No discussion of pensions is complete without reference to the "ageing problem." But this description is a new manifestation of pension misselling: people are living longer, healthier lives, something we should be celebrating. Indeed, one of the best features of the Turner commission's November report on pensions is that it considers longevity not as a problem, but as part of the solution.
High birthrates in many developed countries in the 1950s and 1960s were not maintained in subsequent decades. Thus the number of older people is rising, and from 2020 the number of pensioners will rise, both absolutely and relative to the workforce. This trend has been known for 25 years. Few countries, however, have taken significant action. Faced with larger numbers of pensioners, most have adopted one of two strategies. The first is largely to ignore the problem, allowing pension spending to rise broadly in line with the number of pensioners, as in several western European countries. This approach creates fiscal problems now, with worse to follow. The second is to reduce the average pension. This approach—Britain's in the decade to 1997—avoids fiscal problems but at the risk of creating pensioner poverty.
There is a third strategy: to reduce the number of pensioners by increasing pensionable age—but this has been a no-go area in most countries as the political pain is immediate and the benefits for future pensioners and the budget come later. Among OECD countries, only Norway, Iceland and the US have taken steps to raise pensionable age above 65.
Britain's problem has not been high pension spending, but a low average pension. State pensions are among the most parsimonious in the OECD for people on average earnings. Yet British demographics are not as bad as most other developed countries: the ratio of contributors to pensioners is set to halve to about 2:1 by 2050; in some countries, if nothing is done, the ratio will be closer to 1:1.
Why, then, do we need a pension commission? It is necessary, first, because of problems with the state pension. In the 1980s, the Conservative government cut the link between the basic state pension and earnings, tieing it instead to prices. This reduced pension spending, but imposed the cost of demographic change on pensioners, who fell increasingly behind overall living standards. Labour came to power in 1997 pledging to reduce pensioner poverty and to keep to strict spending limits, so it introduced a means-tested top-up for the basic pension. That arrangement did an excellent job, lifting nearly 2m pensioners out of poverty. But it does not work in the longer term, as explained below.
It was thought that low public pensions would be offset by Britain's well-developed system of private pensions. But these have declined sharply in value—for short-term reasons like poor stock-market performance, as well as long-term trends, notably the fact that flexible labour markets have reduced employers' incentives to run generous pension schemes.
The commission was established to set out a strategy that offered security in old age for the rising number of pensioners while also respecting constraints on public spending. Its first report, published in 2004, offered diagnoses; its second makes recommendations.
The Turner commission's strategy
The commission correctly argues that there are four, and only four policies that can address pension finance: accept pensioner poverty, increase public spending, lengthen working life, and/or increase saving.
Its recommendations are based on two assumptions: that the first policy is unacceptable; and that none of the other three on its own is a complete solution. Its strategic answer is therefore that policy should combine all three. The broad recommendations are: higher state pensions with less means testing; some increase in public spending; a higher effective retirement age; higher savings through simple, cheaply administered savings arrangements; and better public education about pensions to assist the politics of reform.
Higher state pensions. Since 1997 the government has kept down costs by providing a low basic pension (now £82 a week for a single person) with additional means-tested top-ups tied to earnings, bringing the total to about £110. As noted, this approach has been effective in reducing the number of poor pensioners. Even in the short run, however, there are disadvantages to means testing, including incomplete coverage, high administrative costs and stigma. In the long term this approach hinders the drive to encourage older people to continue working, since a pensioner is less likely to work part-time if extra earnings are offset by a reduced pension. Means testing also discourages saving (on current trends, by 2050 nearly three quarters of pensioners will face a means test). The complexity of the state system is a further impediment to saving.
The commission therefore argues that the link between the basic pension and wages should be restored, so that anyone with a fairly full record of contributions (or of credits for caring activities) will get a pension without means testing at broadly the level of today's pension plus the top-up, about £110 per week. The commission advocates paying the basic pension (£82) on the basis of residence, thus helping those—especially women—with an incomplete contributions record, the remaining pension being based on contributions.
Separately, the commission recommends that people should be able to take part of their pension while continuing to work part-time (as in Sweden). On full retirement, people would claim the rest of the pension, which would be larger because it had been deferred.
This approach—a flat-rate pension above the poverty line—echoes the 1942 Beveridge report. It would protect old people from poverty; it would also encourage them to continue working and saving. It is, however, costly. The commission suggests two ways of meeting the cost: increasing public spending, thus imposing some of the cost on taxpayers; and raising the state pensionable age, thus reducing the number of pensioners and imposing some of the cost on the older generation.
Higher public spending. Given its parsimonious pension spending, Britain has some fiscal leeway. It is against that background that the commission's proposals, an increase in public spending on pensions from 6.2 per cent of GDP currently to between 7.5 and 8 per cent in 2050, should be judged.
The expenditure projections in the report have provoked controversy, its root being the question of what would happen to public pension spending between now and 2020 if nothing were done. The commission has factored into its calculations the saving from phasing in an increase in women's retirement age to 65 between 2010 and 2020, and assumes that the current policy of indexing the means-tested top-up to earnings remains in force. On those assumptions, its preferred option sees public spending increase only slightly. In contrast, the treasury baseline for public spending appropriates all the gains from women's later retirement for non-pension uses and assumes that from 2008 the means-tested top-up is indexed only to prices. On that assumption pension spending will fall between now and 2020. This is politically unsustainable.
Later retirement. This helps to contain spending, making higher monthly pensions possible. It also provides government with additional options for addressing uncertainty about future fertility rates and life expectancy. But because of the political difficulties, most countries have ducked the issue.
