The topic of pensions is normally guaranteed to send most people to sleep except for a few actuaries who are equivalent to the train-spotters of the financial world. However, in November Britons woke up to discover that there was a crisis with their pensions. After three years of deliberation and consultation, the chairman of the UK Pensions Commission, Adair Turner, had issued a report on the state of the UK pension system. It concluded that things needed to change if the UK was going to be able to afford to provide adequate pensions for its elderly population.
The causes of the pension crisis have been well rehearsed over the years: people are living longer and too few babies are being born. Neither of these two factors should have come as any surprise. Life expectancy has been increasing for the past 200 years and shows no sign of slowing down, especially as the levels of smoking among the population has declined. Birth rates have been declining for the past 30 years, after the post-WWII baby boom. The UK’s fertility rate, like that of almost all other developed countries and a number of developing ones, is below the level needed to maintain, in the long run, the current size of its population.
The coincidence of these two trends means that the number of older people as a proportion of younger people is increasing. This is expected to put an increasing strain on the economy as the number of non-producers increases relative to the productive population although this will be partially offset by a smaller proportion of young people.
Turner identified four possible responses to the increasing numbers of elderly people: allow them to get poorer; increase taxes to pay more in pensions to the elderly; increase the retirement age; or compel individuals to save more for their retirement. As the first option is socially unacceptable and the second politically so, it was no surprise that Turner proposed a mixture of the third and fourth options.
The UK’s pension system is based on three pillars: a basic state pension, the State Second Pension and private provision. The basic state pension is currently payable to men from the age of 65 and women from the age of 60, although the latter will increase to 65 between 2010 and 2020. Turner has proposed that the pension age should be increased in line with increases in life expectancy.
This will be taking the basic state pension back towards what it was intended to do when originally introduced in 1908 when the age of entitlement to a state pension, for both men and women, was set at 70. At that time life expectancy was around 50 years and those who reached 70 were not expected to live much beyond it. In 1925 the age was reduced to 65 and in 1940 it was reduced to 60 for women. Currently in the UK life expectancy from birth is 76 for men and 81 for women. Men who survive until 70 can expect to live another 12 years and women can expect to live another 15. No wonder Turner’s proposal to raise the state retirement age was perceived as generally non controversial, the most negative comment being why it took them three years to come up with it.
The actual age when the basic state pension can be drawn is to a large extent arbitrary, being more dependent on what the government thinks it can afford than on any objective definition of old age. However, the state retirement age of 65 has entered the national consciousness as the de facto definition of old age. So any change from this — even when entirely reasonable — will come as a shock. Fortunately for most people old enough to be shocked, the changes will not come in quickly enough to affect them.
The second set of proposals from Turner related to the creation of a national pension saving scheme. This is an alternative to the State Second Pension which is a “pay as you go” system, meaning that current contributions are used to pay current pensions and no fund is maintained. Turner’s national scheme would have everybody join unless they proactively opt out because, for example, their employer provides a better scheme. Employees would have to contribute five per cent of their salary and employers three per cent with the government providing the equivalent of a further one per cent through tax relief. This proposal was also fairly non controversial given the current low levels of saving for retirement even when house ownership and potential inheritances are taken into account.
What is not so clear is what any resultant increase in savings would do to the economy. Forcing people to save more for their retirement could reduce other forms of saving or lead to a reduction in current consumption. It could also be simply seen as another form of taxation on top of a generally increasing tax burden. It will be a brave government who introduces this.
One factor that is generally absent from the discussion of the so-called pension crisis is increasing the fertility rate. However, this is not a cheap option either for families or for the state which provides an increasing amount of childcare benefits. At least it would put more control into the hands of individuals who would not be relying so much on the state or the stock market to provide for their retirement.
The UK in many respects is better off than other countries. The UK’s pension commitments are less generous than elsewhere; the fertility rate although low is higher than countries such as Italy and Spain; and there is a steady stream of immigrant workers who help to keep up the size of the working population. Therefore whatever pain the UK has to go through could well be multiplied in other places.
What will actually happen with the Turner report remains to be seen. What is clear is that the writing is on the wall for a reduction in state pension benefits and an increase in individual provision.
Dermot Grenham is an actuary for the Prudential Assurance Company in London. His briefing paper on population is available with the other MercatorNet backgrounders.
"Profile: Adair Turner: Trying to sell a pension plan in a political boxing ring"
London Times, Dec 4, 2005
Ask the expert: Adair Turner on pensions
Financial Times, Nov 27, 2005