October pensions supplement: Paying for longer lives

Just over a century after Britain put in place its first effort to address dire poverty among the elderly, it faces another crisis for the aged.

Repeated reforms through successive governments in the second half of the 20th century were a patchwork of measures which balanced thin payouts to those too old to work against generous incentives encouraging workers to save.

In doing so, it sought a system that both alleviated old age poverty while remaining fiscally sustainable, and in the closing years of the 20th century, it appeared to do both. But in recent years, it has become clear that it did neither.

Britain, of course, is not alone in facing this dilemma; nearly every developed economy, along with many fast-growing countries, faces similar challenges.

At the heart of the matter is what is perhaps man’s greatest achievement of the 20th century: the extension of human life. In Britain, just under half of all people born in 1900 would live to age 50.

Men lucky enough to reach age 65 in 1911 were likely to live another 11 years, and that remained pretty much the case for the next 60 years. By 1971, that had only risen by one year. But in the following 40 years, post-65 male life expectancy rose by a further six years. Between 1971 and 2010, the cost of providing a pension, on average, rose by a third.

And it will not stop there. By 2015, life expectancy for men aged 65 is projected to be nearly 26 years and for women aged 65 it will be more than 28 years.

But it is not just rising longevity that is causing governments, including in Britain, to cut pension benefits.

Fertility rates have fallen so far and so fast that the nation is not producing enough babies to keep the population stable. That means that tomorrow’s workers will have to pay taxes high enough to support many more retirees than they do today.

In 1971, 2.3 per cent of the population were over the age of 65; that has risen to roughly 15 per cent as of 2012. But by 2052, these will be a quarter of the population, and over 11 per cent will be over age 80. To put it another way, while the population overall will rise by 15 per cent, the working age, tax-paying population will rise by only 4 per cent.

Paying for this growing burden of elderly survivors is not a challenge unique to Britain. Like many industrialised countries, the UK plans successive increases in the state pension age.

But even that may not be enough. And as governments seek to curb their pension costs, policy is increasingly placing the onus on individuals to save for their own retirement. That represents a sharp policy reversal for the UK.

For much of the postwar period, Britain’s pension system coupled relatively mean state provision with very generous tax incentives for private savings. According to the Organisation for Economic Cooperation and Development, Britain’s state pensions, as a percentage of average median wages, are among the lowest of any country, but the value of tax incentives, at 0.8 per cent of GDP, are the most generous.

The incentives were particularly generous for employers. These created pension schemes delivering benefits tied to wages and term of service; long-stayers on high pay gained most, but those on lower incomes gained, too.

By the end of the 2013 tax year, tax relief to savers and employers—much in the form of workers’ national insurance contributions—totalled £38bn, or just under 4 per cent of GDP.

This did much to lift the nation’s elderly from poverty; while over half of all retirees were in the bottom quintile of earnings in 1977, by 2010/11, that had fallen to around a quarter.

But that still left too many people dependent solely on the state pension to live in old age poverty. The introduction of means-tested benefits helped at the margin, but has raised the cost to the state. Worse, it acts as a disincentive to the central plank of the emerging UK policy on pensions, to encourage individual savings.

Plans for a new, flat-rate state pension, the scrapping of many means-tested benefits for retirees, along with the end of generous tax incentives to employers, is forecast to reduce the growth rate, proportionally, of what the nation will have to spend on pensions. Without reforms, pension costs would rise to 8.5 per cent of GDP by 2063/64, from 6.9 per cent today. With the reforms, they will rise to 8.1 per cent of GDP.

But the real challenge for policy today is how to make retirement more affordable for everyone. Can people really afford to save more than they already do? How can they make their savings pots large enough to provide a retirement above subsistence level?

Private sector employers have rowed back on their pension provision in droves. While over half offered defined benefit pensions in 1970 and just under half did in 1997, that has fallen to around a quarter and many schemes are closed to new entrants.

The plans embraced by employers—and endorsed by government policy—now entirely shift investment and longevity risk to individuals who are badly placed to manage either of these.

To its credit, the UK has—at least as far as some pension policy is concerned—abandoned the classical view that individuals always act rationally in their own self-interest when making financial choices.

A raft of research finds that even when employers offer to make contributions to workers’ pensions, relatively few actually save. Moreover, when faced with complex investment choices, most people do nothing.

Wisely, the UK has learned some lessons from behavioural finance in shaping recent policy. Since 2012, workers have been automatically enrolled into a savings scheme, overcoming the natural inertia that sets in when people are asked to make complex financial decisions. So far, the program has been a stunning success, with fewer than 10 per cent “opting out” of saving. (See interview, p12.)

But a look backward makes clear the weakness of a system that provides income in old age on the basis of financial decisions made by those at work.

And professionals have been no better than amateurs. As occupational schemes mushroomed in the 1970s, 80s and 90s, trustees piled into equities with one eye on the bull market that began in earnest in 1982. This was a clear example of the  “availability heuristic”, where people unconsciously assume the recent past is a good guide to the future. This caused them to turn a blind eye to the wider historical sweep of the past 200 years. In that context, the decade from 2001 to 2010 was normal.

And following the dotcom crash in 2000, people’s natural loss aversion led them to pile into housing, instead of investments. A system that relies on individuals’ investment choices to free them from poverty in old age has serious shortcomings.

Meanwhile, the cornerstone of UK pensions policy since the 1920s was that tax-advantaged savings could not be splurged. Retirees had to buy an income stream.

In his March Budget, Chancellor George Osborne dropped a bombshell on the pensions industry. No longer would those with even very small pension pots be required by age 75 to buy an annuity delivering a set income for as long as they lived. Instead, they could take their entire savings and spend or invest it as they saw fit.

