What are the origins of the Pension Crisis and what can be done to deal with it?

So what is the State Pension

Well, according to the Pension Service, an individual can build up entitlement to the basic State Pension, if they pay, are treated as having paid, or are credited with, standard-rate National Insurance contribution, Credited means that the Government has added some contribution to the individuals National Insurance for them. From April 2000, one can be treated as having paid National Insurance contribution if their earning are at or above the lower earning limit and at or below the primary threshold (£79 a week and £91 a week in 2004/05). The primary threshold is the amount of earning above which they will pay National Insurance contribution, so in 2004/05, a person needs to have earning of at least £79 a week to build up entitlement to a state pension. The years during which one builds up their entitlement to the basic pension are called qualifying years, a man needs 44 qualifying years to get 100% basic state pension. Women reaching the age of 69 before 2010 normally need 39 qualifying years, but this will increase to 44 as their retirement age moves from 60 to 65 by 2020.

Some people do not get the full basic state pension because they have not paid enough contribution. They may only have worked for a few years or they may have had earning below a certain level (the lower earning limit). It is estimated that one in four single pensioners and nearly as many pensionable couples are living in poverty

From 2010, if one choose to put off claiming their state pension once they have reached State Pension age, they will earn extra state pension at a rate of 10.4% a year, and they will be able to put off claiming their state pension for as long as they want. With the parliaments approval, the government proposes by 2005, to provide an alternative lump-sum payment rather than an increase to weekly pension if one put off claiming their pension.

Before the early 1980’s the state pension and other welfare benefits increased each year in line with changes in the index of average earnings so the unwaged shared in increasing national prosperity. However the landmark Social Security Act of 1980 replaced the indexation of the basic pension with earning growth, to the changed in the consumer price index (inflation) which generally rises less than the index of average earning, and since the government granted the Bank of England operational independence to control inflation using interest rates in May 1997, the UK has experienced low levels of inflation and inflation is now at its lowest level for forty years. As a result, although not directly linked to the health of the stock market, the current PAYG pension system has resulted in increasing inequality between people with jobs and those without jobs with it amounting to about 16% of average earning (Pension Institute)

Second Pensions

Relying on the state is not enough for most to live on, given the high expectation of living standards and rising costs of healthcare, so individuals can build up a second pension (on top of your basic state pension) through the state or by a private arrangement of some kind.

The additional state pension was called the State Earning Related Pension Scheme (SERPS) until 6 April 2002, SERPS was based on ones record of National Insurance contribution and level of earning as an employee. The additional state pension one for build up from 6 April 2002 is called the State Second Pension. This is the government’s reform of SERPS to provide a more generous additional state pension for employee on low or moderate earning and certain carers and people with a long term illness or disability whose working lives have been interrupted or shortened. For State Second Pension purposes, earning up to £11,600 are low earning and earning between £11,600 and £26,600 are moderate earning (for 2004/05). It may also be inherited by a surviving husband or wife but with a maximum of 50% only. This is currently about 19% of average earning (although over half of the workforce are in contracted out schemes– Pension Institute)

Contracting Out

One cannot leave the basic state pension but, in some circumstances, they can choose to leave the state second pension and join a private scheme of some kind instead and this is known as contracting out.

An occupational pension (non-state) may be a Defined Benefit also known as a final salary says how much an individual will receive as long as they make certain contributions. This was popular for company schemes, where an employer promised to pay a certain proportion of an employee’s salary at retirement. Defined Contribution, also called money purchase, simply says how much the individual must pay in. the eventual pension depends on how well those contributions are invested. If the fund manager loses the lot, then tough, and most employers are taking advantages of the switch to put less than half as much into defined contribution schemes as they were into defined benefit schemes.  

Although Final Salary schemes are easy to understand, it, and other occupational schemes are “being scrapped” according to The Independent because the employer takes all the risk of coming up with the pension, no matter what happens to the stock market, the fact that the Chancellor is stripping more than £5bn a year from pension-fund finances by taking away their dividend tax credit is making it quite costly, so this level of uncertainty is now resulting in final-salary pension scheme dying, according to The Economist, among the top 350 quoted companies, the proportion of final-salary schemes open to new members fell from 64% at the end of 2001 to 33% at the end of 2003. Final-salary schemes are now becoming the preserve of the public sector- a disparity that’s bound to cause resentment.

According to the TUC, this, along with the stock market bust have resulted in a staggering deficit in the UK pension funds, from a surplus of £80m in 2000 to a £160bn deficit by June 2003, and despite stock market recovery reducing this to about £60bn by end of last year, many companies are still pulling the plug on final salary schemes.

Individuals could also contract out of the state pension by joining a Stakeholder Pension Scheme which are low charge, flexible pensions. This was introduced 3 years ago as a simple defined contribution scheme that anyone could pay into, with management charges capped at 1%, the individual pays in as much as £2,808 a year, which the government tops up to £3,600. but they have turned into a tax dodge for the wealthy (about half of all tax-relief granted on personal pensions goes to the richest 10% of earners– The Times). Every company is required to set up a stakeholder scheme for their employee, but 4 out of 5 are empty. Neither employer nor employees contribute a penny. It fair to say that this is yet to get off the ground but the fact this system is not being utilised reveals either a lack of consumer knowledge or sheer ignorance, thereby creating a market failure leading to a government failure.