Pensions cost more now than in 1948 because a) the real pension is 2.6 times higher, b) retirement lasts for longer because of increased life expectancy and c) there are more pensioners relative to workers, because of declining fertility. On its own, element a) requires no change in contribution rates since earnings have risen by more than pensions, and b) could be accommodated without increasing contributions by raising pensionable age. The policy problem is that a) and b) are combined with c), so that maintaining a given real pension requires an increase in contribution rates or a larger than proportional increase in working life, or a mix of the two.
The fact that extending working life is only part of the solution strengthens the argument for it. The data in the bar chart (right) tell a compelling story about the change in people's life courses. A man who retired in 1950 had typically left school at 14; the average retirement age was 67; and if a man reached the age of 67 (significantly less likely then than today) his remaining life expectancy was 10.8 years. Thus a typical pensioner had contributed for 53 years to get ten years of retirement, about five years of contribution for each year of retirement. A man retiring in 2004, in contrast, left school at 16 and retired on average at 64, with a future life expectancy of 20 years. Thus a typical man contributed for 48 years for 20 years of retirement, slightly below 2.5 years of contributions for each retired year. Raising the retirement age does not have to mean shorter retirement. On current projections, a man who retires at 68 in 2050 will still have two more years of retirement than today.
Rightly, the commission explicitly rejects sudden change, its central projections assuming that state pensionable age rises to 66 in 2030, 67 in 2040 and 68 in 2050. Thus today's over-50s face no change, and someone in their 40s faces no more than an extra year of work.
As well as being raised, retirement age should also be variable, as a response to uncertainty. When life expectancy is static or easily predictable, variations in age-at-death are risks insurance can address. Increasingly, however, longevity has become harder to predict. If people live longer than expected, pensions become more expensive than expected.
To address this uncertainty, the commission proposes that in the long run, pensionable age should be related to life expectancy, thus insulating the finance of pensions from longevity. Pension finance would adapt automatically to the new circumstances, without surprises for workers near retirement, and without compromising living standards in old age.
Later retirement should be supported by flexible choice between work and retirement. It is bad economic policy and bad social policy to force people to step over a cliff when they retire—to move from full-time work to zero work. Thus the proposed system offers choices between continued full-time work, complete retirement, or partial retirement, combining part-time work with partial pension.
A final issue here is the distributional effect of later retirement. Poorer people start work earlier and have lower life expectancy, they thus contribute longer than richer people and enjoy fewer years of retirement. This cannot be grounds for keeping the current retirement age for ever, but it requires careful design of other instruments to assist older workers: occupational health, more training for older workers, benefits connected with disability, and flexibility over retirement options.
Longer healthy life is arguably the greatest achievement of the 20th century. The trouble is not that people are living longer but that they retire too early. If we were designing a pension system for a new planet where people lived longer and longer, we would not choose a retirement age fixed at 65. Instead, workers should retire later, but each person should have more choice over the move from full-time work to retirement, on a pension higher than today. Retirement would be longer, notwithstanding later retirement.
Higher savings. The final element in the pension commission's strategy is increased saving, and minimising current impediments. One of these is poor consumer information: survey evidence suggests that over 50 per cent of Americans do not know the difference between a bond and an equity. Another impediment is high administrative costs: under plausible assumptions, an annual administrative charge of 1 per cent of an individual's pension pot reduces his accumulation at retirement by 20 per cent. Stock-market turbulence can create a further obstacle to saving.
To address these problems, the commission advocates a national pensions saving scheme, designed to be easy to understand, simple and cheap to administer and safe, so that people trust it over the long term. Each worker would have an individual savings account. The system would operate on the basis of auto-enrolment: workers would automatically be signed up for the scheme by their employer, and would have to choose to opt out.
Contributions would be 4 per cent of relevant earnings by the worker, plus 1 per cent from tax relief and 3 per cent from the employer, with additional voluntary contributions possible. Administration would be streamlined, with contributions probably collected alongside income tax; the government would negotiate with a small number of managers, who would manage the funds on a wholesale basis. The result would be low administrative cost—the report talks of 0.3 per cent of a worker's accumulation, much lower than the rates currently charged on individual accounts.
Annuities are a separate part of the jigsaw. The report has less to say on this topic but, importantly, does include the idea that the national pensions savings scheme should have reserve powers to negotiate annuity purchases for specific groups.
Improved public education. The costs of having more older people and fewer younger workers must fall somewhere: on workers through higher contributions; on pensioners through reduced pensions or a reduced period of retirement; or on workers and pensioners through higher general taxation. Thus educating people about the realities matters. Such education should make three points. People today live longer, and the extra is mostly healthy life. As a birthday card puts it, "Birthdays are good for you. Statistics prove that the people who have the most will live the longest." Second, working lives are shorter. Third, retirement is mostly longer. It is a mistake to let public discussion focus exclusively on pensionable age, since this concentrates on costs (later retirement) while ignoring benefits (longer life). People will live longer than previous generations and will work for fewer years, be retired for longer, and have higher pensions.
Conclusion
There is much in the details of the report which can legitimately be debated. The commission rightly invites public discussion, and both the first and second reports have set a measured tone for doing so, a tone that has been well reflected by the coverage in the serious press around publication date—a welcome contrast with the strident and ideological tone of much of the US debate on pension reform.
The great strength of the report is that it focuses on the right objective—sustainable security in old age—and recommends a series of mutually reinforcing policies that provide a strategy for achieving it.
