Slowly but surely, the crisis in state pensions is coming

The number of pensioners in all developed countries is growing while in many the population paying taxes to provide the pensions is shrinking
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The Independent Online
One of the reasons politicians in the industrial countries are starting to sound very gung-ho about reducing government deficits is that the notion of a looming crisis in state pensions has finally filtered through to them.

It has taken several years of hammering away at the subject by international organisations such as the IMF, but at last, in countries such as Germany and Italy, even the most short-termist of politicians knows that without changes in pension provision, politically thorny as that is, there could be a fiscal explosion before the end of their career.

The cause of the pension problem, approaching many governments with the slow inevitability of lava flow, is the combination of pay-as-you-go state pension schemes with demographic change. The number of pensioners in all developed countries is growing while in many, the working-age population paying the taxes to pay the pensions is shrinking.

The penny has dropped that pay-as-you-go schemes are unsustainable. The British government was one of the first to take action by encouraging people to opt out of a state scheme, which was made much less generous by being linked to prices rather than earnings, and set up a private pension.

If other countries follow the same route, and allow their unfunded state pension schemes to wither, there will be some big macroeconomic implications. One of the most important, and one which has been tackled by economists, is what will happen to national saving rates as a result of ageing populations and changes to pension systems. The other, so far under-researched, is what the implications for inequality will be.

Of course, the first law of economics is that for every economist there is an equal and opposite economist (the second law is that they are both wrong). So it is not too surprising to find that there is no definitive answer to the question of savings. To be fair, this is because it is an empirical question. There will be two opposing forces acting on national savings during the next few decades.

The first is the demographic impact. The standard theory about how people choose between spending and saving is the "life cycle hypothesis", which argues that early in their working life people borrow, in their prime years they save, and in retirement they run down their savings.

Aggregate this across a nation, and the theory predicts that saving will rise in countries with a growing working population and fall where there is a growing number of the non-working elderly. There is some evidence of a negative relationship between savings and the proportion of the old in the population for a cross-section of countries.

However, the demographics are a bit more complex. For the next 20 years or so, most industrial countries will see more saving by the working population, for the baby boom is still in its prime years. After that, national savings rates are likely to decline. But the outlook varies widely between countries and the amount of extra saving in the meantime could be huge.

A recent paper by David Miles, a professor at Imperial College, for the City investment bank Merrill Lynch, calculates that for the big four European economies savings rates will peak between 2010 and 2020 at rates 2-3 percentage points higher than their current levels.

For the UK the peak comes at 2.3 per cent above the 1995 rate of 20 per cent in 2010. But savings will not drop below the 1995 level until 2035, he predicts.

The picture gets more complicated when you try to take account of whether the simultaneous changes to state pension systems change patterns of saving. This question is addressed in a new book by Professor Richard Disney of Queen Mary College*.

Prof Disney argues that the key feature of the change in pension systems is not the trend from state to private pensions, but the trend from defined benefit schemes to defined contributions schemes.

Most private sector pensions were, until recently at least, defined benefit plans provided by companies. The economic purpose of a pension that guaranteed workers a given fraction of their final salary was to bind them to the company over a working career.

Of course, this has become more expensive as company workforces age. It does not suit younger workers either.

Private pensions are increasingly of the defined contribution type - essentially a personal savings plan with pensions determined by the return on the accumulated savings.

According to the book, the coverage of defined contribution schemes has almost doubled from 8 per cent of pension plans in 1987.

Prof Disney writes: "Where there is an insurance motive for pension provision the switch from a publicly or privately funded defined benefit plan to a group or individual defined contribution plan seems to involve the participant in much greater risks."

The risk of providing for retirement is switching not simply from the government to the private sector but from companies to individuals as well.

The transition from pay-as-you-go state pensions to private pensions might reduce the national savings rate if it involves the government or private sector in saving less or borrowing more to meet the shortfall.

In addition, if people have a choice, they might well opt to pay less into their pensions. However, if the system to which industrial countries are switching places more risk on individuals, savings could increase.

Anecdotally, it is clear that many people in Britain have already added provision for their old age as an extra burden to be saved for.

Certainly in Chile, which privatised its pensions in 1981 by introducing individual retirement savings plans, private sector saving soared from 0.2 per cent in 1981 to 12.7 per cent in 1989, more than offsetting a drop in public sector saving as the government stepped in to finance the unfunded pension obligations of the previous state scheme.

The real catch in the privatisation of pensions is distributional. If this issue is not addressed explicitly - and it is not - the costs of pension reform fall on the most vulnerable people.

In the UK there is a growing class of poor pensioners, with no private cover and a state pension which leaves them further and further behind the rest of the population.

With the honourable exception of the Labour MP Frank Field, whose new book on the subject of how to provide universal pension cover in a modern economy was published earlier this week, few politicians have addressed the distributional question.

Mr Field proposes compulsory individual saving for retirement and unemployment, restoring the insurance aspect of welfare, but has costed state provision of the means to save for people with incomes of less than pounds 100 a week.

This proposal does involve extra taxes, however, even though some of the money needed would come from winding down the State Earnings Related Pension Scheme completely.

For countries which have traditionally used the tax and benefits system to redistribute income, the switch from unfunded to insurance-based pensions - or health-care or unemployment cover, for that matter - raises issues as thorny as the ones being left behind.

* "Can We Afford To Grow Older?" Richard Disney, MIT Press pounds 24.95