Hamish McRae: Changes to the pensions system could cause a fall in demand and tax revenue

What happens if we do all save a lot more for our pensions then? And not just us - all the other ageing countries too?

What happens if we do all save a lot more for our pensions then? And not just us - all the other ageing countries too?

Nearly all the debate over the past three days has been about the problem in Britain, seen though British eyes: how we need preferably to work for longer, probably pay higher taxation and most certainly save more.

That is of course the right perspective from a national point of view but there is another way of looking at the issue: if we were indeed to save more (which we will have to do) and other countries also save more (which they have to do) what then? What would happen to global demand and global savings?

Let's focus in particular on the private sector and look at where the world is now. At the end of last year just over half the world's private sector pension fund assets were held by US funds, 21 per cent by Japanese and 9 per cent by the UK. So between them, these three countries account more than 80 per cent of the stock of assets (see first chart). But that proportion is bound to decline. Continental European countries will have to build up their stock of private pension assets to buttress the unsustainable public pension position. And there has been an uneven but fascinating rise in the stock of pension fund assets, and the numbers of members of pension schemes, in emerging markets (see second chart).

At the moment, the decisions of savers and pension fund managers in the US, Japan and the UK matter hugely but as time goes by we will all, in relative terms, matter less. The savings and investment decisions of the rest of the world will become more important, just as the decisions taken in China now affect the entire world economy.

Britain, however, will be very interesting over the next five years for two main reasons. One is that we have an unusually innovative investment culture - maybe not innovative enough but innovative nonetheless. Thus a much higher proportion of pension fund assets is invested abroad when compared with the US. The seminal decision by the Boots pension fund to move out of equities at what proved to be the top of the bull market has influenced fund managers around the world. And new ideas about the best way of ensuring that there will be an adequate stock of assets to meet liabilities in 30 years' time are now being canvassed around the City.

There is a second reason why we are interesting: the changes in the system under which people can pay into a pension fund that start in April 2006. That is less than 18 months away. As you may recall, the present restrictions on the amount people can pay into a pension are related to salary, age and the type of pension concerned. The new rules are that there will be a lifetime cap of £1.5m (rising a bit as the years go by) and an annual maximum of £215,000 that can be paid in.

Up to now, most of the debate about this has been over the size of the cap. It has been argued that it would require more than that to fund the indexed pensions enjoyed by some senior civil servants. I'm sure that politicians who have gone on the Brussels gravy train would need more too were they to have to save for their pensions. And there has been a row about the numbers of people affected, with the Treasury suggesting it would be only a few thousand and the industry reckoning it would be 10 times the Treasury estimate.

But that is a static analysis. Much more interesting, surely, is what people will do when the new limits come in. The numbers of people will indeed be small, even if the higher estimates prove to be right. But since 1 per cent of earners pay nearly a quarter of income tax revenue, what these people do is quite important to revenues and to investment flows. Someone on a good income and close to retirement might decide to put all his or her salary into a pension fund, pay no income tax at all and use savings for day-to-day expenditure. People who have accumulated the limit might reckon there was no financial incentive in going on working and retire earlier than they otherwise would. Still others might decide to wait for a change of government and a different tax treatment.

That is at the top end. At the middle and bottom reaches, the tax incentive may encourage more voluntary contributions to pensions but it could have exactly the opposite effect, with people delaying paying into pensions because there is no set annual percentage ceiling. We simply don't know what people will do.

This is unknown territory. But what we can say is that if people as a result of these tax changes increase their savings, it could make quite a sharp dent in tax revenues. It could also make a sharp dent in demand.

If people save more, how will those funds be invested? In theory, an increase in the amount of money going into any market increases the price of the assets and cuts the return. I could see individuals with their own personally managed pension plans being quite interested in buying shares. Mainstream pension funds will have to steer their investment towards bonds because bonds mature at a particular date in the future and there will be great pressure for funds to match assets and liabilities. But people can be more adventurous and use their freedom to seek higher returns. If the big money is constrained from going into equities, that will hold down prices but also create value opportunities for less constrained investors.

The general point here is that if indeed we all save more for our retirement and those savings are invested, the tendency will be for returns to be driven down. That is what has happened in Japan, which has a huge excess of savings and which exports much of those savings to the US, thereby helping it cover the current account and fiscal deficits. If Japan did not export capital on such a scale, domestic returns would be even lower.

How low might returns go? Here the only sensible approach is to take a very long-term view. Over the past 150 years equities have delivered a total real return of about 7 per cent - though in practice taxation would have made it impossible to achieve that. In 2000 we came to the end of a 25-year bull market when returns averaged close to double that. Now a period of single-digit returns seems more likely. But we have to be aware that if the whole developed world does start saving a lot more, returns will drop further. In the short run, shares will do well and long-bond yields will decline. But in the medium term, this is none too healthy: an excess of savings chasing too few investment opportunities sounds rather like Japan in the 1990s.

It would be nice to make some judgement about the profile of savings in the developed world over the next decade or so, then look at what might happen to asset prices as the funds flow in, and then again as the funds flow out to pay for the pensions.

I don't think that can be done except in the broadest terms. But meanwhile we should look carefully at the little UK experiment, the new pension rules of 2006. Will we save more or less? No one can know.