Pension System of the USA and the UK - Essay Example

Introduction

Pension system refers to the arrangement where both the employers and employees adhere to hence provision of disposable income after retirement. It involves deduction of a part of the employees’ income during his/her work phase period (Harris, 2001). The planning and implementation of the scheme is founded on specific principles and guidelines whose implementation is dependent on the specific country or state. These principles are dictated by the constitution and through reforms that are enforced by the legislature arm of the government. Generally, pension systems can be categorized into two; defined benefit (DB) and defined contribution (DC) plans (Rabelo, 2002). A DB system involves the accumulation of lifetime income/benefits which are invested in certain sectors such as stock markets. The returns on the investments are made once the retired employees sells the portion of the investment in their name. A DC system involves the monthly saving of specific monthly premiums in a specified account. The amount of benefits is accessed by the beneficiaries “as it is” since it is not invested in any sector.

Pension systems can be further categorized based on their source. Based on this, pensions are classified as occupational, social and state and disability. Occupational pensions are provided through employment which is defined by the employee-employer agreement (Pascuzzo, 2016). Under this arrangement, both the employee and employer contributes a specified amount. Social and state pensions are those that are provided by a state where the beneficiaries do not contribute any portion at all. Under disability pensions, beneficiaries are the disabled who do not contribute and the criteria for selection is evidence of specified minimum years of service.

Other categories of the pension system also exist. They include pension funds, insurance schemes, personal pension plans, among others. Pension funds are self-administered schemes. Pension funds may be administered through either a trusteed or an insured plan which depends on the pension plan commitments to workers (Rabelo, 2002). However, they face constraints from peer group pressure and the judgment may be biased. Enforcement of the guidelines involves delegation of authority to the trustees who are obligated to pay on actors’ behalf and pursuant to the collective bargaining agreement. Pension funds are instruments designed to accumulate assets for retirement. This paper is based on analyzing pension funds. Content is obtained by analyzing the pension system of states by comparing the pension systems of USA and UK, public and private funds and the U.S. social Security fund.

Pension System of the USA

The pension system of the USA can generally be categorized into public and occupational. Public pensions encompasses the disability function and it is referred to as OASDI (Old-Age, Survivors, and Disability Insurance) program (Harris, 2001). The amount of public pensions is outsourced from the compulsory contributions of both the employer and employee (social security tax), remitting tax from the beneficiaries of upper-income social security and interests obtained from the trust fund reserves. Occupational pensions are those that are related to employment. It can be categorized into either DC or DB plans.

DC schemes are the most prominent forms of occupational pensions. However, DC scheme is made up of various subtypes with 401(k) being the most widespread and prominent of them all. 401 (k) plan is an arrangement between the employer and employee where both parties make contributions that are accessed at the end of the working tenure (Pascuzzo, 2016). Other subtypes of DC scheme include 403 (b) plans, 457 plans, Thrift Savings plans and employer-sponsored IRAs.

Accompanied by the various uncertainties and complexities, the pension system is widely regulated. This ensures that the enrolment of employees is automatic and the methodology of contribution. Regulations also determine the disbursement of pensions after retirement. Currently, the pension system in the USA is guided by Multiemployer pension Reform Act of 2014 which was signed in December 2014.

Pension System of the UK

The pension system is relatively similar to the American system and can be grouped as public and occupational pensions. Pensions are based on the income that employees earn and on voluntary contributions. According to the UK pension system, public pensions are grouped into basic state pension (BSP) and the state second pension (SSP). BSP refers to the premium payments for pensions whose benefits are accrued after 44 years whereas SSP refers to the state-based pensions for citizens whose income capacity is low or moderate (Mercer.com, 2016). Occupational pensions in UK are voluntary and can be categorized into either DB or DC schemes. Regulations of the pension system in the UK is based on the 2012 reforms. According to the reforms, all employees are automatically enrolled into the pension system with the option to opt out at will.

Comparison between USA and U.K. Pension Systems

Basic information; According to a survey done by Melbourne Mercer and the Australian Centre for Financial Studies in 2014, the performance of countries in terms of pension systems was graded. The grading ranged from A to D where A implies the best pension system whereas D represents the worst pension system. UK had a grade of B while USA had a grade of C (Mercer.com, 2016). This implies that although the UK’s system is good, some areas still need improvement whereas although the USA’s system is good, it includes possible risk factors which if not addressed would limit the sustainability of the system.

Pension System; Both the American and UK system incorporate auto-enrolment of the members into the pension systems. This ensures that the systems gain/derive maximum benefits by increasing coverage and the amount of contributions. This improves the sustainability of the system and hence ensuring availability of the disposable income for the elderly. The UK’s plan is based on the two-tier system whereas the USA’s plan is founded on one-tier system (Rabelo, 2002). This implies that according to the USA’s system, pensions are a function of state-derived benefits and includes the basic pension state (BSP) and the pension credit (PC). For the UK’s system, the mandatory pensions are a composition of personal, stakeholder, and occupational pensions.

