If state schemes are not to create huge fiscal deficits then benefit levels must fall or contributions from workers (labour taxes) must rise or statutory retirement ages must be increased. The UK has, implicitly, chosen the first option; by having basic state pensions rise in line with prices the ratio of benefits to average earnings falls gradually over time. This decline will be fast enough to offset the impact of an ageing population and allow contribution rates to be fairly flat. Of course, the implication is that those people who rely exclusively upon a basic state pension will, over time, suffer an increasingly large drop in their resources as they move from work to retirement.
So what is to be done? Forcing people to save is an option, and one the UK government may ultimately introduce. If rates of return on saving are high, the magic of compound interest over long horizons can help generate high retirement resources with quite modest saving rates. Take someone who starts work at 20, retires at 60 and lives for a further 20 years. Suppose their real income grows at 2.5 per cent a year while in work. With a real rate of return on assets of 6 per cent a pension worth 60 per cent of final salary that then kept pace with typical wage rises could be generated by saving about 10 per cent of income for every year of work.
But if the working life is incomplete, or the return on saving lower, things look worse. If assets only yielded 4 per cent - still a good bit more than can now be earned on safe investments like government inflation- proof bonds - the saving rate would need to be about 20 per cent. That is very much higher than the average household saving rate in the UK. And it is dramatically higher than the average (over the working life) saving rate of a high proportion of the population who hold few financial assets at any point in their life.
Rather than expect, or force, people to save much more in their working lives it may be more desirable for people to work to greater age. It is increased life expectancy that is the main factor behind the projected fall in the support ratio. With unchanged retirement, greater life expectancy either requires greater contributions from income during work or lower consumption in (a longer) period of retirement. But to let all the adjustment from greater life expectancy come through lower consumption, with no extension in the typical working life, is strange. Market mechanisms might naturally make the option of working longer more attractive. As the population ages one can expect wages for increasingly scarce workers to rise. At the same time the incentive to work longer is clear enough for those who have saved little in earlier life and now face the prospect of living for 20 years on a state pension worth only a small fraction of typical wages.
There are two powerful reasons why an extension in the typical working life, brought about by a rise in the age at which peoplestop work, is appropriate. First, people are healthier and stronger for longer than in the past while most work is much less physically demanding. Even manual jobs (gardening, making cars) have been revolutionised by machines capable of a wide range of tasks.
Second, the proportion of people's lives that are spent working has fallen to very low levels. Consider the lives of typical males born in the UK 150 years ago, 50 years ago and today. An average boy born in 1847 would have started work before becoming a teenager (and quite probably long before). He would have had a life expectancy of just over 40 years and would probably have worked for close to 60 hours a week for all but one or two weeks of the year. Assuming eight hours a day spent sleeping, this would imply that about 40 per cent of his waking life would have been spent at work. A boy born 100 years later, in 1947, could expect to live for 64 years (just under statutory retirement age). Typical hours of work are down to about 50 while the typical age at which works begins is probably up to around 17. Now, a bit above 30 per cent of the total waking life is spent at work.
What about a boy born today? If there were to be no change to the current retirement pattern, he would not expect to work beyond 60 (and would be highly likely to stop work before that). Work also begins later - with a much higher proportion of young people going on to higher education work might typically begin at 20 for a boy born in 1997. Life expectancy is now about 75 while typical working years might have 46 weeks, in each of which there is unlikely to be more than 40 hours. What these figures imply is that the proportion of waking life spent at work, at current average retirement ages, would only be about 16 per cent. So a boy born today might only spend about half as much of his waking life at work as someone born at the end of the Second World War.
An increase in the age which people stop work of five years would take the proportion from 16 to 18 per cent - hardly a massive erosion of one's lifetime allocation of leisure but enough to sharply reduce the proportion of income that might need to be saved to fund retirement consumption.
Suppose the working life is from 20 to 60 and 20 years are spent in retirement. If the rate of return on savings is 5 per cent in real terms and wages grow 2.5 per cent a year it takes a saving rate of a bit under 15 per cent to generate a fund that can finance consumption in retirement that starts at 60 per cent retirement income and rises in line with the incomes of those in work. If the work life is extended by five years that saving rate falls to under 10 per cent.
For the proletariat of Victorian Britain, work was nasty, brutish and long; life was nasty, brutish and short. One hundred and fifty years of almost uninterrupted economic growth has transformed this. Life is less nasty and considerably longer; work is very much less unpleasant and there is a lot less of it. An increase in the age at which people typically stop working is the most natural and painless way of reacting to the implications of an ageing society.
David Miles is Professor of Finance at Imperial College and an economic adviser to Merrill Lynch.
Typical working lives
Date of Life expectancy Age start Retire Working Hours in Proportion of
birth (male, at birth) work at age weeks in a week waking life
year spent working
1847 41 11 * 51 60 40%
1947 64 17 * 48 50 31%
1997 74 20 60 46 37 16%
* Retirement age greater than life expectancy