Pensions need to redistribute human capital

There are many sources of uncertainty in people's lives. One useful way to categorise them would be those that most people would rather do without (and might pay something to avoid) and those without which life would be duller. Sport has uncertain outcomes; without that uncertainty most matches would be reduced to displays of physical virtuosity which were of limited interest. People actually value the uncertainty of outcomes here. And there are clearly attractions to having some uncertainty about your love life, about just how good that restaurant is or how wonderful a new film might be.

Most people could do without uncertainty over whether their house will burn down, and they could live more happily with less risk that they will be burgled. To avoid the consequences of such events most people buy insurance, and markets work pretty well in providing the means for people to sell these risks; insurance companies buy much of this sort of risk because they can work out quite accurately the odds of having to pay out.

But some of the most important and unpleasant risks that people face cannot be easily insured against and this has important implications for the role of the state. Consider uncertainty over future income from employment. It is hard to insure against a prolonged downturn in your future earnings. You can buy (at high cost) insurance against illness which prevents you from working for a period; and you can get insurance contracts which make mortgage repayments if you are unemployed. But spells of unemployment or of illness are only a part of labour income uncertainty. More important - especially for young people - are the risks that you go into the wrong career; or that you join the firm that is about to go under; or that you fail the crucial exams that would have set you off on the fast track.

The kind of insurance contract you might find tempting at the start of adult life would be one that promised to give you the sort of income that someone with your characteristics could, on average, expect over their working lives. If your actual earnings turn out to be much lower you receive payouts from the policy; if you do spectacularly well you pay the insurance company the excess. Now this policy would be excellent in some ways - it removes income uncertainty - but hopeless in others. What incentive do you have to put in lots of effort at work when the insurance company will take the extra income? What incentive do you have to go to work at all if the policy compensates you for earnings below the average? Since slavery is outlawed, the insurance company can not enforce this contract.

The absence of a decent market for insurance against income risks is a form of market failure or incompleteness. (Incidentally, only an economist would think of describing the absence of slavery as a type of market failure). And it is a market failure with profound consequences. Income from labour makes up somewhere between 60 and 80 per cent of the total value of production in most developed countries; one implication of this is that the value of human capital (the earnings power embodied in people) is probably three to four times as large as the value of other physical assets (machines, factories, cars, houses etc.). Financial markets allow you to insure physical assets quite well, but these assets are much less important than human wealth which is largely uninsurable.

All this has consequences for the desirability of different pension arrangements and for the role of state pay-as-you-go schemes where pensions are financed out of taxes. For the reasons noted above, human capital in real economies is not readily tradable; I cannot now sell shares in my future labour income. As Robert Merton, one of the intellectual giants of modern economics, has observed, the implications of this obvious point are rather profound*. In a world where the most important single class of asset cannot be traded the portfolio decisions of private agents are substantially restricted.

People begin their life with no assets other than human capital, spend a period out of the labour force, work for a substantial proportion of their lives but are then retired for a significant proportion of their lives. Their portfolios of assets are significantly different from what they would have chosen if there were a financial asset with the same characteristics as a claim on human capital.

Specifically, in the early and working periods of life far too much of their overall wealth will be in the form of human capital, earnings power, which cannot be traded (only current hours of work can be sold). In retirement, when their remaining human capital is zero, the portfolio of assets will be far too heavily weighed in favour of marketable financial assets. This makes for less than ideal risk-sharing.

The key point about all this is that tax-financed state retirement pensions may well represent as close as one can get to a human capital-type asset. In the absence of a market in human capital a system whereby the government levies a tax upon current workers and uses the proceeds of that tax to finance retirement pensions may help correct the market failure. Such a scheme gives the old a means of acquiring a claim upon human capital whilst also in effect reducing the exposure of the working and young to current shocks to real wages. Dismantling a pay-as-you-go state pension scheme will make the problem of incomplete markets more severe.

This would not follow if there were tradable assets which had the characteristic of claims upon human capital. And it might be thought that claims upon corporate capital - in other words, shares - had those characteristics. After all a corporate share is a claim upon some part of the output generated with the help of capital and labour.

The returns generated by ownership of a share of capital income in principle could track returns to human capital quite closely. But in practice the returns on corporate capital and the returns on labour look rather different. If we look at the returns on a stock market index in the UK and the returns to labour the correlation is almost zero (see table). It is important to be clear about the implication of this observation.

It is not that pay-as-you-go, state-run pension schemes are superior on risk grounds to funded schemes. Rather it is that there is some role for state-financed schemes which redistribute money from current workers to the current retired. In the rush to privatise bits of the welfare state it is crucial to understand what private markets can and cannot do; private firms may be able to do many things more efficiently than the public sector. But it is a dreadful mistake to believe this is a universal truth.

* 'The Role of Social Security as a Means for Efficient Risk Bearing in an Economy where Human Capital is not Tradable' (1983) by Robert Merton, University of Chicago Press

David Miles is professor of economics at Imperial College, University of London, and an adviser to Merrill Lynch