July 1, 2013 by johnmillsjml
Exchange Rate Reform Group
BULLETIN – July 2013
What can be done about the UK’s pension crisis?
There was a time not very long ago when the prospects for UK pensions looked much better than they did in most other parts of the developed world. Both the institutional and financial structures in the UK looked robust enough for pension payments to be made according to nearly all the commitments which had been made. Over the last two decades, however, the situation has dramatically deteriorated. The commonly cited reasons for this happening are as follows:
Longevity There has been a steady increase in the life spans of the population as a result of rising living standards, better healthcare and improvements in environmental conditions. Whereas the average age at death was 71 as recently as 1974 it is now 78 and still rising. Although there has been some tendency for people to continue working for longer than they did before, this trend has been nothing like as strong as the rise in longevity. As a result, the ratio between the proportion of the population who are not working because they have reached retirement is much larger than it was and it is still growing. In 1950 the proportion of the population over 65 was 11%. It is now 17%.
Government A number of government decisions have weakened the capacity of funded pension schemes to meet their obligations, of which the most conspicuous were the pension contribution holiday in the mid-1990s and the change in the way tax was deducted on the dividends from pension funds in 1997. In addition, attempts to deal with pensioner poverty by topping up pensions which had not been earned by payments undermined the incentive to say for retirement.
Regulation The pensions industry was not well regulated leading, in particular, to the insolvency of Equitable Life in 2000 and its subsequent restructuring
Agreements Some parts of the population, who had favourable pension contracts, finished up by being far better off as the UK’s economic situation deteriorated than others. In particular, those in the private sector with defined benefit payments based on final salary fare far better than those in money purchase schemes, while an agreement – made at a time when continued economic growth looked secure – that public sector pensions should be inflation proofed as well as being on a defined benefit basis has greatly enhanced the position of public sector retirees.
Underestimation There has been a consistent tendency for the cost of pensions, particularly those in the public sector to be underestimated. Between 2011 and 2013 alone, Office for Budget Responsibility estimates for the cost of providing public sector pensions rose by £13.4bn despite the pension reforms, such as increased contributions, which have been put in place.
Charges Administering pensions has always been a business which required fairly high charges. At a time when the economy was growing reasonably strongly, these were a large but not overwhelming problem. Once economic growth slowed to a crawl, however, causing pension savings pots to stagnate, charges become an unbearably high burden on the eventual sums available.
Low Interest Rates The very low interest rates available to savers and to those responsible for savings pots means that annuities now produce much lower income flows than used to be the case.
The Future for Pensions
While all these factors have doubtless contributed to the pensions crisis from which the UK now suffers, none of them deal with the really fundamental reason for the UK being unable to meet so many of its pension obligations. The root cause is that the total resources needed to meet all these commitments is not sufficient, because the economy is not growing. If – instead of flat-lining – we had a reasonable rate of economic growth, we could relatively easily meet all the pension commitments we have in both privately and publicly funded schemes. This would be the case both for schemes which rely on previously accumulated savings and those which are on a “pay as you go” basis, which includes nearly all public sector obligations.
It is much more difficult to see what will happen if economic stagnation continues for years ahead. Because people are living longer but the average retirement age is growing only slowly, the total number of people entitled to a pension is rising all the time in relation to those who are still working. Two thirds of state benefits go to pensioners at present, a proportion which is continuing to rise. Over the period 2015 to 2025, the number of people who are over 65 in the UK population is expected to rise from 11.5m to 13.5m. Meanwhile, the retirement age is only planned to increase for men from 65 to 66 by 2020 and for men and women to 67 by 2026.
In 2013 the total sum of money paid out to pensioners of all sorts will be approximately £256bn, or just under 16% of our Gross Domestic Product (GDP). Some pensions, once they start being paid, stay constant in money terms while others, particularly in the public sector, are inflation index linked, thus staying constant in value terms. In addition, there are some pensions which are uprated, usually annually, to take account of rising living standards among the population at large – assuming these occur. Broadly speaking, therefore, on average, pensions in real terms are expected to stay roughly constant in value terms, so that the standard of living of pensioners stays about the same in all future years after they retire. Taking the economy as a whole, if the proportion of the population of pensionable age stays constant while the economy keeps on growing, it is easy to see that pension commitments should in these circumstances be relatively easy to accommodate. This is not, however, the position we are in. We have a rising percentage of pensioners and no growth. This is why we have a pension crisis.