Pensionable Age and Premium Rate; according to the USA’s system, the pensionable age is 65 years although the age is expected to be raised to 67 years by 2027. The UK’s system defines the pensionable age to be 65 years for men and 60 years for women although plans are being implemented to raise the age for women to 65 years by 2020 (Mercer.com, 2016). The pensionable age of the UK’s system is set to be further raised to 68 years for both gender from 2024 to 2046. The premium rate of the pension scheme is shared by both the employer and employee in the US system and it is set at 12.4% whereas the premium rate is defined at 23.8% where the employee accounts for 11% with the employer accounting for 12.8%.

Private and Public Pension Funds

The term pension funds refer to plans, schemes or funds that provide retirement income. Public pensions refer to the retirement plans for individuals who work in the state and or local governments as well as the federal government. As such, the public pension funds are regulated under public sector law. Beneficiaries of such pension include firefighters and law enforcement officers. On the contrary, private pension funds are provided to employees working for companies in the private sector. Contrary to the public pension funds, the private pension fund is controlled under private sector law. However, not all companies offer private pension plans to their employees.

The debates on whether public sector workers earn less as compared to those in the private sector have led to disagreement on pay. Differences also exist in the pension plans in private and public sectors (Reilly 2013). For instance, in the US, as of 2012, eighty-four percent of public sector workers had access to a DB plan compared to twenty-one percent in the private sector. Also, it was found that 71% of public sector workers received health care coverage for early retirees as compared to 18% in the private sector (Reilly 2013). While the private sector has heavily been relying on merit pay, bonuses, profit sharing, et cetera, the public sector relies on job tenure, average general increases as well as the cost of living. Instead of many private workers receiving a DB, they have Defined Contribution plans (Reilly 2013). It is evident that pension benefits are a significant source of income for the retirees.

The government regulates pensions by determining the minimum and maximum funding limits, enforcing nondiscriminatory clauses, guaranteeing benefits in well-defined benefit plans. For the Defined Benefit plans, the retirement benefit is dependent on the number of years of service and the average earnings (Reilly 2013). This is why those employees who work for longer receive higher pensions as compared to some early retirees in the public sector. In defined contribution plans, an individual’s contribution, either personally or through the employer is part of their earnings. Such contributions are sent to an account where the contributions, as well as the returns or assets, accumulate (Reilly 2013). In such a case, the retirement benefit is what has accumulated in the account and is dependent on time; amounts contributed as well as return on investments. This mostly happens in private pension plans.

In my opinion, I feel that the private pension fund effectively provides an alternative to the public pension fund and form a successful financial solution necessary in the future. This is because, with an increased aging population, the retired persons form a significant financial burden to the public pension fund and brings doubts of its sustainability. In many countries, the governments are making calls for the public sector employees to raise their pension and work for longer. In others, there are talks to raise the taxable base. Such moves are contributing to more people favoring the private pension funds.

The orientation towards increased preference for the private pension systems has been boosted by the fact that private pension funds provide better plans as compared to public pension systems and that the individual can have control over what they want. For instance, before engaging in any private pension system, one may consider the institutions financial stability, the financial offer, its experience in investment and administration of its clients’ money. That private pensions do not undergo redistribution is another major reason why many favor the private sector pensions. In addition, personal assets accumulate in the client’s personal account. Given such factors and the continued dissatisfaction with the public pension system, I feel that the private pension systems should anticipate a substantial increase in individuals subscribing to them.

The U.S. Social Security Fund

In the states, the payment social security benefits are provided by the Social Security Trust Fund under the Social Security Administration as established by the 1935 Social Security Act (Pattison 2015). Through this Act, the Congress was authorized to appropriate funds to a reserve account and also establishes a payroll tax enough to provide those funds (Pattison 2015). The Federal Old-Age and Survivors Insurance Trust Fund and the Federal Disability Insurance Trust Fund are collectively referred to as the Social Security Trust Fund (Pattison 2015). Recognized social securities are old-age, survivors and disability insurance. It is the Social Security Administration that collects taxes from payrolls and uses that money to pay for the benefits of the old age, survivors as well as the disabled insurance benefits in the form of trust funds. If the program results in an excess, the surplus funds are used to improve the Trust Funds value.

The Social Security Trust Fund in the US structure has two separate funds. The Old-AGE and Survivors Insurance Trust Fund (OASI) is the largest and has a special interest in the federal government securities which are bought using OASI payroll tax revenues that are surplus to requirement (Van de Water 2014). Disability Insurance Trust Fund is much smaller and has a special interest in the federal government securities which are bought using OASI payroll tax revenues that are surplus to requirement (Van de Water 2014). Trust funds are categorized as ‘off-budget’ and are treated differently as compared to other federal spending (Pattison 2015). Payroll taxes, as well as other earmarked incomes, are deposited in the two trust funds. It is from them that social security benefits, as well as administrative benefits, are paid.

One major observation about the social security trust fund is that it runs surpluses a trend that has been happening since 1984. This is because the amount that is paid in by the workers is much more than the amount of money that is paid out to the current beneficiaries (Hoffman and McKenzie 2014). Such surpluses are forwarded to the U.S Treasury and form part of the general budget of the federal government or are traded for special securities of the U.S government or in interest-bearing Treasury bonds. Such balance ensures legal authority for the Social Security benefits to be paid for even when the income generated by the social security program is insufficient by itself (Van de Water 2014). As of 2015, the reserves were too large, just enough to ensure that cash flow will continue for about 20 years.

