Baby boom or pensions bust

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Baby boom or pensions bust

Larry Elliott, The Guardian

December 1, 2003

Perhaps the most powerful contraceptive in the world is the notion that making babies is the answer to the pensions' crisis. As a come-on, whispering sweet nothings about the demographic time bomb is not exactly Cary Grant.

It may, however, come to that. People are living longer and one way of paying for their extended retirement is to increase the size of the future workforce. We've had digging for victory; soon it could be bonking for Britain.

All parties know that there is a problem looming out there. As Adair Turner, who is heading the independent pension commission, puts it, Britain has accepted for years that state pensions are less generous than in other developed countries but we reassured ourselves that the success of our occupational pensions made up for it.

Today things look a lot less promising. Companies have been closing defined benefit schemes - where they guarantee an employee a proportion of their final salary on retirement - in favor of defined contribution schemes, where the size of the pot depends on how well an individual's investment performs. Risk has been transferred from companies to individuals, who can see the value of their pension nest egg plummet in turbulent times.

Turner's view is that DB schemes are in retreat not because of the equity bear market but because companies underestimated just how much longer we were living.

Assuming that life expectancy had reached a ceiling, they increased the generosity of schemes and took pension holidays at the same time. Nigel Lawson's changes, which made running pension surpluses tax-inefficient, and Gordon Brown's £5bn raid on dividend tax credits made matters worse.

Later this month, the government actuary's department will reveal that estimates of life have again gone up. So we have a situation where people can expect to live longer but have far less confidence about how much they are going to have to live on. Rough rule of thumb calculations suggest that the 9.3% of GDP spent that makes up pensioner income will have to rise to 13.5% over the next 25-30 years for living standards of the elderly to keep pace with those of the rest of the population.

In these circumstances, there is only a small number of options: pensioners get relatively poorer, we save more so that our pension pots are bigger, we work for longer, or we fix the demographics. Option one is obviously unacceptable, and there has to be a doubt as to whether option two is feasible. In theory, it is conceivable that forcing workers to save more into private schemes would raise the pool of funds available for investment and that this in turn would lead to higher growth rates, higher profits and higher share prices. But given the hit to present consumption and the declining marginal returns to investment, argument rages about whether it would.

How are today's workers going to react to being obliged to limit consumption through enforced savings when the administrative costs of pensions are high and the returns uncertain? One suggestion is that the burden of enforced saving should be placed on companies through higher taxes. They, after all, are the ones closing down DB schemes, to the detriment of their workers. The problem is that we, the workers, now own the companies through pension funds. If taxing them more heavily means lower dividend payouts and/or less investment it would be a case of robbing Peter to pay Paul.

The third option - raising the average retirement age - is also fraught with political danger, yet in the end may be a nettle that has to be grasped. If the average of retirement rose, the projected 13.5% of GDP needed to give pensioners a decent living standard in retirement could be far too high an estimate.

Before moving on to option four, it's worth exploring whether there is merit in a hybrid scheme. The Swedes, for example, have introduced a pensions' system where risk is shared. Workers are guaranteed a final benefit but in return accept there has to be flexibility about when the pension is payable, with the precise timing dependent on the latest estimates of longevity. This seems a reasonable compromise, since as Turner put it in a recent lecture there are "real issues about increasing numbers of relatively low-income people being exposed to high return volatility, as state provision becomes more basic and as private DB provision retreats".

A Swedish-style approach has merit, and it might be possible to persuade the public to accept a grand bargain in which individuals would agree to pay more tax so the state pension could be pegged to earnings, with the rider that the average retirement age might also have to be increased in the face of rising longevity. One real advantage of compulsory saving into a state pension scheme is that administration costs are much lower than with private pensions. This did not seem to matter so much when private pensions were delivering double-digit annual returns, but it makes a real difference if, when returns are 4%-5%, one percentage point of that is eaten up by annual charges.

Even so, there are counter arguments. One is that pushing up the tax burden would make the economy less competitive. A second is that it is all very well asking white-collar workers to put in a few more years at the office, but unfair on manual workers who have been slogging away at boring and often backbreaking jobs. This is a fair point, although it could be circumvented if the government stipulated that a worker had to put in a set number of years in the labor market before the pension could be claimed. If, for example, the bar were set at 44 years, it would mean the manual worker leaving school at 16 would be able to get a pension at 60, but the graduate would have to work until 66 or 67. A more redistributive system could allow the manual worker to put in fewer years than the white-collar professional. Reform would also be a chance to correct the flaw in Beveridge's original state pension by crediting women for time spent at home raising children. Also, we could reduce the average retirement age without all of us working beyond 65 if we stopped throwing workers on the scrap heap in middle age and encouraging early retirement.

Finally, the problem would wash away should the economy become far more productive over the next 25 or 30 years. Should output per person grow by 5% a year rather than 2%-2.5%, fewer workers could support a larger number of pensioners. Yet there is little sign of productivity rates increasing at all, let alone at this spectacular rate.

Which brings us to David Willetts and his suggestion that western societies should be looking to defuse the pension time bomb by increasing birth rates. The Conservative party's work and pensions spokesman says fertility rates are linked to the way we organize societies. Italy has extended families headed by a male breadwinner and a high percentage of 18- to 24-year-olds living at home. It also has the lowest fertility rates.

Countries such as Sweden, where far fewer young people live with their parents, tend to have higher fertility rates. Britain's declining fertility rate, Willetts argues*, may have something to do with the fact that rising house prices mean that the average age of the first time buyer is now 32.

France has a higher birth rate than Italy or Germany, and Willetts says it could be the result of the 35-hour week providing a better work-life balance for mothers and fathers and a tax system that provides strong financial incentives to have a third child. The Willetts idea seems to be a 35-hour week to put us in the mood to make babies, government dosh for procreating and full-time childcare outside the home. Well, it beats working.

* Old Europe? Demographic change and pension reform; David Willetts; Centre for Economic Reform