Hamish McRae: Gordon Brown's abusive relationship with pensions won't ruin his own retirement

If there is one good thing to emerge from the challenge to the Chancellor that his tax changes in 1997 have wrecked Britain's funded pension system, it is that the whole debate is now so wide open, we can as a country think a bit more clearly about how our private pension sector should be encouraged (or not) in the future.

There has been a lot of damage done to private sector pensions over the past decade but that is not entirely the fault of Gordon Brown. What matters is not to kick him about the head for a decision he took 10 years ago but rather to think where we go from here.

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A little analysis first. At least six things have gone wrong with our private pension system. One is that the pool of savings available to pay pensions has grown more slowly as a result of that £5bn-a-year "raid" by the Chancellor.That was obvious at the time. I looked back to what I wrote that Budget afternoon - how we had to be aware this decision meant there would be less money for pensions than there would otherwise have been. We did not, however, know by how much. BDO Stoy Hayward calculations suggest the burden has turned out to be much larger than even the professionals appreciated.

The next three things that have gone wrong have been widely acknowledged. There was the collapse of share prices post 2000 - a once-in-a-generation bear market that hit UK pension funds severely because they were more heavily invested in equities than their counterparts elsewhere in the world. There was the fall in long-term interest rates, which helped cut annuity rates. And there was the rise in longevity, which further cut such rates.

Together they were, for pension schemes, the perfect storm. That storm was made even worse - and this is more controversial - by flawed regulation and flawed professional advice.

Flawed regulation included solvency requirements that pushed funds to switch out of equities at the wrong time, further damaging share prices and meaning that they failed to reap the full benefit of the recovery. Flawed advice from the pension consultants compounded this switch, in effect forcing them to make this switch out of equities. Other professions should take some of the blame, too. Actuaries failed to catch the implications of the rise in longevity.

There is, however, a sixth flaw which has been largely ignored , and this is that the structure of company pensions no longer reflects corporate organisation or work patterns. The final salary, or defined benefit, schemes are presented as the Rolls-Royce option. But actually they are absurd in a world where people move between employers on average about every eight years and where their final salary may be a lot lower than their earnings earlier in their careers. And while the pension pot, or defined contribution, schemes are more appropriate, the terms on which they are offered are usually worse than the defined benefit ones. The limits on payments into these mean people cannot hope to get as good a pension as is available to senior employees in the public sector.

Indeed, in a world where an increasing proportion of the workforce is becoming self-employed, the whole idea of the pension being attached to the employer rather than the employee is outdated. We don't often nowadays have company housing; people make their own choices and take their own responsibility for where they live. The same will be so with pensions.

What will happen - indeed is already happening - is the development of a variety of defined contribution schemes - some run by employers, some by specialist providers - where people build up their own pension pot. Depending on the size of the fund and their perceived retirement needs, they can then trade off the decisions of when to retire, how much to divert into the pot while still working, and how big an income they want to have in retirement. The concept is rational, simple and should apply to every income level.

Remember, though, the UK pension industry is still very large. The Watson Wyatt figures in the pie chart above show that we have the third-biggest pension sector in the world. While relative to GDP we are down a bit vis-à-vis the US or the Netherlands, we are in a vastly better position than continental Europe or indeed most of the rest of the developed world. This is not an ideal place from which to start but it is not bad. Most countries would envy us.

Unfortunately, if the concept is clear, the application is a terrible muddle. For lower earners, there is the government-sponsored scheme, which seems a bit of a flop, and I shall try to come back to this issue another time. But if we could fix the pensions of the 50 per cent of the population in some form of company or private scheme then we would have broken the back of the job.

Sadly, the new regulations for private sector pensions now being introduced are of Byzantine complexity. There is the little matter of the £1.5m cap on the size of an individual's pension pot.

That sounds a lot until you consider that Mr Brown's notional pension pot (the size he would need to buy as good a pension as he is entitled to at the moment) is around £2m. If he gets promotion to Prime Minister, the pot will rise to some £4m. The Liberal Democrats have duly asked him to forego the higher pension, which makes a nice political headline. They should have pressed him to change the rules for the rest of us.

As for the complexity, I have just been reading a brief from Prescient, the pension advisers. Let me just give you a taste of the comments as they apply to employer contributions for directors of investment companies. Page BIM 46005 refers to CTM 08340 in the Corporation Tax Manual. CTM 08340 in turn refers to IM 8053 to IM 8057 to IM 8060. But these references refer to a manual that has been withdrawn. Apparently it will be amalgamated with some other manual but no date has been given for when this will be issued. When pressed for clarification, the Revenue replied: "The investment company guidance will broadly follow the BIM guidance and you should be able to get a steer from there".

Gee thanks. If that all sounds a bit nerdy, consider this. When the new rules were brought out, it seemed that people could build up pension pots which, if they died early, could be transferred to their children's pensions. Now that will be taxed. OK, you might think, it would be part of the estate and be taxed at 40 per cent. Er, no. It will be much higher because you pay tax back both on the unused pot as well as the estate.

So what happens next? The pension industry is moving in the right direction but is burdened by huge complexity. This is the fault of the Chancellor. Not only does he behave in an almost abusive way towards the industry, he is treating the private sector workers much worse than the public sector ones, for it cannot be right that he can get a better pension than anyone in the private sector is allowed to save for. But he cannot fix the problem because he has in fair measure caused it. So simplifying pension regulation will have to be done by someone else.

The dismal science gets into our hearts and minds

Anyone who believes economists only concern themselves with neo-classical endogenous growth theory - as in the speech Ed Balls wrote for Gordon Brown when he was still in opposition - should glance down the list of papers being delivered to the Royal Economic Society's annual conference this week. They show how economics can not only explain some aspects of human behaviour but guide policies to make them more effective.

For example, on the NHS, there is a paper by Professor Neil Rickman and others showing how financial incentives and risk management in hospitals can help cut the instance of infections such as MRSA. Meanwhile, Professor Alvin Roth will demonstrate how market systems can help ease the shortages of kidneys for transplant. He will also show how New York and Boston have adopted a new system for parental choice of schools.

Other papers look at more quirky aspects of the way we make our choices. For example, students who are friends tend to pick the same company for their mobile phones. If that is unsurprising, what about the finding that Italian students tend to pick the same operator as their mothers rather than their fathers?

Another example is how women change their behaviour if they think they are likely to get divorced - they increase their hours at work - and when households default on their debts. Apparently, people tend to default not because they genuinely cannot pay but because, weighing up the benefits and penalties, they decide whether it is advantageous to do so.

The range of these papers is extraordinary. Aside from the examples cited above, they look at big issues such as happiness across Europe (despite the stereo-types, Scandinavians are happier than Mediterraneans) and the impact of religion on behaviour. And they look at smaller issues such as how contestants on TV quiz shows make their decisions.

The common theme, though, is how broad the subject of economics has become and how it can help us all understand how the world works. I should disclose that I am on the Royal Economic Society's council, but I do believe that the more it can get this message across, the more likely it is that policy makers will make better decisions... even if it is just how to sell mobile phone services to Italian mothers.