The two trust funds are entirely invested in the securities provided by the US Treasury. These Treasury securities are backed by credit as well as the full faith of the US government (Pattison 2015). The US government securities are considered by investors as among the world’s safest investments because the US government has never, not even once, defaulted on its obligations. Those Treasury securities held by the social security trust funds are more attractive to the investors due to certain features. For instance, they do not fluctuate in value, and one can always redeem them at par and even if they ought to be redeemed early, there is a guarantee that social security does not lose money invested (Van de Water 2014). Another special feature is that such securities earn interests at similar rates whether they mature in a year, medium- or long-term. As of 2013, the Treasury securities accumulated by the trust funds were almost $2.8 trillion.

In the short term, social security is adequately financed although there are projections that it may suffer in the long-term with a shortfall of approximately one percent of the GDP in a period spanning the next 75 years (Van de Water 2014). Based on the recommendations in 1983 by the Greenspan Commission, it was anticipated that the fund will always be in surplus, and this has been the case as pointed out earlier. However, currently, the projections are that the two trust funds will run with annual surpluses until the year 2020 (Van de Water 2014). However, the interest income which the trusts earn from the security bonds and the proceeds from bonds that will be redeemed will be enough to support social security until 2033 while still paying full benefits. According to Van de Water 2014, it is after that period that the trust funds will be short of the treasury bonds which they can cash in. While benefits will continue to be paid for, it will not be full payment.

One contentious issue about the trust funds is when it comes to the federal government borrowing. While some critics argue that by lending the reserves of the social security trust fund to the federal government is in a way a misuse of such funds, I feel that such suggestions are illogical. It is my understanding that when the governments face a deficit in its budget, the Social Security surplus provides an avenue where the government can borrow less from the to try to reduce the deficit. As the Treasury holds this cash, it is pointless for the Treasury to borrow from the public when the cash from the social security is available to it.

Conclusion

Pension system stipulates how the elderly have access to disposable income at old age especially when their productive years are over. It involves specific arrangements where a part of the income that earned (during the productive years) is set aside on a monthly basis and then accessed at retirement. Pension systems are defined and designed by governments. The stability and success of the pension system will, therefore, be dependent on the mechanism and methods that are put in place through legislation. As a result of the differences in the systems that are developed by various countries, viable differences in the structure and implementation of the pension system plays a significant role.

A comparison of the pension systems between the USA and the UK showed a variety of aspects that defines the pension system. The analysis showed that both systems incorporated automatic enrollment of individuals into the system hence increasing the amount of contributions that is collected. Pensions systems in both systems were grouped into direct-benefit and direct-contributions pensions. The USA was found to have a larger proportion of its citizens on DC schemes. However, differences between the systems included the amount of premium paid, the pensionable age of the contributing members. Pension funds can be further categorized into public and private. Public pension funds are those that are advanced for the employees of the state whereas private pension funds are those that are provided by employees working for the private sector.

To ensure sustainability and effectiveness of the pension systems, there are certain regulation that guide the functioning of these systems. These systems are defined by the legislature in form of either reforms or laws.

Reference List

Harris, D. (2001). A comparison of US and UK pension security systems. 1st ed. [ebook] Available at: http://www.actuaries.org/EVENTS/Seminars/Brighton/presentations/harris.pdf [Accessed 21 Apr. 2016].

Hoffman, M, and McKenzie, K. (2014). The Reality of Social Security: If Reform Doesn't Happen, What Must Each of Us Do?. Journal of Accounting & Finance (2158-3625), 14, 2, pp. 124-134

Reilly, T. (2013). Comparing Public-Versus- Private Sector Pay and Benefits: Examining Lifetime Compensation. Public Personnel Management, 42, 4, pp. 521-544

Mercer.com. (2016). Mercer | Global Pension Buyout Index. [online] Available at: http://www.mercer.com/our-thinking/global-pension-buyout-index.html [Accessed 21 Apr. 2016].

Pascuzzo, P. (2016). An International Comparison of Pension System Performance in Delivering Adequate Retirement Incomes. [online] Available at: http://webcache.googleusercontent.com/search?q=cache:8U9HRLIsk5wJ:www.challenger.com.au/group/Documents/Attachment_A_ChallengerInternationalComparisons.pdf+&cd=8&hl=en&ct=clnk [Accessed 21 Apr. 2016].

Pattison, D. (2015). Social security trust fund cash flows and reserves. Social Security Bulletin, 75, 1, pp. 1-34

Rabelo, M.F., 2002. Comparative Regulation of private pension plans. Retrieved March, 20, p.2008.

Van de Water, P. (2014). Understanding the Social Security Trust Funds | Center on Budget and Policy Priorities. [online] Cbpp.org. Available at: http://www.cbpp.org/research/social-security/understanding-the-social-security-trust-funds [Accessed 21 Apr. 2016].