The Entrepreneurial Audit: Welfare and pensions
The self-employed in the UK have had a complex and ill-defined relationship with the welfare system ever since its founding
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This is the third article from our report The Entrepreneurial Audit which offers 20 policy ideas for government to strengthen self-employment and micro businesses in the UK.
Welfare entitlements, past and present
The self-employed have had a complex and ill-defined relationship with the welfare system ever since its founding. People ‘working on their own account’ were originally excluded when the first elements of social security were introduced in 1911, and were treated as an anomaly when William Beveridge drew up his plans for the welfare state as we know it today.
Over time, the self-employed have become eligible for more protections, including the Maternity Allowance, Childcare Vouchers and the new Single Tier State Pension. However, they are still excluded from several benefits that are open to employees (see Table 2). This includes Statutory Maternity Pay, Statutory Paternity Pay, Statutory Sick Pay, holiday pay, and employer pension contributions. Of the benefits paid by employers, some are partly reimbursed by the state while others are wholly paid for by the employer.
Business advocacy groups and politicians alike have urged the government to close the gap in benefit entitlements between employees and the self-employed. The Deane Review reported there was “a clear desire for equal treatment and recognition” and that “discrepancies should be reviewed”. Labour leader Jeremy Corbyn has likewise called for the self-employed to have the same “safety net” as employees, echoing his predecessor Ed Miliband’s pledge to give “equal rights” to people who work for themselves. Most business lobby groups have made similar calls, including the Federation of Small Businesses, Ipse and Enterprise Nation. So too has the RSA.
But how might an extension in welfare coverage be paid for? Some believe the self-employed already receive more protections than their National Insurance contributions merit, and in an austere fiscal climate the government is unlikely to make a move without an equivalent increase in taxation.
One option is to create a top-up system, whereby the self-employed would voluntarily choose to pay more in National Insurance in return for extra protections. However, this idea has two significant shortcomings: first, it could lead to a two-tier welfare state that would lock out the poorest from protections which should arguably be universal; and second, it would depend on people having considerable foresight about the risks they may face and how their lives are likely to pan out. In the countries where such a voluntary top-up system is in operation — including Hungary and the Czech Republic — take up of extra benefits tends to be low.
An alternative option — and our preferred approach — is to finance the extension of extra protections by raising the rate of Class 4 NICs from 9 percent to 12 percent of earnings above the low tax threshold, as proposed in the last chapter. We are unware of any public polling or focus groups where this idea has been mooted to the self-employed. However, a number of the business support representatives who attended our roundtable on this research project in November 2016 were confident that many business owners would not feel aggrieved at such an increase, so long as it was clearly linked to new entitlements (even if they were not to benefit directly and immediately themselves).
On the question of which benefits should be extended to the self-employed, most commentators talk of Statutory Maternity Pay. The RSA backs this call, however believes there may be a stronger case for prioritising the creation of a paternity pay model for self-employed fathers, given the complete absence of support for them at present. Such a ‘Paternity Allowance’ could mirror the structure of the Maternity Allowance in relation to SMP, meaning it would be paid at a rate of £139.58 a week or 90 percent of average earnings (whichever is lower) for two weeks. We estimate a Paternity Allowance would cost around £20m to introduce in England and Wales.
The self-employed should also be able to share their parental leave in the same way as employees, and have access to an Adoption Allowance that would assist self-employed parents of adopted children. As the RSA has argued in previous studies, there is a strong justification for extending parental benefits to the self-employed since these are not just protections for workers but also for children, who should be entitled to the same degree of support regardless of the occupation of their parents.
Recommendation #6 — Establish a Paternity Allowance and an Adoption Allowance for self-employed parents
The government should use proceeds from an increase in Class 4 NICs to create a Paternity Allowance for self-employed fathers and an Adoption Allowance for the self-employed who adopt children.
Smoothing the transition to Universal Credit
The one area of welfare where the self-employed have enjoyed near parity of treatment with employees is means-tested benefits, where eligibility is determined by income rather than built up through National Insurance contributions. Two of the most important of these are Working Tax Credits and Child Tax Credits, which serve to top up the incomes of low paid workers. Approximately 18.8 percent of the self-employed are in receipt of tax credits, versus 10.6 percent of employees.
