Commission report sets out framework for pensions debate
The Pensions Commission's first report spells out four policy options for the UK: accepting that pensioners will become poorer, relative to the rest of society; raising tax rates; increasing the rate of savings; and raising the average age of retirement.
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This first report from the Pensions Commission concentrates on gathering data and forming judgments on the problems for
Given the demographic changes, the adjustments now needed to
pensioners becoming poorer relative to the rest of society;
taxes devoted to pensions rising to pay for a more generous state system;
private savings increasing; and
average retirement ages rising.
The average age of retirement is currently 63.8 for men and 61.6 for women but to solve the underfunding problems without other factors coming into play, these figures would need to rise by 2050 to 69.8 for men and 67.4 for women.
If nothing is done by 2050, pensioners will be poorer by 21% in terms of the proportion of gross domestic product avalable for their use.
In 2002/03 some 11.3 million people in work were not making contributions to any private pension scheme and 8.8 million of them did not have a partner contributing.
The Commission says "unless government initiatives can make a major difference to behaviour, the present voluntary system of pension savings, combined with the present state system, is unlikely to deliver adequate pension provision."
Achieving overall adequate levels of pension provision must involve some mix of the following three possible ways forward:
a major revitalisation of the voluntary system;
changes to the state system; and
increased compulsion beyond that already implied by the state second pension and the contracting-out arrangements.
Consultation on the data collected and the judgments made ends on
Recommendations will be made in a second report expected in autumn 2005.
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"The report is long and full of facts. That is deliberate." These were the words chosen by Adair Turner, who leads the Pensions Commission, when introducing its first report*. The aim, he explained, was to set out as clearly as possible what the Commission had learned and the judgments it had reached. He, Jeannie Drake and John Hills - as the three commissioners - now seek reactions. In particular, they want to know if others think the facts they have collected, and the judgments they have formed, are correct so that an agreed understanding of the key pension issues can emerge.
The Commission was announced in the Green Paper Simplicity, security, choice: working and saving for retirement . Its purpose was "to assess trends in occupational and private pensions and long-term saving, and to advise on whether there is a case for moving beyond the current voluntarist approach." The Commission was asked to report regularly and this is its first report.
At this stage, the Commission is not making recommendations on specific policy changes. It wants to receive responses to its initial analysis by the end of January 2005, and then produce a second report in the autumn that will include specific policy proposals.
Demographic change
The key challenge to the provision of adequate pensions in future comes from the changing demography of the UK population. Greater life expectancy (OP, August 2004) and falling birth rates will produce a near doubling of the percentage of the population aged 65 years and over between now and the middle of the century. As a result, the ratio of those aged 65 or over to those aged between 20 and 64 will increase from today's 27% to 48% in 2050. "We must now make adjustments to public policy and/or individual behaviour, which ideally should have been started in the last 20 to 30 years", says the report.
The commissioners point out that the adjustments now needed to UK pension provision involve some mix of the following four options:
pensioners will become poorer, relative to the rest of society;
taxes devoted to pensions must rise to pay for a more generous state system;
private savings must rise; and
average retirement ages must rise.
Turner comments: "There is no alternative to these four options and we must as a society and individuals decide what mix we want." He does, nevertheless, suggest that selecting just one of the options as the means of solving the problem is almost certainly untenable and that a mix is needed, although he views (for understandable reasons) the option of pensioners becoming poorer, relative to the rest of society as being the least attractive.
Retirement age
The report is careful to distinguish between "state pension age" and "retirement age" (although broadcast media on the day the report was published were not necessarily as careful). The report uses "retirement age" to mean the age at which individuals actually retire, and points out that this varies enormously from individual to individual but is currently, on average, 63.8 for men and 61.6 for women. State pension age is, of course, the age at which people can draw their state pension and it is emphasised that an increase in retirement age can occur without any change to state pension age. This is an important point politically because the current government has already stated its policy not to increase the state pension age, but nevertheless to encourage later retirement beyond age 65.
The report looks at ways in which the average retirement age can be increased but comes to the conclusion that later retirement cannot, by itself, resolve the issue of how society can provide adequate income to so many pensioners for so long. The data suggest that to offset the rise in the dependency ratio, solely by increasing the average age of retirement, it would need to rise to 69.8 for men and 67.4 for women by 2050. Such a high average would mean millions of people working well into their 70s, and such a prospect currently looks improbable. Indeed, such an increase in the average retirement age would on average increase the years of adult life spent working by more than 13%. In contrast, the life expectancy of a young adult is expected to increase by little more than 2% over the same period.
