We have further to go on pension reform

'The criticism I would make of Mr Lilley is that he hasn't gone far enough, though to be fair, he's probably gone about as far as any politician would dare just ahead of a general election'

Last December the International Monetary Fund published a paper called "Ageing Populations and Public Pensions Policy". This might not seem like a title to set the pulse racing but it should nevertheless be essential reading for anyone interested in the background to the Government's announcement this week of plans to privatise the basic state pension, changing it, in the process, from a tax-funded pay-as-you-go scheme to a funded investment approach.

The study finds that existing public pension arrangements are beginning to contribute to serious fiscal stresses in most industrial countries, and that these can only get much worse over the next few decades in the absence of appropriate reform. The countries most at risk are those that rely heavily on pay-as-you-go schemes, where pension liabilities are funded out of current government revenue. Among the developed countries, these are Germany, France, Italy and the UK.

The paper then goes on to examine the various options for reform, including - surprise, surprise - the exact same one as that proposed by Peter Lilley and the Government. It just goes to show that there's no such thing as a new idea in politics. Actually, the trail proposed by the Government has already been blazed by Chile and a number of other Latin American countries, inviting some uncharitable comparisons with the economics of the banana republic. None of this should detract from the underlying merits of what Mr Lilley is trying to do here. Indeed the criticism I would make of Mr Lilley is that he hasn't gone far enough, though, to be fair, he's probably gone about as far as any politician would dare just ahead of a general election.

Britain approaches the problem of state pension liabilities from a very different perspective to that of other European countries. In Britain the problem is not so much the growing cost of our pay-as-you-go arrangements as their inability to deliver a decent level of benefit. The flat rate state pension is not a living wage and the benefit offered by Serps (the state earnings-related scheme) is also inadequate for most people.

This is the very reverse of the position in Germany, France and Italy, where the promised benefits are very generous but the tax raised to pay for them increasingly inadequate. The challenge for Britain is to find ways of forcing up the level of benefit without significantly adding to the burden of taxation; the challenge on the Continent is the arguably even more difficult one of cutting benefit to a level that the Government can afford.

The differing nature of the problem requires correspondingly differing approaches to reform. On the Continent the emphasis has to be on adjusting both contributions and benefit structures, so as to bring them more into line. In Britain, raising the level of benefit requires people to recognise that they need to save more during their working lives or work longer.

Long-term demographic trends towards a more aged population are adding to the seriousness of the problem. People are living longer, and they have fewer children with the result that fewer and fewer workers are paying for the retirement of more and more pensioners. According to the IMF, there are approximately four people of working age in Britain at the moment for every one person of pensionable age.

This ratio falls to a level of a bit more than two to one by the middle of the next century. If you think this a sorry state of affairs, the outlook in Germany and Italy is much, much worse. In Germany last year, the ratio was a little bit better than Britain. But by the middle of the next century there will be fewer than 1.5 workers for every pensioner. The prognosis for Italy is worse still. Factor children into this calculation and you are left with the bizarre spectacle of less than one worker for each dependent (defined as those below the age of 15 or above the age of 65). Japan faces an equally daunting future. Official policies to restrict child birth will make China the most aged population of the lot.

So in some respects, Britain is sitting pretty. Its ageing problem is not as severe as that of many other countries and its pay-as-you-go arrangements are mean enough to be affordable. According to John Hills of the London School of Economics, National Insurance contributions as they stand are easily sufficient to fund present arrangements into the indefinite future. Indeed there may be scope to cut them.

So why doesn't the Government just leave well alone? Even the IMF concedes that the fiscal cost of introducing a fully funded scheme in place of a defined benefit pay-as-you-go system may be very high. "Meeting these costs may require, in many cases, an amount of fiscal adjustment that is substantially higher than what would be needed to fix the pay-as-you- go system," the IMF paper says.

As it is the extra fiscal cost for Britain is relatively small, if only because present arrangements pay out so little in benefit. This makes the transition to a fully funded system just about feasible where others would find it next to impossible. Indeed the Government claims that by changing the tax treatment of private occupational and personal pension schemes, it can actually make the whole thing pretty much fiscally neutral. We will see.

The upshot, in any case, is that at some stage in the dim and distant future, the Government will be shot of the pounds 40bn a year cost of providing state pensions altogether and the fully funded scheme will be yielding a flat rate pension for all at least three times higher than the present state pension. If that sounds like magic, it's actually just slight of hand. The extra benefit is derived from the effect over many years of an accumulated investment return. As for getting shot of the liability, that comes at a heavy cost to the present generation of taxpayers, who must continue to fund the costs of pensions during the transitional period while progressively being deprived of the National Insurance contribution of those joining the workforce.

In other words, it is us, the present generation, who pay for the lower taxes and higher public pensions of the next generation. All very noble, I'm sure, but would anyone actually want to vote for it? Even John Major concedes that of, itself, this is not a great vote winner. Labour believes it to be a positive vote loser.

Whatever. The truth of the matter is that whoever wins the next election is going to have to do something about long-term pension benefits. Even Mr Lilley's funded public pension delivers a level of benefit too low to live on. The solution is to go further - to persuade or compel people to save a much larger proportion of their earnings than the piddling little amounts envisaged in this proposal. The justification for compulsion in this case is an obvious one. Forcing people to save for their old age is in essence just a privatised form of taxation, only at least everyone knows what the money is eventually going to be spent on. It's the way to go.

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