While tax credits are a vital lifeline of support, one particular issue facing self-employed claimants is that of over and under payments. The entitlements of the self-employed are calculated at the beginning of the tax year based on what they earned the year previously. However, this is only an estimate and their real earnings can deviate from the prediction, sometimes significantly. Those who subsequently earn less than expected may struggle with insufficient tax credit, while those who earn more could find themselves having to reimburse money to the tax authorities. HMRC recently secured powers to settle unpaid tax bills by accessing people’s bank accounts directly.
The government expects that this problem will be resolved with the introduction of Universal Credit, which will affect both employees and the self-employed. The flagship welfare programme will roll six means-tested benefits into one, including Tax Credits, Housing Benefit and Jobseeker’s Allowance. The hope is that this will streamline what is a convoluted and bureaucratic welfare system, and ensure that there is always an incentive for people to increase their working hours. DWP estimate that it will save £38bn over 12 years from its inception and result in 300,000 more households moving into work.
The self-employed will be treated significantly differently than under the legacy Tax Credits regime. Before being able to claim Universal Credit, they will first need to attend a Gateway Interview with a Jobcentre Plus work coach, who will determine whether or not they are ‘gainfully self-employed’ — that is, running a business with a reasonable expectation of profit. Those who pass this test will then be exempt from having to search for other work. Alongside this, the self-employed will have to start reporting their earnings on a monthly basis rather than annually, and do so through an online account.
However, unlike claimants looking for conventional work as an employee, the self-employed will have their Universal Credit entitlement pegged to a ‘Minimum Income Floor’ (MIF). This is an assumed level of earnings that, for most workers, will be the equivalent to the National Living Wage. Anyone earning beneath the MIF will not have the difference made up by a larger Universal Credit payment. So, assuming the MIF is set at £1,100, a self-employed worker would receive the same UC entitlement whether they earn £300, £500 or £900 — a stark contrast to the Tax Credits system where benefits generally rise as earnings fall.
The rationale for the MIF is twofold: first to minimise the incentives for the underreporting of income; and second, to ensure the welfare system does not subsidise loss-making businesses indefinitely. While the RSA agrees with these objectives, the current design of Universal Credit appears to be out of kilter with the realities of how businesses function. For example, the government has established a ‘start up period’ that will exempt the newly self-employed from the MIF during their first 12 months in business. Yet only a small proportion of the self-employed will be able to reach the equivalent of the National Living Wage in the space of a year.
Combined with the monthly reporting requirement, the MIF is also likely to be detrimental to claimants with volatile income. Someone paid in large lump sums throughout the year may in one month earn so much that they are entitled to zero Universal Credit, while in another earn very little but see no increase in their UC entitlement due to the MIF. As Table 3 shows, two people can earn the same amount over the course of the year yet end up with widely different UC payments because one has lumpier income patterns than the other. The MIF may also be triggered when claimants have large expenses in one month, such as investments in tools or a sizeable utility bill.
Other challenges relate to administration and compliance. A study undertaken by the University of York into the potential impact of UC found that many of the self-employed were comfortable with the idea of reporting their income on a monthly basis. However, it remains to be seen whether claimants will always be able to meet the strict seven day reporting deadline. As we understand it, claimants will also have to provide a different set of information through the UC online portal to that required from HMRC for their Making Tax Digital updates and self-assessment forms, possibly necessitating two sets of books.
Together, these problems not only serve to leave the self-employed materially worse off, they also risk sinking businesses that could in time be self-sufficient and net contributors to the exchequer. We propose several reforms to put Universal Credit back on the right tracks:
- First, the start up period where the self-employed are exempt from the MIF should be extended from 12 months to 24 months, in recognition of the time it can take for businesses to become viable. During this extended period, the self-employed would still be required to report to the Jobcentre Plus to show that progress is being made.
- Second, the reporting period for Universal Credit should either revert to an annualised system (as under tax credits), or work on a quarterly basis (which would align with the new tax reporting period). Shifting from monthly to annual or quarterly reporting would help to mollify the impact of lumpy incomes on people’s UC entitlements.