This situation is made much more difficult by the fact that pensioners are both an increasing proportion of the population and also considerably more inclined to vote in elections than those who are younger. The result is that there is massive political pressure to protect pensioners at the expense of other sections of the population. This problem is particularly acute because those who are now becoming pensioners have generally done disproportionately well over the past decades compared to those who are younger,
There are three ways in which this problem can be tackled. These are:
Reduce pension payments If there is only a fixed amount of money to pay out in pensions and the number of people with claims on the pension system continues to increase, the only way ahead is to reduce the average amount paid out per head. The major problem here, however, is that both in the private but particularly in the public sector, there are contractual agreements in place which will ensure that a significant proportion of pensioners go on getting paid relatively good pensions. The inevitable result will therefore be that those who do not benefit from agreements such as those linked to final salaries will be heavily squeezed.
Increase the proportion of GDP going to pensioners Increasing the proportion of our national income going to pensioners would obviously make it easier to avoid pension poverty, especially among those not benefitting from contractual pension arrangements. This could be done either by getting people to save more for their retirement or by using the tax system to provide larger pensions. The government is now putting increasing pressure on those at work to save more for their retirement but it is not all clear that this is going to make a massive difference. It is also trying to get contributions from those in final salary schemes, particularly in the public sector, to pay more but, again, the results at least so far have been marginal. This leaves our already over-burdened tax system as a last resort but it is far from clear that realistically there is going to be sufficient capacity to fill the gap. Already just over 20% of all central government expenditure goes on pensions. The danger, then, is that an increasingly serious pension poverty gap will open up, affecting particularly adversely those without any contractual protection, as adequate funding from any source to provide everyone with a reasonable pension fails to materialise.
Get the economy to grow faster The fundamental reason, however, why we have a pension crisis is that everyone’s expectations were for many decades based on the footing that the UK economy would continue to go on growing. It would then supply more and more resources from which, one way or another, the money to provide pensions at a tolerable level for everyone would be available. The pensions crisis thus highlights once again how vital it is that the UK economy breaks out of its current stagnation. The changes which are needed are set out in the enclosed Summary. We need to use monetary and exchange rate policy to make exporting much more profitable and importing correspondingly less so. We need to rebalance our economy so that a substantially higher proportion of our GDP comes from manufacturing than is the case at the moment, so that we can both pay our way in the world and gain the benefit from productivity improvements which are much easier to secure in manufacturing than in services. We need to be able to run our economy at full throttle instead of being constantly constrained by balance of payments deficits. If all this was done, it would then be possible to shift the UK economy to growing at 3% or 4% per annum, and to reduce unemployment from its present level of just under 8% to maybe 3%. A combination of both much increased growth and much less unemployment would then make the pensions crisis much easier to resolve for the following reasons:
More resources would be available from a growing economy Even if the proportion of GDP spent on pensions stayed the same, the total sum available would grow larger every year. This would be particularly important in making pension paying capacity available for those in either the public or private sectors without contractual protection. Because inflation proofed pension schemes provide benefits which rise with inflation but not real growth, they pre-empt resources if there is no growth. Funding is freed up, however, if the economy is expanding.
There would be more public sector taxable and spending capacity available for pensions In so far as government action would be necessary to provide reasonable pensions for those otherwise likely to be left in severe poverty, reduced claims on public expenditure as a result of falling unemployment and greater tax receipts would make it easier for the state to find the necessary resources without levels of taxation being raised to inefficient and damaging levels. Pension commitments are already such a high proportion of total government expenditure, however, that the gains from this source may be limited.
There would be much better returns on investment From the point of view of those managing pension funds, much more growth in the economy would produce considerably greater returns on savings and investment, thus helping to get pension schemes which are at present unable to meet their commitments to have a much better prospect of doing so.
It is clear that the only real way to solve our pensions crisis is to get the economy to start growing again at a reasonable rate. If this is not done, a further major increase in inequality will be reinforced as those covered in both the public and the private sector by contractual schemes pre-empt resources away from those not so protected, leaving too little available to avoid pensioner penury. As with so much else, a huge amount depends on our running our economy better.
Published by the Exchange Rate Reform Group
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