The government's "fundamental review" of pensions, which was to have been completed early this year, is now timetabled for a green paper in the autumn. It has been delayed twice and, along with other aspects of welfare reform, has cost the jobs of two senior ministers. But it was a delusion to think that so complex a review could be done quickly. For a policy whose effects are so long-lasting and affect nearly everyone, speed is not a priority. Getting it right is more important. It is too early to tell whether the government will, but the thoroughness of the review gives cause for optimism.
The sad aspect of the pensions debate, as Daniel Ben-Ami, editor of Investment Adviser, has pointed out, is the way in which a blessing-people living longer, healthier lives-is transformed into a problem. None the less, politicians are understandably worried about care for the elderly poor. State pensions are in permanent decline (the basic pension is projected to be worth only 9 per cent of male average earnings in 2040) and the aged who lack other income have only that basic pension plus pensioners' income support-which is not taken up by one third of those who qualify for it. Pensioners who have had low wages, or a limited past working life, are almost invariably poor. Most such pensioners are women.
The most complex issue, however, is second-tier pensions. The government is committed to introducing "stakeholder pensions," which would collect contributions and invest them in private funds. These would differ in many ways from the "appropriate personal pensions" set up by the Thatcher government, which became blemished by "mis-selling" scandals and high marketing costs. More recent plans suggest that the stakeholder schemes will blend a funded element with a pay-as-you-go (PAYG) element, to reduce risk. This idea depends critically on reducing the costs of funded pensions.
The third big issue is the effect of population ageing on government finances. This is a concern for countries where existing eligibility for state pensions will, in 30-40 years, require either huge increases in taxes, or budget deficits. But it is not a big issue for Britain. According to the Pensions Provision Group the cost of state pensions will fall from 11.7 per cent of total earnings in 2000 to 10.4 per cent in 2040 and 8.9 per cent in 2050. (To the extent that there is a problem of a rising number of non-workers being supported by a dwindling number of workers, it is as much social as demographic: people staying longer in full-time education, retiring earlier and so on.)
Even in Britain, any serious effort to improve the future of the elderly poor will be costly. The guaranteed minimum pension advocated by the Commission on Social Justice, which Labour appointed when out of office, has been costed at ?2 billion a year. A diluted version of this proposal, which would repackage pensioners' income support and ease the means test, is supported by Gordon Brown and is likely to appear in the green paper.
Lack of transparency in the links between pension contributions and pension eligibility has contributed to the fuss about "compulsory pensions" and Tony Blair is said to worry that compulsory contributions would be seen by voters as higher taxation. But in fact, every employed person is already subject to compulsory pension contributions, entitling him or her to a basic state pension and a second-tier pension. The present second tier contains a variety of choices: the state earnings related pension scheme (Serps), an employer-run occupational scheme or a personal pension. (Out of a working population of 25m there are now about 6m in Serps, 10.7m in occupational schemes and 7m with personal pensions.)
A degree of compulsion is justified, to avoid providing an incentive for people to spend now and become a social security burden later. The proposed "stakeholder" scheme is aimed at plugging the gaps in the present system. It will serve people who are not in existing pension schemes and would otherwise join either Serps or a personal pension plan. It will also serve the self-employed, who have no official second tier.
But the stakeholder scheme also threatens to require much higher contribution levels. The present rate for second-tier pensions is buried inside national insurance contributions (NIC), which also cover the basic pension. Those who remain part of Serps pay 4.6 per cent of earnings (the employer pays 3 per cent and employee 1.6 per cent) through NICs, while those in personal or occupational schemes opt out. But fund managers argue that an adequate stakeholder pension scheme will require a contribution rate of at least 10 per cent of earnings over 40 years to provide a pension of 50 per cent of final salary. Such a steep increase would not only be electorally unpopular, it would also increase the cost of employing someone-and push unemployment up.
Risks and costs of funded pensions
Conservative front-benchers, together with the pension fund managers and most of Blair's advisers, favour further privatisation for second-tier pensions to resolve this dilemma. This means phasing out Serps and channelling the contributions into pension funds. This was the "unthinkable" idea which Frank Field was appointed to think last year.
The case for funded pensions rests partly on the high rates of return which pension funds have earned in the past ten to 15 years. In real terms these have averaged nearly 8 per cent, whereas Serps pensions, linked to average earnings, gain about 2 per cent yearly.
But past performance is no guarantee of future performance. Three quarters of the funds' high rate of return consists of capital gains. A decline in real stock market values of 5 per cent each year for two years, followed by no change for the next eight years, would reduce the real annual returns to pension funds over ten years below the growth of earnings, and therefore render Serps better than funded pensions. And that is without allowing for the sales and management costs of personal pensions, which reduce the future pension by anything from 8.5 per cent to 25 per cent.
Field entered office with high hopes that the stakeholder plan could reduce these costs by standardising the schemes, thereby gaining economies of scale. But the fund managers object to standardisation beyond a certain point, and when Field suggested that stakeholder funds should be run only by mutual insurers (which have lower costs than plcs) he brought the full wrath of the City on his head.
There are other ideas which could help keep costs down-distribution through supermarkets, using only passive funds which track the market-but the private sector is still unlikely to get anywhere near the 0.9 per cent (of pensions) that it cost to run state pensions last year.
Besides the costs, there are also risks involved in privatising pensions. The National Association of Pension Funds has pointed out that performance of personal pension funds has varied immensely. Personal pension funds have yielded much more than defined benefit ones (based on the retiree's final salary) or as little as a third, depending on how well the underlying assets have performed. Such variance is not appropriate for people of average income or less, and little wealth.