- Third, the information and accounting requirements for the Universal Credit and tax self-assessment systems should be aligned as far as possible. DWP should also consider whether to give the self-employed greater leeway on the seven day reporting deadline in extenuating circumstances.
- Fourth, the responsibility for undertaking the initial Gateway Interview should pass to New Enterprise Allowance business advisers. These will be better placed than JCP work coaches to determine whether claimants have a credible business and be classed as gainfully self-employed.
Recommendation #7 — Reform Universal Credit to ensure it responds to the realities of starting and growing a business
The Department for Work and Pensions should iron out the flaws in Universal Credit to ensure it is fair in its treatment of the self-employed and employees, and that it does not hinder potentially viable businesses:
- Extend the start up period from 12 to 24 months
- Move from monthly to annual or quarterly reporting
- Give NEA advisers responsibility for undertaking the Gateway Interview
- Align information and accounting requirements for the tax and UC systems
Protecting income during periods of ill health
So far we have discussed how the self-employed might be able to access contributory benefits and means-tested benefits on a par with employees. However, there is one important entitlement we have yet to address: sick pay. Unlike employees, the self-employed have no right to Statutory Sick Pay and must for the moment fall back on Employment Support Allowance (ESA). This is paid to most people at a rate of £102.15 a week, and becomes means-tested after a year. It can also come with a requirement to take part in training and attend job interviews if the claimant is deemed partially fit for work.
The Association of British Insurers estimates that 80,000 self-employed people move onto ESA every year. Worryingly, however, most of the self-employed appear to favour ploughing through an illness rather than seeking support. Recent polling undertaken by the Department for Business, Energy & Industrial Strategy (BEIS) found that more than 80 percent said they would try not to take time off work should they become sick or injured, while 15 percent said they had no recourse to any support, be it savings or a spouse’s extra income. Those who find themselves in the position of having to work through an illness may end up causing greater harm to themselves over the long run.
In the absence of state help, some have advocated that the self-employed turn to Income Protection (IP) insurance, which can help to maintain people’s incomes for long periods should they fall ill. According to the Federation of Small Businesses (FSB), however, only 9 percent of the self-employed are signed up for an IP product. This may reflect the high cost of premiums, which can be prohibitively expensive for older people working in more hazardous industries. Quotes given to us by a leading price comparison website suggests that the cost of income protection insurance for a 49 year old electrician would be almost twice as much as that for a 29 year old graphic designer.
Costly premiums may be an inevitable feature of the insurance landscape. But they may equally reflect a private insurance market that is struggling to generate the economies of scale needed to bring down costs. If this is the case, there may be a role for the government to play in pooling risk among the self-employed at a grand scale, for example by creating a collective insurance protection scheme. The aim would be to do what Nest has done for the pensions sector: open up cost-effective financial products to those who would otherwise be excluded from the market, and to do so in a way that minimises any crowding-out of existing private sector activity.
Alongside orchestrating wider insurance coverage, the government could take the step of fully opening up the new Fit for Work service to the self-employed. The aim of this new programme is to provide speedy health support to people who have fallen out of work, with the intention of nipping in the bud any long-term issues. The Fit for Work service has two elements: first, an advice service (delivered online and over the phone) that provides informed guidance, for example on how to manage musculo-skeletal problems or deal with stress; and second, an assessment service with a trained healthcare professional that results in a detailed Return to Work Plan. While the self-employed are able to access the advice line, they are currently excluded from the more comprehensive assessment. Locking out the self-employed from a service that could get them back into work is a false economy for the government.