And while this prompted wild cheering from those who had long believed the insurance industry gouged retirees—sales practices were long under review by regulators—more sober voices have expressed concern.

First, repeated surveys have shown that most people substantially underestimate how long they will live in retirement. And even the proposed “guidance” at retirement which everyone is supposed to receive is likely to leave that question unaddressed. That is because telling people their “average” life expectancy does not address the odds of living longer. Today, a 65-year-old man on average will live to 86, but there is a one in five chance he will live to over 90.

Second, there is little evidence that the “gut” choices that individuals make about investment will be any better than those in the past.

For example, conventional wisdom is that bonds should be shunned because yields are “abnormally” low. But how much higher they can go remains to be seen, particularly in an environment where inflation is as low as it is now. UK 10-year gilts are now yielding under 2.5 per cent—up from under 2 per cent a year earlier—but those arguing that rates today are “abnormally” low do not have history on their side. Looking at data from the Bank of England going back 300 years suggests that the period of the 1970s through to the 1990s was aberrant. Yields in low single digits are more the norm.

And third, while much emphasis has been placed on choice, little has been said about the regulation of products sold to those as retirement vehicles. There is no certainty that alternatives will deliver better outcomes for retirees than annuities.

Moreover, there is ample evidence that the single greatest factor affecting the size of a pot at retirement is the fees levied on it during the savings period. So far, government has made only half-hearted efforts to control these.

In addition, pension experts, including those at the OECD, are questioning the wisdom of not annuitising at least a portion of income.

In short, there can be little certainty about the ability of investment returns to deliver a retirement pot that is capable of ensuring an adequate standard of living over a working lifetime.

Instead, the solution to what looks like a pensions crisis may be to simply re-think what is meant by retirement. Mass retirement itself is only a late-20th century phenomenon. Before then, most died shortly after they could no longer work, and those who did survive were most likely to be wealthy.

Working more at older ages is not simply required to sustain pension systems; workforce participation rates need to rise just to maintain GDP growth if fewer young, new workers are added to the population.

And finally, the opportunity cost to women of choosing to have babies must be reduced. This can be done through measures requiring employers to allow longer maternity leave without loss of job or status and through the greater availablility of flexible and affordable childcare. Policies of this sort might bring Britain’s fertility rate closer to that which ensures a stable work force. More people at work means that the burden of providing pensions falls upon more shoulders.

But even the introduction of a more coherent system of saving for old age and a rise in state pension age—solutions to the pensions crisis that Britain and other industrialised have embraced—do not get to the heart of what ails us now.

Britain is no better placed to cope with the unprecedented rate of population change in the form of longer lives and falling births than any other rich country.

With a shrinking pool of working age people, Britain would be challenged to maintain GDP growth even without its pension burden. Output, after all, is the sum of goods and services produced. Barring some surge in output per worker, a shrinking workforce by definition implies slowing GDP growth.

One solution might be to do more with what we have.

There is considerable scope to raise the percentage of people at work at older ages, a trend which is already underway. Between the 2001 census and that in 2011, the percentage of those at work aged 65 to 75 roughly doubled to 16 per cent.

When “young” older folks are counted, those aged between 65 and 69, over a fifth of British men are at work. This is far better than in France where only 6 per cent are working, but far worse than the US or Japan where the percentages at work are 35 and 49 per cent respectively.

The question is whether Britain’s labour markets are sufficiently flexible to accommodate an influx of labour from those traditionally considered too old to work and whether more needs to be done to ensure that people remain on the job longer.

But more troubling is the picture presented by those in the decade before retirement where long-term unemployment rates are highest. The percentage of working Britons aged 55 to 64 has risen to 58 per cent from 50 per cent, but that has been lopsided. While women are increasingly likely to be at work at those ages, the economic activity rate for men is stagnant.

In particular, Britain needs to do more to cut the opportunity costs that reduce female workforce participation, particularly those associated with the bearing and raising of children. Increasingly, these are likely to be workers with the highest productivity, if for no other reason that they have been completing tertiary education at higher rates than men since the late 1990s.

The rising numbers of highly educated women has coincided with rising rates of women at work. By the end of 2013, the number of economically inactive women in the UK aged 16 to 64 had fallen to 28 per cent. By comparison, in 2000 the number was 30 per cent and in 1973 it was 40 per cent.

But to put that rising workforce participation into perspective, it has also coincided with the falling fertility rates that are giving rise to the population imbalance.

If more women could be persuaded to have several children, increasing longevity could be met with a increase in the retirement age and workforces would remain broadly stable.

The opportunity cost of childbearing shows up in OECD data on part-time employment. Indeed, among the world’s wealthy nations, the UK has one of the highest rates of female part-time employment, a condition reflecting both the limited opportunities for affordable childcare and workplace rules that do not support working mothers.

Finally, that leaves reliance on immigration to fill the ranks of workers, a solution which for all the public opprobrium it attracts, has been remarkably successful over the past decade.

Some 2.1m foreign migrants, overwhelmingly of younger working age, came to the UK between 2001 and 2011. While the UK’s population grew by 7 per cent over that time, the percentage of those aged 30 to 34 fell by 5 per cent and those aged 35 to 39 fell by nearly 15 per cent. Those aged 85 and over rose by a quarter.

And UK employment data show that migrants are even more likely to be at work than native born Britons.

Britain faces an uphill struggle to finance a viable system to support its growing army of elderly people. Undoubtedly, higher rates of individual savings and longer working lives must be part of that solution. But in crafting a sustainable solution, policymakers must take account of profound population changes that require efforts to boost its workforce.

Without these, the nation risks not only spreading old age poverty, but a stagnant economy as well.