Yesterday’s inflation figures – with CPI inflation down to 1.2 per cent – are, on the face of it, good news, but not necessarily for the government finances. As Sam Bowman of the ASI has highlighted, it is exactly these sorts of economic conditions which make the government’s ‘triple-lock’ state pensions guarantee more expensive (a phenomenon examined in Sharper Axes, Lower Taxes – p. 138).

The triple-lock on pensions introduced in April 2011 means that the nominal value of the state pension will rise by the higher of CPI inflation, average earnings or 2.5 per cent each year. It’s fairly obvious to see then under what conditions pensions spending would become relatively more expensive for the government. One scenario is if earnings growth is very low relative to CPI inflation (as we saw earlier in the Parliament). Another is if earnings growth and CPI inflation are both much lower than the guaranteed 2.5 per cent per year – as we see now. Then tax revenues from the working population are likely to disappoint as the commitments made to pensioners rise.

Figure 1 shows the evolution of the basic state pension (BSP), CPI, average weekly earnings (AWE) and a working-age benefit – Jobseekers’ Allowance (JSA) – from 2010. As can be seen, the basic state pension has risen faster than inflation and significantly more than earnings since 2011 when it was introduced. Jobseeker’s Allowance, whilst falling in real terms, has risen faster than earnings too. The triple-lock therefore has been moderately costly so far compared with a scenario where the government just increased the state pension by CPI inflation alone. But the government is working on the assumption that from here and into the next Parliament, earnings growth will rise substantially. If this doesn’t occur, then the triple-lock could become a major fiscal mistake.

Figure 1: Evolution of benefits, prices and earnings



Source: ONS and House of Commons Library

Though both inflation and earnings growth are very low, the Chancellor yesterday made a big point of saying how much more than these variables the state pension would be rising. Yet the rationale behind giving pensioners an inflation and earnings busting state pension increase is not clear. From an economic perspective, given the existence of a state pension, you can make a good case for linking increases to prices in order to preserve purchasing power. One could also argue that the value of the pension should be linked to earnings to preserve relative living standards during retirement, arguing that tax revenues are also likely to go up as earnings increase (though this is much more contentious). But it is difficult to justify increasing the pension by the higher of the two (i.e. changing the justification for the increase from year to year) and impossible to make the case that a third safety net of a 2.5 per cent rise should be included too.

This is especially the case when there are plans to freeze many working-age benefits in the next Parliament, having limited them to 1 per cent per year increases in the final years of this one. From the perspective of equitable treatment, a continuation of this policy looks unjustifiable. And the recent paths of the variables used to determine the state pension increase also highlight the considerable risk that the policy has for the state of the public finances. At a time when other countries are trying to de-risk pension provision, we seem to be increasing the risk of ours.

Of course, we know why this policy is popular with politicians. Pensioners vote – and politicians still remember the uproar when the state pension was only increased in line with low inflation such that pensioners received a nominal increment of 75p in 2000 (for a discussion of the fallacies in how this was reported – see p. 84 of Geoffrey Wood’s Fifty Economic Fallacies). But raising the basic state pension this significantly (relative to both prices and earnings), in the context of a stubbornly high deficit and when an ageing population is going to put upward pressure on spending over the coming decades, is very fiscally imprudent. Indeed, the OBR estimates that keeping the triple-lock in place will raise pension spending overall by around 0.9 per cent of GDP within 50 years – about £16 billion in today’s money. And that’s assuming robust earnings growth returns soon.

If the government is looking for ways to reduce spending, in the next Parliament and beyond, linking the state pension to prices and abolishing the triple-lock is a good place to start. This is precisely what I recommended on a recent Newsnight episode. But if we really want to de-risk the pension system from this sort of politics and avoid some of the fiscal and economic problems associated with a Pay-As-You-Go system, we need to think more radically about shifting to a funded system. Watch out for a forthcoming IEA paper which will outline how enabling more contracting out of the state pension system can get us closer to that.