Simplifying the complicated

Following the publication of the first report of the Independent Pensions Commission in October 2004, HARVEY COLE examines the core issues in addressing the future pension provision conundrum.

Pensions: Can the new 'Red' Adair douse the flames?

Without denying Adair Turner any of the deserved credit for producing a clear and comprehensive analysis of the problems facing effective future provision of pensions, it should be pointed out that there are only a few basic principles to be considered. He duly put his finger on these, perhaps most importantly to stress that none of them will be able to do the required trick individually.

To pay out more in pensions, and to target the money more effectively, you have to ensure some combination of people spending less on current consumption during their working lives, levy higher taxes (whether or not these are disguised as national insurance contributions), persuade them to retire later, or to save more during their working life. There can be no disagreement there. Deftly, Turner sidestepped making his own recommendations, which will be deferred until after the election of the next government. But, the devil will as usual be in the detail, and acrimony can be expected when the debate is engaged on how these ingredients can be combined to produce a palatable recipe.

The fall and rise of the state pension

Nevertheless, some things are already becoming clear. The previous conventional wisdom by which a basic pension would be provided by the state, to be supplemented by private arrangements, has been discarded. Not merely is it now realised that linking the basic pension to inflation rather than earnings must erode the relative incomes of those relying on it as the economy expands, but the last 20 years or so have already seen the basic pension fall from over a quarter of average earnings to no more than 16 per cent – in spite of rising by 40 per cent in real terms.

Instead of an objective of a split of retirement income between public and private provision of 40/60, there is emerging agreement that the proportions will need to be reversed. Indeed, recognition of the case for a much-increased basic state pension is almost universal.

This is not just a case of the failure of private schemes to deliver the expected returns following a poor period for stockmarkets. Even with better investment performance, the returns from individual schemes must be something of a lottery. People cannot be expected to be skilled at picking out the best providers of their future incomes, and even the best advice will not necessarily improve their prospects. After all, the overall performance of all fund managers is, by definition, bound to be average. While there is a role for people taking some decisions (and the responsibility for them), it is not acceptable for too high a proportion of their living standards in retirement to depend on having picked the 'right' investment vehicle many years in advance.

This points to the future state pension accounting for at least three-quarters of an average retirement income, providing an elevated floor which individuals can choose to try and supplement by their own savings. And, that basic payment should be at least partially linked to growth in the economy. When the press is pursuing some 'fat cat' who has performed poorly in running a large company, they are fond of referring scornfully to his perks as including an 'index-linked pension'. Far from being a lavish entitlement, this is just the same in principle as the rise of 75p a week in the basic state pension that the government offers when inflation is running at a mere one per cent – to the derision of the same press.

Simplifying the complicated

A much larger basic pension, available to all, would also make administration of the system easier and less costly. Gordon Brown has attempted to concentrate additional assistance to the retired on those with total incomes below certain thresholds. This is an admirable aspiration, but breaks down into over-complexity in practice. It involves widespread means-testing, with the inevitable consequence that withdrawals of the supplementary payment as income rises constitutes a marginal rate of tax that can reach well over 60 per cent. There is also an increasingly acknowledged problem of identifying beneficiaries in the first place and ensuring that they put in applications. Finally, and fatally, incentives to saving are damaged if it is clear that a certain level of income is guaranteed in any event.

It would be much simpler to pay the basic pension universally, but to tax it on a sliding scale related to total pensioner income. Marginal rates could then rise to over the current top rate of 40 per cent on the largest incomes. Cynics might wonder if, given recent fiascos with large computerised systems, this could be made to work in practice, but it would be defeatist to regard this as a decisive objection, particularly in view of the other benefits that would flow from it.

More tax relief

To the extent that private provision should be encouraged, the incentives need to be reconsidered. The objective is to secure that some consumption is deferred; there must therefore be an alluring prospect on offer. At the moment, approximately 15 million people make contributions to private pension schemes, almost all of them through schemes run by their employers. Between them they receive £13bn in tax relief. But, over half of this is claimed by the 2.5 million who are liable to a higher (40 per cent) rate of income tax. Those lower down the scale should be offered larger tax credits – perhaps 30 per cent rather than 22 per cent – and it is probable that the higher paid individuals would also find that rate a sufficient incentive to maintain their own contributions.

A further advantage of a much improved basic state pension would be to create at least partially offsetting reductions in public expenditure on a wide range of other benefits and their administration. It could also eliminate the need to introduce compulsory savings (taxation under another name) to boost the payments made into private schemes.

How old will the population be?

By 2050, the projected population will be about 65 million – a rise of five million. However, immigration will account for approximately three million. The age structure of immigrants does not appear to have been fully taken into account in deriving estimates of the numbers drawing pensions in 2050. To the extent that they are younger than the existing population, the future 'dependency ratio' could be more favourable than recent calculations have suggested.

Insure the deficits?

Private pension schemes are nearly all in technical deficit, partly as a result of poor investment performance, and partly because of actuarial factors. But, in many cases, the threat is theoretical rather than real. This is because the relevant accounting standard (known as FRS 17), in effect, requires them to show their position if all existing liabilities crystallised immediately. That means that they would have to pay out all pensions accumulated by their employees. Such an event would occur only if the company went bankrupt (or possibly following a takeover that excluded full payment to cover any shortfall in the pension fund).

With many large companies now having pension funds with a greater value than their stock market capitalisation, this can be alarming. But, it surely ought to be possible for companies to ensure annually against the risk of bankruptcy for a relatively small premium related to their individual financial situation? That would be preferable to the present system by which the government charges a levy on all firms, effectively making the more solid companies assume part of the risk posed by the more risky.

The 'deadweight' problem

Whatever the solutions eventually arrived at, there should not be any fears about the long-term affordability of any schemes offering carefully calculated improved benefits. We are continually warned that by mid-century, the retired sector will absorb 17.5 per cent of GDP against just under ten per cent now – and perhaps a bit more if the real level of benefits is improved. But even a poor performance of the economy, growing by an average of no more than 1.5 per cent a year, would see GDP double and provide resources for a substantial increase in living standards for the non-retired sections of the population.

Of more concern is the extraordinary failure of the actuarial profession to 'cotton on' to the rapid and obvious improvement in longevity. This has resulted in a serious under-allowance when looking at the viability of most private schemes. The implied overstatement of the death risk among those aged over 60 has been as much as 225 per cent, even though actuarial advisers to life-assurance companies seem to have picked up on this.

The real problem facing any rapid improvement to pensions is the 'deadweight effect'. It will be difficult and costly to the present generation of contributors, who face the burden of payment for their own improved benefits as well as partly funding future levels for the longer run.

While some transfer of purchasing power to those already retired will form part of any reformed system, benefits to the current generation of contributors will have to be phased in gradually.

Ahead of the politicians putting their conflicting oars in, sorting out the pension conundrum looks feasible and not too painful. The ideal situation would be for everyone to start paying contributions from birth, but that is another story for another time.

Harvey Cole, ECA's economic and development consultant, can be contacted by telephone: 01962 865930 or via the editor.