all income above £94. Employees contracted out of the State Second Pension get an NI rebate of 1.6% of earnings between £82 and £630, and their employers get 1% to 3.5% depending on their scheme.

Additionally, there is also an allocation from the Fund towards the NHS of 2.05% of the first slice of eligible earnings from employees and the full 1% on income above £630. Employers pay 1.9%. Remainder goes into the Fund and can only be used for payment of benefits or cost of administration.

In principle, the National Insurance Fund operates on a pay-as-you-go basis, with 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 that need to build up reserves to cover their future liabilities.

The Government Actuary, who reports on the state of the Fund each year, recommends that the Fund should also keep a balance, to cover any unexpected shortfall in income, of not less than 2 months’ benefit expenditure.

In practise, 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 month’s benefit 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 only rise in line with prices. By 2010, if present policies continue, the Actuary’s figures show that the balance will rise to over £60 billion, about £48 billion above the recommended level.

Is it a real fund?
It is often suggested that the Fund only exists on paper and is not real money available for spending on pensions and other benefits. Such suggestions are entirely unfounded.

On days when more money is received than paid out, the surplus is transferred to a National Insurance Investment Account managed by the National Debt Commissioners (CRND) who invest it in government guilt-edged securities.

Can the money be spent?
The purpose of keeping a balance in the Fund from year to year is to cover occasions when more money is being paid out in benefits than is received in contributions and investment income. This not only happens on a daily basis; expenditure may exceed income over the year as a whole, as it did on 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 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 another to suggest that Government should plan tospend 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 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 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 is not taken into account in deciding whether, or by how much, pensions should be increased each year.

But money in the Fund is only part of the story. At least as significant is the amount of which the Fund has been deprived by a succession of measures that 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, balance in the Fund would be many times greater than it actually is. Strategy adopted over the past 25 years has been to maintain the ever-increasing flow contributions while holding down the 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 irrisistible. Some of the methods used are described below.

The Treasury supplement
Under the Social Security Act 1973, the Treasury supplement to the Fund was fixed at 18% of combined contributions of insured persons and employers. In the 1980’s, however, the Conservative Government decided that, with the earnings link broken, the Supplement could be reduced and eventually abolished. 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.

Abolition of the 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 2 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 need for any contribution from the Treasury.

However, loss of the Supplement has had a catastrophic effect on the Fund. Reintroducing the Supplement now at its pre-1981level of 18% of contributions would bring in an extra £11.3 billion a year – more than enough to meet the gross cost of £109 a week pension, without taking into account the resultant savings in pension credit.

Another reason for restoring the Supplement is that it would make 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 Supplement, rather than from contributions levied only on earned incomes (and in the case of employees’ contributions, only on earnings below the upper limit of £630 a week).

Green taxes
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 1996, the climate change levy in 2001 and the aggregates levy in 2002. Purpose of these taxes was to make companies pay for the environmental damage caused by their activities. The greater part of proceeds from each tax was to be returned to employers as a whole by a reduction in their NI contributions of 0.2% of landfill, 0.3% for climate change and 0.1% for aggregates. 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 cost 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 reduction in their contributions, it should also have been credited with proceeds of the taxes. Instead, the Treasury has been allowed to pocket proceeds, while the entire burden of taxes has fallen on the Fund.

As a result, over the whole period since they were introduced, green taxes have cost the Fund at least £13 billion, and are currently costing well over £2 billion a year in lost contributions. This is plainly indefensible. The Fund should be fully compensated for 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 contributions has been allocated to the National Health Service. Originally the whole of contribution income was paid into the National Insurance Fund, from which the appropriate amount was transferred to the NHS. However, the current legislation provides for contributions to be paid into the NI Fund after deducting the appropriate NHS allocation.

In 2002, Government decided to increase the contribution rates of employees and self-employed by 1% of earnings (including earnings above the upper limit) from 2003-04, using money raised in this way to increase the NHS allocation. Impression given at the time was that the NI Fund would not be affected, since additional contributions would go direct to the NHS.

However, in 2003 Government Actuary pointed out that the 1% contribution would have an adverse effect on the Fund. 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 to be paid into the NI Fund.

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). Therefore, it is safe to assume 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 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 the State Pension.

Who is responsible for National Insurance?
Before 1 April 1999, responsibility for policy in relation to National Insurance contributions and the NI 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 the need to preserve (or restore) public confidence in the system.

Has the National Insurance system got a future?
Despite what some critics may argue, there is no crisis in the state system. National Insurance provides an excellent and efficient way for guaranteeing that both employees and employers fund the pensions of today’s retirees, with the annual cost of delivering State Pension being £5.40 compared to that of the means-tested Pension Credit that is £53.70.

In addition to restoring the Treasury supplement and compensating the Fund for losses resulting from “green” taxes and NHS allocation, consideration must be given to raising contributions above the upper earnings limit from 1% to 11%, to ensure that all employees pay a fairer proportion of their income towards the Fund.

Detail is from NPC Briefing No 34 that provided an insight into the National Insurance Fund in layman terms.

Text reinstated 13 November 2008.