Current approach unsustainable
Current government plans and private savings
levels imply, says the report, that the total pension income of normal-age
retirees will rise from today's 9.1% of gross domestic product (GDP) to a
midpoint estimate of 10.8% by 2050, and that there will be no significant shift
in the balance of provision from state to private sources. This level of
transfer of GDP from workers to pensioners is insufficient and implies either
poorer pensioners relative to average earnings or significantly higher average
retirement ages - see box 1. Turner states: "if we look at the combination of
present state pension plans and present levels of private savings levels, they
will not deliver the resources needed to maintain pensioners' relative living
standards without major increases in retirement age." But he adds: "we find
little evidence that people accept the increase in retirement age which is
required to close the gap."
Looking at overall trends in UK pension provision, the report makes six main points:
the
behind that former "rosy picture" were hidden multiple inadequacies for specific groups of people even while the system worked well for many others;
it is now planned that the state system will become less generous in order to constrain public spending in the face of a rising number of pensioners;
private pension provision is in significant, underlying decline. This is marked at present by a slight decline in the proportion of the workforce covered by private provision and by the long-term shift away from defined-benefit to defined-contribution schemes where the value of contributions going into defined-contribution schemes are worth on average about half of the value of defined-benefit scheme membership;
overall funded pension saving is not rising to meet the demographic changes - and the problem was formerly hidden by serious overestimation by the Office of National Statistics of the level of pension saving; and
the retirement risk is being transferred from the state, from employers and from the financial services industry to individuals who are often ill prepared to deal with it.
Current private pension provision
In the Commission's analysis, the "rosy
picture" of private pension provision mentioned above was always exaggerated
because it failed to reflect the huge diversity of individual experience. Box 2
shows that in the UK in 2002/03, some 11.3 million people in work were not
making contributions to any private pension scheme - nor did 8.8 million of
them have a partner contributing. Unless they had accrued pension rights from
previous arrangements, they were therefore relying entirely on the state
system. These non-contributors include about 1.7 million self-employed people
whose only current pension is the basic state pension since they cannot
participate in SERPS and/or the second state pension (S2P).
Even among those who benefit from participating in some form of private pension, the rate of the benefit will vary widely from one person to another, often in a fairly random way. Members of private sector final-salary schemes, for example, often enjoy pension benefits worth twice as much as new employees working beside them who are unable to join the scheme. Also, members of public service schemes have accumulated pension rights relative to salary that are roughly double those of private sector scheme members.
The nature of these inequalities are therefore often surprising. The commissioners note that, while pensions are smallest for low-income earners, in replacement rate terms, they are the group for whom the state has become, and plans to become, more generous. Conversely, many middle and lower-middle earners are members of private sector defined-contribution schemes with inadequate contributions or in no private scheme at all.
The report states: "An interesting feature of the trends is that while the 'savings gaps' of the past were concentrated in particular labour market groups (women, the lower-paid, the self-employed, employees of small firms), they are probably spreading most rapidly among middle income earners and above, often male, in mid and large as well as small firms. It is noticeable indeed that a deterioration in private pension savings is occurring in the same group most affected by the planned reduction in the generosity of state pension provision, ie middle income earners."
Pension under-saving
Looking at private and state pension provision, the Commission's initial "base case" results suggest that in the UK there are around 9.6 million individuals who are either not saving for pensions or are under-saving. Yet many of these are under-saving by relatively small amounts. Running an alternative case with target replacement rates that are five percentage points lower reduces the estimate to 8.5 million. This illustrates the sensitivity of results to the adequacy benchmarks selected. These estimates, however, will steadily increase as the shift from defined-benefit to defined-contribution private provision affects more and more individuals. One salutary statistic reinforces the Commission's point that it is not just the usual suspects who appear to be heading for difficulties in retirement - some 66% of employed men aged 36 to 45 and earning from £17,500 to £24,999 appear not to be saving enough to achieve the income replacement benchmark set at two-thirds of final earnings.
A key point stressed in the report is one of timing. The average pensioner's income relative to the rest of society is higher now than 20 years ago, and is likely to remain so over the next decade. The problem will emerge in 15 to 25 years' time unless policies and the behaviour of individuals change in the meantime.
Other forms of savings
In impressive detail, the report examines forms of savings other than pensions (see Factfile). For example, in addition to assets of about £1,300 billion in funded occupational and personal pension schemes and pension rights worth about £500 billion in unfunded public sector schemes, UK individuals collectively own about £1,150 billion in other financial assets, and a further £2,250 billion in housing assets net of mortgage debt.