There is also demographic risk. No minister has mentioned it, but the government actuary, Chris Daykin, alluded to it in February when he said that "funded systems themselves are likely to come under considerable stress as the population ages, so it is wise not to regard them as a panacea for the problems of an ageing population."
Politicians and the media have accepted the myth that, with an ageing population, PAYG pensions impose a heavy burden on working people who have to support more pensioners, whereas funded pensions pay pensioners out of past saving. In fact, extra consumption by pensioners in any generation imposes costs on everyone else in that same period, whether the pensions are funded or PAYG. In the case of PAYG the money comes from tax and in the case of funded pensions it comes from dividends-in both cases it comes from current output.
Strong pension fund performance has been mainly the result of rising share prices. For this, the funds themselves are in large part responsible. Their membership and the flow of contributions grew strongly from the 1950s until recently. The cash influx had to be invested, so the funds bought shares in huge quantities from private shareholders, pushing up prices. Rising share prices resulted in capital gains and stunning pension fund performance worldwide.
An ageing world population will reverse this trend. The chart (see left) shows how the personal pensions set up by the Thatcher government have been building up assets and members, and projects their future profiles of pensioners and transactions in company securities. They will be buyers for several years yet, but in the 2020s they will become sellers.
Occupational pension funds, which have been growing since the 1950s, are already selling company securities (last year they sold ?15 billion worth). Market values are being sustained by foreign investors, personal pension funds and personal equity plans (PEPs).
One way of avoiding the problem of declining equity values is for funds to switch into government bonds, but these are low return investments and would thus require higher contributions. Some economists also argue that pessimism about returns is too parochial and overlooks the possibility that British funds can invest abroad in younger, faster-growing economies. But ageing prospects in the US and Canada are similar to those in Britain, while in Europe and Japan they are even worse. The picture in developing countries is not much better and, as we now see, carries with it extra risk.
Consequently we face a worldwide decline in pension fund returns in the second quarter of the next century. The relevance of this is simple: a future government will have to bail out the Blair administration's stakeholder pensions if these are mostly funded. Unlike the mis-selling episode, the stakeholder pensions, although managed by financial institutions, will be seen as the responsibility of the government.
What should be done?
Every employee and self-employed person should be offered a choice. People able and willing to take risks, fully explained to them, should be able to contract out of Serps into a stakeholder pension. This would be broadly similar to a personal pension, but more closely regulated, with only about 12-15 managers selected on the basis of tenders of their costs. Their funds should contain more bonds and cash the older the member; and more than occupational funds hold. The minimum contribution should be about 7.5 per cent of earnings.
People whose employers have occupational schemes should be able to contract into them. The government intends to make this compulsory for employees of firms with approved schemes. If this is done, a minimum pay-out ratio will have to be reintroduced (it was abolished by the 1995 Pensions Act).
Serps should be enhanced and risk-averse employees and self-employed people should be allowed to join it. The contribution rate should be raised by about 3 percentage points and the pay-out ratio should depend on contributions. Currently, the government decides the pay-out ratio from time to time and its actuary then calculates the contribution rate. This has made Serps vulnerable to changes of government. It would help, too, if Serps were removed from the national insurance fund and given its own set of accounts.
The upper earnings limit would also have to be indexed to earnings, not prices, as it was before 1980. If this is not done, Serps will wither on the vine. If it is done, and the contribution rate is raised, a gradual rise in the Serps pay-out ratio would offset the decline in the basic pension. The changes suggested would entitle a single person with average earnings and a 42-year contribution record to a state pension of about 35 per cent of earnings, slightly higher than the present ratio.
Others may prefer a halfway house-a mixture of PAYG and a funded scheme. The present Serps contribution (4.6 per cent) could be supplemented by one to a stakeholder fund-say 3 per cent. (This was proposed by Field before he resigned, although the details of his plan are not clear.) But unless the stakeholder scheme costs are reduced far below those of personal pensions, a 3 per cent contribution rate would be largely eaten up by the costs.
It is doubtful whether stakeholder charges can be sufficiently reduced. It is even more doubtful that the average contributor would receive a market rate of return if the various social objectives the government favours are built in. Serps is not redistributive-pensions are strictly linked to contributions. Field proposed that the disabled, the low-paid and various kinds of carers be subsidised by the majority of stakeholder contributors. This might appeal to the Treasury, as it would limit the demands for welfare top-ups for the needy from exchequer funds. But it would also undermine public support for the stakeholder scheme. People with average earnings will not want part of their savings diverted to the poor. Although "taxes" and "contributions" are the same, people perceive contributions as payments related directly to their own welfare.
Public support for the future pension scheme is vital, otherwise it will be vulnerable to changes of government. Given the importance of costs, it may also be necessary for a state agency (call it the Pension Agency) to manage the compulsory contributions and pay the resulting pensions. Financial institutions will invest the funded portion, but it is unlikely that they can compete with a state agency in the efficient running of the scheme.
Some of the cost of the stakeholder pensions could be covered by deficit-financing, at least at the height of the demographic imbalance (when the baby-boomers reach retirement). The drawback of public deficit-financing is that it "crowds out" private investment. But with a falling labour force requiring a smaller stock of capital, this may not matter-in any case there will have to be temporary disinvestment by either the private or public sectors.
One fact emerging from the pensions review is that the state is more efficient than the private sector in managing pensions for those with average income or less. This may run counter to the philosophy of New Labour. But election slogans and promises often prove incompatible with the real world. Some such promises can be implemented and later abandoned. Pensions must be built to last.
