Stephen King: No more free lunches for tomorrow's pensioners

We are simply open to the waxing and waning of asset performance from one generation to the next
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The Independent Online

Pensions aren't the most exciting things in the world. But when the pension fund industry starts to throw its collective arms up in the air and surrenders all sorts of potential new business, you know that something odd is going on. Fearful of another round of "mis-selling" accusations, the industry has veered away from making promises that it may not be able to keep. It's basically saying that millions of people, looking forward to a rewarding retirement, are going to find themselves in a bit of a mess. The likely returns on assets over the medium term are simply not going to be high enough to allow people to spend today and spend in their dotage. And, to underscore the argument – much to the Government's irritation – the industry wants to encourage people to go back into State Earnings Related Pension Schemes (Serps).

All this sits oddly with the persistent claims made by the UK Government and others that, unlike our European neighbours, there is no pension funding crisis, either imminently or over the next few decades. These claims are based on two key assumptions. First, occupational pension schemes in the UK are huge relative to those elsewhere in Europe. Second, because of this, the public sector pension burden will remain a lot smaller for the UK than for other countries across the European Union.

To back up this view, the first table shows numbers produced by the European Commission on the long-term outlook for public pension expenditure as a share of overall GDP for a number of key European countries. For some countries, the increase in the public sector burden is substantial. In Germany, for example, it amounts to more than 4 per cent of GDP. For the UK, however, there is no increase. With private sector pension fund assets already very high, the assumption is that the increased burden associated with an ageing population will be met by the stock of assets already in existence, the marginal contributions to that stock over the medium term and the success with which our pension fund managers extract decent returns to meet likely future liabilities.

The second table provides a consistency check. The table shows old age dependency ratios for countries in Europe. Admittedly, the increases for some countries are quite a lot larger than for the UK. Nevertheless, the UK's population is still ageing rapidly. So, if it's true that there is no pension problem for the UK, it must be the case that the UK has simply been wise enough – or lucky enough – to have accumulated lots of assets over the past few decades. Indeed, this is borne out in figures published in the latest edition of the OECD's Economic Outlook. These show that financial wealth for UK households amounted to 455 per cent of household income in 2000, compared with 360 per cent for France and 280 per cent for Germany. Of course, these figures include a lot of things other than pensions but, nevertheless, they seem to suggest that the UK is, indeed, in a better position than other countries.

Despite this good news, however, the UK is not off the hook. Part of the problem relates to the performance of equities over the past few years. UK pension funds have typically had an average of 75 per cent of their funds under management invested in equities and, for the most part, this has meant substantially higher capital gains for UK pension funds than for funds elsewhere in Europe, where a more cautious investment strategy has been adopted. That's fine, of course, so long as equities offer better returns than other asset classes. However, with equities having recorded pitiful returns over the past few years, assets have simply not risen in line with longer-term assumptions.

Unless equities now rebound incredibly quickly, the implication must be a lower level of pension provision for the future or, alternatively, a requirement for future pensioners to put more of their income away today. In simple terms, the free lunch may be over: no longer is it the case that we can spend with abandon and know that modest pension contributions today will deliver enormous future benefits through capital gains alone.

Yet it is precisely this assumption that has dominated Government thinking on pensions over the past few years. The incentive for the Government is obvious. By passing the burden of adjustment on to the private sector – or, at the very least, claiming that the private sector is well-adjusted to deal with pension provision – it puts the Government's own finances in good shape. It suggests that there will be no nasty shock over the next few decades in the form of higher government borrowing or painful rates of taxation on a shrinking working population.

The danger with this view is rather similar to the dangers associated with the crackdown on public sector capital spending seen during the 1980s. Back then, the government's main objectives were to deliver tax cuts and to reduce government borrowing. For a while, the policy succeeded but only by reducing public sector capital spending. By doing so, the government was funding tax cuts at the expense of depreciating public sector assets. For voters at the time, this wasn't a significant burden. Today, however, the costs are coming through more clearly in terms of our railways, health and education. As a result, the lower tax burden of the 1980s and 1990s is in danger of becoming a significantly higher tax burden as today's Government attempts to make up for lost time.

The problem with pensions is not so much an issue about depreciating public assets but, rather, a lack of appreciating private sector assets. It might look as though the Government has a strong and stable fiscal position over the medium term but sticking to this position may eventually imply a much lower level of income for pensioners in 30 or 40 years' time. Europe's problem is one of public sector pension promise that may only be achieved through higher tax or more borrowing. Britain's problem is a lack of public sector backup for a private sector that may be unable to deliver a decent income for pensioners in the future.

Oddly enough, Britain's pension problems may reflect a lack of recognition of some of the theories and predictions of James Tobin, the great Nobel Laureate who died on 11 March. One of Tobin's insights could be summarised in straightforward terms: "Don't put all your eggs in one basket". The high weighting of UK pension funds in equities has served to reward many lucky people over the past few decades but, every now and then, high weightings towards risky assets are likely to backfire. There is no guarantee that returns will ever be high enough to fund plentiful consumption both today and tomorrow – as the Japanese have found to their cost over the past 10 years. Ultimately, the only safeguard of a decent pension is a high level of savings from current income. Without that, you are simply open to the waxing and waning of asset performance from one generation to the next.

Stephen King is managing director of economics at HSBC.

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