Recommendation #8 — Protect the self-employed against dips in income caused by illness and injury
In the absence of Statutory Sick Pay, the government should explore alternative ways of protecting the incomes of the self-employed at times of ill health. More specifically:
- Consider the scope for a collective income protection (IP) insurance scheme, in the same mould as Nest
- Open up all elements of the new Fit for Work service to the self-employed
The future of pensions and retirement security
The final aspect of welfare policy in need of review is pension coverage. The self-employed were recently granted eligibility for the new Single Tier State Pension worth £155.65 per week, however this is not a cure-all and in most cases people will still need other sources of income in retirement. A private pension is one of the best savings vehicles available, yet few of the self-employed are currently signed up to a scheme, and those who are tend to save little and save late:
- Only 23 percent of the self-employed are enrolled onto a private pension, versus 61 percent of employees
- The self-employed closest to retirement (55–64 year-olds) have £85,500 saved on average, compared with £162,250 for employees — nearly a twofold difference
- Just 8 percent of self-employed 25–34-year-olds are enrolled onto a pension, with late savers depriving themselves of the benefits of compound interest (see Figure 6)
Several factors lie behind these low numbers. The self-employed have no equivalent of auto enrolment, which has been a key driver in boosting pension coverage among employees. Nor do they benefit from employer pension contributions, estimated to be worth an average of £91,500 over the course of a savers’ lifetime. Research by Citizens Advice also reveals widespread misperceptions about the value of pensions — such as the false belief that ISAs deliver better returns — as well as broader fears about the stability of pension funds. Half of the self-employed surveyed by Citizens Advice said they do not trust pensions as a safe place to store their money.
How might pension coverage among the self-employed be improved? The solution favoured by the Deane Review is for the government to work with private pension providers to offer more flexible products for the self-employed — a move the RSA would back. However, history tells us we cannot leave it to the market alone to rise to the challenge. Nor is the government likely to be willing to create additional financial incentives, such as extra tax relief for contributions made by the self-employed. In any case, the Pensions Commissions reported over 10 years ago that financial incentives had failed to boost enrolment numbers among the wider workforce.
There is, however, a compelling and cost-effective alternative in the form of nudging techniques that are underpinned by behavioural science. One idea is for the government to present the self-employed with what is called a ‘forced choice’ question, possibly at the point when they complete their tax returns. This would ask them to opt in or out of a pension scheme, such as those offered by Nest, the government-backed pension provider. An evaluation undertaken by Harvard University of a similar initiative applied in a US workplace found that enrolment rates increased from 9 percent to 34 percent in the first four months of implementation.
Recommendation #9 — Boost pension enrolment among the self-employed through an opt-in / opt-out question
The government should present the self-employed with a ‘forced choice’ question asking whether they would like to opt in or out of a private pension scheme. This could be presented when the self-employed complete their tax self-assessment.
The virtues of the LISA
Alongside pension reform, it is also worth considering how ISAs might be used to complement or top-up retirement savings. Research undertaken by Nest found that the self-employed often prefer to use ISAs because they are simpler to understand, involve fewer intermediaries, and allow savers to access their money more easily — an important feature for business owners managing volatile incomes.
In this regard, the new Lifetime ISA (LISA) may prove to be an ideal savings vehicle for the self-employed. For every £4 that savers invest in a LISA, the government will add an extra £1 bonus, with an annual savings limit of £4000. Legal and General estimate that if a 25 year old took out a LISA and saved the full amount of £4000 every year, with an estimated annual growth rate of 5 percent they could expect a tax-free sum of £416,000 by age 60. The LISA is only intended to be drawn down during retirement, or used for purchasing a property.
For all its promise, however, the Lifetime ISA has a number of limitations, the first being that it is only open to people below the age of 40. It is unclear why the government has chosen to insert a low age clause, and it seems unjust to lock out older self-employed people who lack the same access to adequate savings products as their younger counterparts. A second issue is that savers must pay a 5 percent penalty if they withdraw their money before the age of 60, or for another reason than to purchase a property. Given that savers would also lose their bonus in the process, this penalty seems unnecessary.
If the government intends the LISA to be used as a savings gateway for the self-employed, they should consider raising the age barrier, possibly by another 10 years, and scrapping the penalty on LISA withdrawals. We would also urge the government to consider allowing the self-employed to freely draw down on their LISA while keeping their bonus, on the condition they repay the funds within a short period of time. This extra liquidity would be attractive to the self-employed with fluctuating incomes, and would help people to manage in extenuating circumstances, such as during a time of illness or business expansion.
Recommendation #10 — Transform the Lifetime ISA (LISA) into a suitable savings gateway for the self-employed
The government should make adjustments to the Lifetime ISA to ensure it runs with the grain of self-employed lifestyles. More specifically:
- Raise the age limit for opening an account from 40 to 50
- Scrap the 5 percent penalty for early withdrawals
- Allow account holders to freely draw down on their savings on the condition they promptly repay the funds