These other assets can play a part in generating retirement income but do not provide a solution to the under-saving problem. This is because the ownership of the financial assets is unequally distributed and, for most of the owners, these assets could only generate a very modest income. As regards housing assets, the data suggest that, while the liquidation of housing assets during retirement is likely to remain limited in scope, the inheritance of housing assets by those who already own a house may play an increasing role in retirement provision. Overall, however, the report says that home ownership does not provide a sufficient solution to the problem of pension provision given:
(i) the uncertainty over future house prices;
(ii) the other potential claims on housing wealth such as long-term care; and
(iii) the fact that housing wealth is not significantly higher among those with the least pension rights.
Present voluntary system failing
The remit given by the government to the Pensions Commission included considering whether there is a need to "move beyond the voluntary approach". The Pensions Commission answers this question by concluding that "unless new government initiatives can make a major difference to behaviour, the present voluntary system of pension savings, combined with the present state system, is unlikely to deliver adequate pension provision". The report identifies five big barriers to the success of a voluntary pension saving system in the UK, namely:
many individuals do not make rational, long-term financial decisions;
retail pension products are inherently expensive due to the selling cost;
the "bewildering complexity" of the state system and the private system and interfaces between them exacerbate the problem;
the public's growing lack of trust in financial advisers and governments (although many still trust their employers); and
the disincentive effect in means-testing, which will grow over time if the pension credit threshold remains earnings-linked but state retirement pension remains broadly price indexed.
Three ways forward
In chapter 7 of the report, the Pensions Commission's stated aim is to create "a framework" for debate on how to proceed. It seeks to stimulate debate and highlight the difficulties, as well as the advantages, of any way forward. In the Commission's view, the achievement of an overall adequate level of pension provision must involve some mix of the following three possible ways forward:
a major revitalisation of the voluntary system;
changes to the state system; and
increased compulsion beyond that already implied by S2P and the contracting-out arrangements.
Revitalising the voluntary system would involve, says the Commission, a big increase in the number of employers paying contributions on behalf of their employees. It could also involve consideration of moving away from the current system of granting tax relief on contributions - say by moving over to a system where the state matches contributions up to a stated ceiling. It would also have to involve a major reduction in the selling and administration costs of contract-based pensions (rather than the 50% increase on sales costs recently accepted by the government on stakeholder pension schemes during the first 10 years after the sale). Radical approaches to increase the public's understanding of pensions would also be needed.
Changes to the state system concentrate on three aspects: the importance of means-testing, its complexity, and the contributory principle that is a major driver of inequality between men and women. The Commission comments on the many proposals being put forward by pension representative groups for a higher basic state pension and, playing devil's advocate, says "if these proposals are made, the potential consequences and disadvantages need to be faced alongside the potential benefits." It points out that a basic, non-contributory state pension set at the guarantee credit level, but with no S2P and no savings credit, where state pension expenditure is limited to today's 5% of GDP, would require state pension age to rise to 74 by 2043.
On the key issue of compulsion, the Commission points out that at present the design of SERPS/S2P means that as the years pass the benefit provided becomes increasingly flat-rate and this amounts to a reduction in the level of compulsory pension savings. If it is accepted that there is a case for society to ensure some minimum level of earnings-related pension up to a stated earnings ceiling, the issue becomes whether this should be on a state pay-as-you-go basis or by compulsory savings - although both approaches inevitably involve the transfer of resources from current workers to current pensioners. Choosing between the two approaches should involve consideration of:
the nature of the claim;
the impact of the overall savings rate;
the division of risk; and
selling and administration costs.
Having digested the evidence gathered by the Pensions Commission in this first report, interested parties are now asked to contribute within the framework of the debate set out in chapter 7. Analysis of the issues involved will be the key focus of the Commission's second report expected next autumn.
* "Pensions: challenges and choices,", ISBN 0 11 702780 4, available from The Stationery Office, tel. enquiries: 0870 600 5522, website: www.tso.co.uk/bookshop, price £49.50 (main report and appendices), £30 (main report only) or free (executive summary), andfree from the Pensions Commission's website ( www.pensionscommission.org.uk).
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The research for this feature is based
exclusively on a reading of Pensions: challenges and choices, the first report
of the Pensions Commission, and of the address given by Adair Turner at
the press launch of this report. |
