There is an utterly misconceived view that the present pay-as-you-go (PAYG) pension system can be su...
There is an utterly misconceived view that the present pay-as-you-go (PAYG) pension system can be supported indefinitely and is, indeed, superior to funded alternatives. It is a straight transfer system, usually a double transfer system that redistributes from the young to the old, as well as from the rich to the poor. In funded schemes, by contrast, money is invested by current savers, accumulates over the years and should provide the basis for their own future pension needs.
PAYG was popular when pension schemes were first established for political reasons. A funded scheme will take time to mature and it could be a generation before those who save in such schemes begin to reap the benefits. A PAYG scheme, however, can begin payments to those currently retired out of the tax of payments of those currently in work. It enables politicians to offer benefits immediately to those who have not made savings over the years.
High priest of the PAYG is Douglas Wood, Natwest professor of banking and corporate finance at the Manchester Business School.
"Why," he asks, "with real incomes per head three times their level when the State pension was set up, can we apparently no longer afford something that a much less affluent parish charity can?"
First, the burden that has to be supported is now greater. When the Beveridge Report was implemented after the Second World War, the life expectancy of a man was 67 years and for a woman it was 71 years. The average man expected to start work at 16, retire at 65 and die at 67, requiring only two years of pension support. An increase in life expectancy to 75 years would, given the same retirement age, require five times as much support. The second argument is that society could not even afford it when the system was introduced. It was a bill passed forward to be picked up by future taxpayers.
One reason we cannot afford it is that the ratio of shoulders to burdens is declining. The proportion of those in work and making contributions is falling and the proportion of those drawing benefits is increasing for a number of reasons.
It is all very well to talk of a richer society being able to support higher taxes, but they are already paying higher taxes for a wide variety of other purposes and may not accept the heavier burdens that pension promises impose upon them. Generous pension promises in Belgium and Germany, for example, have imposed huge costs upon future taxpayers there. The workforce in Germany is set to decline by 16% between 1995 and 2020 and already there are only three employed workers to support each retired person - within 10 years this will be down to two.
The problem is less serious in the UK because we have switched over much of our pension system to funded schemes. The rise of occupational and personal pension schemes means that most of our own future pensions will be drawn not from extravagant Government promises about the behaviour of future taxpayers but from funds saved and invested for the purpose. The UK's total of accumulated pension funds stands at nearly £1 trillion.
The problem in the UK is a different one relating to the future of the basic State pension and how self-provision of funded schemes can be extended to previously excluded groups of the population. Our basic pension is too small to provide support unaided. For those who depend solely on it, it is reckoned insufficient to sustain an acceptable living standard and is augmented by income support.
There are three reasons why funded pensions are superior to tax-funded PAYG schemes. First, if people have built up a fund to support themselves in retirement, workers are not dependent on future taxpayers to support them. The ratio of shoulders to burdens no longer matters if the funds are already there. Second, the build-up of these funds creates a capital pool available for investment. That investment boosts economic growth and the whole wealth of society, as well as of the real pension funds themselves. Third, and crucially, people will pay more into a fund than they would tolerate in taxation. Taxation is regarded as money taken away by government, which people resent. A savings fund, by contrast, is property and funded pensions can achieve a higher savings ratio than taxation can.
The question is raised as to whether all PAYG pensions can be replaced by funded ones, taking account of access to the latter to a lower income band than before.
The Labour Government has attempted to grapple with the problem by means of its stakeholder pensions. However, a recent MORI poll indicates that most of those targeted for the new pensions either know nothing about them, are not tempted by them or are not tempted by what they do know. More worrying, perhaps, is the fact that respondents overwhelmingly preferred to settle pensions and savings on the basis of a fact-to-face with someone who they trusted, whereas the tight margins on stakeholder make them much more suitable for impersonal sale by telephone or over the internet.
If the target is employers, the Government should take note of the fact that, while people do in general trust the competence of their employers, this does not apply to small employers, who are felt to lack pensions expertise. An interesting fact to emerge from the US experience of 401K employer-run pension schemes is that a typical take-up rate of 60% can be boosted 85% if the employer puts in a contribution themselves.
One problem is that if we are going to live longer, then we need to accumulate larger funds to handle our future needs. We need to start early in life and to save regularly. Unfortunately it is difficult to motivate young people into the savings habit.
They think that a pension is something that happens to other people. The problem is one of making sa
‘In the know’
Owen to pay £3m
Lasting power of attorney
Three risk profiles
Caused by falling oil price