The death of the welfare state

It has been a bad week for the welfare state. Yesterday, the Independent revealed that Peter Lilley, the Secretary of State for Social Services, plans to cut the level of mortage interest benefit to those who become unemployed.

A few days earlier, the Government proposed a new tax on payouts made under mortgage protection policies, which cover the home loan of borrowers if they become ill or unemployed. The Chancellor's rapid U-turn on the issue came as a relief but should not lull anyone into a false sense of security. The trend of the past 15 or 20 years has been to cut down on state welfare expenditure.

Over a wide area, from pensions to unemployment and health care, benefits have been cut or abolished, leaving people to make their own provision at their own cost. The heyday of the welfare state has long gone.

This is not, moreover, a policy that future governments of a different colour are likely to reverse. Rather than being a matter of ideology, the state cutbacks have been driven largely by demographics and money. Take pensions, for example. With an ageing population, the UK would have been relying on a shrinking workforce to pay for the pensions of an ever increasing number of state pensioners. Over the next 30 or 40 years this would have become an unreasonable burden on the working population so the State Earnings Related Pension Scheme - which gave a salary-related pension - has had to be radically trimmed.

Britain is not alone in these problems. Almost every Western country is looking at ways of trimming its welfare bill for similar reasons.

The question for individuals is how to replace disappearing state provision with something else, and how to afford it. The problem is that privately financed provision is extremely expensive. Bacon & Woodrow, the actuaries and consultants, have calculated for us that the annual cost of making the most basic provision (before paying for schools fees plans and other "frills") is nearly £9,000.

Pension provision is unquestionably the most important item to consider. Over the past 15 years, the value of the basic state pension has withered from 20 to 16 per cent in relation to real earnings.

It is worth about £50 a week, or £94.10 for a married couple - inadequate for most people used to a substantially higher income. Meanwhile, the Government's campaign to persuade people to opt out of Serps has been staggeringly successful. Only 20 per cent of the population is still in the scheme.

Clearly, the earlier you start contributing to a personal pension scheme the better your benefits are likely to be in the end. The pensions industry has been startled at how many people in their twenties have started pension schemes over the past few years, but the evidence is that most of us do not put enough into schemes to achieve a realistic pension payout.

According to Paul Johnson, director of personal sector research at the Institute of Fiscal Studies, 60 per cent of personal pension holders contribute nothing to their schemes beyond the government rebate of 5 per cent of earnings.

This is a big mistake. Take the case of a married man aged 35 earning £40,000 a year starting a personal pension with the aim of providing himself with a pension at the age of 65 worth half his final salary.

Bacon & Woodrow calculates that he would need to build up a fund of £1.6m. Taking the standard investment assumptions used by the Institute of Actuaries (inflation of 4.5 per cent, an investment return of 9 per cent, and a 6 per cent annual increase in salary) he would have to pay £6,390 a year into his fund.

This is a lot of money but, as Andrew Warwick-Thompson, head of B&W's personal pensions department, points out, people should regard their pension as just as important as their mortgage repayments.

Meanwhile, life assurance - the lump sum paid to a policyholder's dependents at his death - lost most of its tax advantages a decade ago. There are no tax breaks on the insurance contributions, although the lump sum paid out in the event of death is still tax-free. For our 35-year-old to take out a policy paying out four times his salary would cost £491.90.

Permanent health insurance to cover loss of earnings if you fall ill is equally expensive and more important than ever. Since 13 April, State Sickness Benefit and Invalidity Benefit have been replaced by a new and less valuable Incapacity Benefit. Not only is benefit cut from £120 to £52.50 a week but benefits will be taxed after 28 weeks.

A PHI policy that would pay out half our 35-year-old's salary and is index-linked would require an initial annual premium of £495.50. It would then rise with inflation and any increase in the policyholder's salary.

As for unemployment benefit, the state pays a woefully inadequate £46.45 per week. Yet the insurance industry has still not got to grips with the need for individuals to supplement this unemployment income. The only policies available are specifically linked to mortgages, to protect loan interest payments.

Nor is there an easy way to provide against ill-health in old age. Long- term health care insurance would seem to be essential now that local authorities are severely cutting back the amount they will pay for nursing home care and other services to old people.

There are, however, virtually no insurance policies covering nursing home fees, which can range from £10,000 to £20,000 a year. Only Norwich Union apear to offer a sheme covering expenses for hospices, hospitals and selected other care. This costs £1,550 per year.

It is clear that the private sector is still some way from offering the kind of insurance protection that individuals increasingly need as welfare benefits steadily wither away. Insurers may eventually start to offer inclusive policies that cover several areas at once for a single annual premium, but there is no sign of this happening yet.

While the lack of protection is a problem, the expense of individuals making all their own provision is at least as big a problem. The total cost of these main areas comes to £8,927.40, nearly a quarter of our 35- year-old's salary before tax.

From what is left he will still have to pay his mortgage, educate his children and pay for holidays.

Inevitably, he will look for savings such as a smaller pension or no PHI insurance. If he falls seriously ill, however, his family is likely to face severe financial problems.

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

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