The Aggregate Model projects long-term government expenditure on pensions and contracted-out rebates, the private pension system and the fiscal cost of tax relief:
- At the heart of the Aggregate Model is a projection of the labour market.
- Future expenditure on the State Earnings-Related Pension Scheme (SERPS) and State Second Pension (S2P) is estimated based on the projection of the labour market.
- Future expenditure on contracted-out rebate rates is estimated based on the projection of the labour market.
- Private pensions and cost of tax relief are projected.
- Basic State Pension is projected by making an assumption as to how entitlements improve over time, based on current government policy.
Labour Market Projection
The starting point for the projection of the UK labour market is the current numbers of employees and self-employed, by earnings band, age and gender. The population of employees is broken down further, into six categories based on how they are contracted-in or out of S2P at the year end:
- Appropriate personal pensions.
- Money purchase schemes.
- Mixed benefit schemes.
- Public sector salary related schemes.
- Private sector salary related schemes.
- Those who do not fall into any of the previous categories.
The labour market module uses data from the Lifetime Labour Market Database (LLMDB) 2005/6. This is a 1% sample of National Insurance records derived from government administration records and contains data on about 700,000 employees. The dataset contains details of earnings and contracted-out status for each tax year from 1978/9 to 2005/6.
Expenditure on SERPS and S2P is modelled by considering the underlying accruals in each year. So, for example, the aggregate amount of SERPS/S2P that will come into payment in 2020 will be the sum of what has been accrued by 64 year olds in 2019, 63 year olds in 2018, and so on.
The projection of expenditure on SERPS and S2P is based on the projection of the labour market:
- The Aggregate Model estimates future accruals by applying the rules of the pension system to the projection of the labour market. Past accruals are calculated using data derived from government administration records.
- The accruals are revalued from the year in which they are earned to the year in which they come into payment in line with growth in average earnings, allowing for the fact that some people will die before they receive their pension.
- Once a pension for a cohort is modelled to have come into payment, it is increased in each year in line with an assumed level of inflation and tapered out slowly as the cohort dies.
- When an individual dies the Aggregate Model applies the rules of the pension system to determine how much of his pension may be inherited by his spouse.
Like all of the models in the PPI modelling suite, the Aggregate Model can model possible reforms to the pensions system.
The Aggregate Model produces its own estimates of future contracted-out rebate rates. These rebate rates are applied to the underlying projection of the labour market to estimate future state spending on contracted-out rebates.
There are five different methods of contracting-out in the UK. The methods differ by the amount of the state benefit they aim to replace. Because of these complexities, different types of contracted-out employees receive different rebates. The Aggregate Model therefore models the five different types separately.
Tax relief forms around 20% of the UK’s expenditure on pensions and the Aggregate Model is one of the few attempts to project the cost of tax relief in the UK.
The Aggregate Model projects tax relief by first modelling private pensions. Private pension income using a stock/flow approach for each of five different pooled pension funds:
- Private sector Defined Benefit schemes.
- Public sector unfunded Defined Benefit schemes.
- Occupational Defined Contribution schemes.
- Personal pensions for employees.
- Personal pensions for the self-employed.
The flows into each pension fund are new contributions, contracted-out rebates, investment returns and tax-relief. The flows out of each pension fund are tax-free lump sums and payments to pensioners.
Pensions are paid out through an annuitisation process, like in Defined Contribution schemes. For Defined Benefit schemes, the pension fund is based on a projection of the scheme’s liabilities rather than its assets, to enable modelling of possible deficits or surpluses.
The model projects the cost of tax relief by calculating the amount of tax relief that would be awarded on new contributions, pension roll-up and lump sums, net of the revenue gained from private pensions in payment.
Basic State Pension
This module is based on data relating to the current average amount of BSP in payment for different cohorts. The existing pensioner population is “aged”, allowing for future increases in the level of the full BSP but with no changes to the proportion of the full BSP received. The average proportion received by new pensioners changes slightly from year to year until an ultimate level is reached. These figures are from the GAD assumptions underlying DWP projections.
General economic assumptions:
- Inflation is 2.5% each year.
- Earnings grow by 2.0% each year in excess of prices.
- The Rossi index, used to increase the additional amount of Guarantee Credit to which carers are entitled, grows by 2.1% each year.
- GDP grows broadly with the size of the working age population and growth in average earnings.
- The age, gender and marital structure of the population follow the Government Actuary’s Department’s principal 2006-based projections for the United Kingdom.
PPI modelling work uses an assumption of nominal investment returns of 7% a year for equities and 4% a year for bonds before expenses.
Additional data and assumptions for the Aggregate Model:
- The current distribution of employees’ earnings is based on the 2002/3 Lifetime Labour Market Database (LLMDB), which is a 1% sample of National Insurance records.
- The current distribution of the earnings of the self-employed is based on the 2006/7 Family Resources Survey.
- Employment rates are derived from the most recent ONS projections of activity rates, modified to reflect more recent estimates from the Labour Force Survey. Employment rates are assumed to increase for women over age 50 to become more in-line with today’s employment rates for younger women as state pension age increases between 2010 and 2020. Otherwise, employment rates are assumed to remain constant after the end of the ONS projections in 2011.