The UK pension system is not working well. The problem is not with the government system – that is economically sound. It is with the savings-based schemes. They are not getting enough savings – partly because savers are forced to take on too much investment risk. The government does not want to make saving for pensions obligatory. But it should be able to design plans that share the risk better.
At bottom, the UK pension problem is not about savings plans but about a changing social structure. Lower birth rates, longer lives and earlier retirements all point in the same direction – to more former and fewer current workers. That means that a higher proportion of GDP has to go to old people – and, by default, a lower proportion to working people. Those still in work might not be happy with this shift, but the only way to avoid it is through big social changes. Much higher birth rates would work wonders, but only after many years. Massive immigration of workers would do the trick more quickly. But the obvious answer is lower retirement incomes and higher retirement ages.
The UK has the least generous state pension provision in Europe. As a share of GDP, it is about two-thirds as high as the continental average, and that includes the provision of free health care and heavily subsidized housing. Even if the government gives into political pressure to push up the state pension, its own burden should remain modest.
But what the government does not pay for is supposed to come from savings. Workers are supposed to put away a good part of their earnings – some into private savings but traditionally more into insurance products and pensions funds.
And the savings system has a big problem – the British seem to like saving less than they once did. They like borrowing more. The increase in consumer and mortgage debt has brought the net savings rate down to worryingly low levels. The government seems reluctant to force savings up or borrowing down. Only a housing crash or credit crunch is likely to change that pattern.
The failure of income-smoothing products has also contributed to the decline in the savings rate.
The principle of income smoothing is simple enough. Savers like products that promise them a minimum rate of return. That was the basic premise of what are known as with-profits life assurance products. There was a minimum income, but no maximum. The promise in endowment mortgages was less explicit, but the principle was the same. And defined-benefit pension plans work almost the same way, except that higher-than-expected returns are used to enable lower corporate contributions rather than make higher payments to pensioners.
Heavy losses and mis-selling penalties have forced insurers to retreat from income-smoothing products. That might not be a big loss. Income-smoothing products were attractive, but high selling costs made them a bad deal for customers. Defined-benefit pension plans are much more efficient. But corporate managers have been so frightened by their true cost that they have closed almost all of them to new members.
Spreading the risk
The decline of income-smoothing products is regrettable. It makes good sense for individuals not to have to bear all the risks of asset price gyrations. They are less likely to invest when they might lose everything. It also makes good sense for companies that are big enough to buy all sorts of assets to share some of benefits of diversification with their customers.
The decline is not only bad. It is also unnecessary. Thanks to lively markets in derivatives, it is easier and cheaper than ever to diversify risks and smooth out returns. It is time to think about creating a new generation of smoothed products.
The old style of absolute promises of future income are probably too expensive. But pension plans offering returns that grew pretty much with the economy – not much better and not much worse – would be cheap to offer and attractive to both employers and employees.
Government revenues and corporate cashflow generally grow along with GDP. And so should pensioner income. The only problem is the wide range of asset prices. And that could be dealt with by smoothing instruments – derivatives, inflation-linked securities and perhaps the longevity bonds suggested by Conservative work and pensions spokesman David Willets. These are government securities that would pay out more if people lived longer than expected.
The Labour government’s pensions commission will not make its policy recommendations until autumn 2005. But it’s not too early to make a wish-list. The main goals should be to push up the effective retirement age as much as possible and keep the basic pension as low as possible. Those should be accompanied by efforts to push up savings. A new generation of smoothed products would be a good place to start.
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