If only the public were made aware or prepared to listen, then they would see the benefits available to them. Almost all private pension schemes have a tax relief on their contribution. With a basic rate of income tax of 22%, every £100 that goes into the pension costs the individual £78 (based on the tax year 2004/05). If the individual pays income tax at the higher rate of 40%, every £100 that goes into their pension costs £60 (based on the tax year 2004/05– A guide to your pension options; The Pension Service, p13). For the tax year 2004/05, a member of a contracted-out occupational scheme earning between £4,108 and £26,00 will get a State Second Pension top-up. A person contributing. A person contributing to a contracted-out personal pension or stakeholder pension earning between £4,108 and £11,600 in the tax year 2004/05 will also get a State Second Pension top-up for that year. The top-up reflects the more generous additional pension provided by the State Second Pension.

There is an opportunity cost to government spending on saving top-ups and some commentators might point out that the money would be better spent on public services such as healthcare and education (get current gov expenditure figures). In a positive light, such schemes are very tax efficient for the contributor, however, this benefit is not widely known or understood and thus this is more evidence that poor consumer knowledge in the pension industry is one of the reasons behind the current pension problem.    

So Who is involved in What.

According to the Pension Institute’s estimates, 64% of employee are accruing funded pensions, 42% occupational and 22% personal (see Table 1), but coverage of occupational pensions is declining, generally reflecting declines in such coverage in the private sector. Meanwhile overall coverage of the self-employed is lower at 41% giving a total coverage rate of an estimated 61.1%.

Source: Government Actuary (2003), PP1 (2003), Department of Employment. Note that there were 27.2m in 2000 of whom 3.1m were self-employed and 24m in “employees in employment”. The remainder are on training schemes etc.       

As reported by Government Actuary (2003), in 2000, there were 10.1m employees in occupational pension schemes, of whom 5.7m were in the private sector and 4.5m in the public sector. This is well down from the from the peak of members in 1967 (12.2m) when the workforce was smaller. As in other countries, it is large employers which are most likely to provide occupational pensions; 95% of employers with over 1000 employees provide a form of occupational pension, while only 24% of those with 5 or fewer employees provide one (Smith and Mckay 2002).

The vast majority of occupational pension scheme members, a total of 9.2m, are contracted-out of the S2P in the manner defined above. 90% (9.1 million) of occupational pension members in 2000 were still in defined benefit schemes (usually offering a guaranteed 66% of final salary for a 40 year career) with correspondingly large employer contributions (when funding status warrants such contributions). Defined contribution occupational funds accounted for 900,000 employees (under 10% of total members) in 2000. The membership of defined contribution funds has undoubtedly risen since then with the introduction of Stakeholder Pension, while defined benefit membership has fallen.

Why is the public not as responsive as urgently needed

The privatisation trends and supply-side focus of the late 1980’s and 1990’s saw many individuals being persuaded to change from occupational pension schemes to riskier personal pensions. The subsequent fall in stock market meant that many individual found themselves much worse off with little to show for their contribution. Following the Maxwell scandal, the pension industry has continued to receive much bad press, as one of the most respected pension providers, Equitable Life, was shamed after reneging on its promise to pay “guaranteed” annuities to its members who had paid high premium, and then there is the massive losses incurred by those who invested in split-capital trusts.

Many believe the Financial Services Authority, the Industry Body and the Government are to blame for providing poor market information by failing to highlight to workers the risks involved in investing in personal pension funds, for example, there isn’t much information about how expensive pension schemes can knock tens of thousands of pounds off its value. Matthew Wall of The Times revealed a difference of more than £100,000 between the charges of the cheapest and dearest personal pension firm: someone contributing £200 a month over 30 years would pay £26,677 with Legal & General’s Stakeholder Pension, but £53,406 with Scottish Widow's Stakeholders Plan. If one paid in £500 a month, charges would be £52,810 with Legal & General, but £169,000 with Allied Dunbar. The credibility of schemes is crucial for workers to invest in them and improving credibility in the pension’s industry should be one of the government’s top priorities in its efforts to solve the current pension crisis.

When people are living longer, they should be saving more, but in fact overall contribution to private pensions in 2001 were only 7.7% of average earning, and 42% of workers are only occasional members of schemes– mainly lower income earning. The recent Pension Commission Report officially announced that people are not saving enough; to the tune of £57bn– nearly £1,000 for every man, woman and child in the country. Apparently, 13m people are not saving enough to provide for a secure retirement, almost half of the 28m working population. They recommend that one puts aside 12% of their income if they start saving for a pension at the age of 25; as a nation, the under 20 age group spend 24% of their earning on restaurants, hotels, recreation, alcohol and tobacco, not to mention % spent on debts already accumulated (after 40 years old and without a saving for a pension, one would then have to put aside 22% of ones earning, each month, in the world we live in, this is a simply untenable).

According to The Independent, a non-smoking female needs to have saved £110,000 at age 65 to buy a retirement income of £100 a week, a non-smoking male would need to have saved £500,000 at age 55 to provide an inflation-proof annual income of £20,000. In reality, the average pension pot is only £30,000, which buys an income of £30 a week. They also believe that about a million UK Pensioner are currently living below the poverty line.

Combining all that I have said already, its fair to say that there are more people who will require financial support in some form or another, but less money available to provide it, which is a worrying problem.

 The troubles of the company pension schemes and the insurance industry's disasters have put people off saving, and according to The Economists (September 18– 2004), the government’s polices have reinforced the message that it is foolish to be prudent, they blame the Means-testing. Gordon Brown decided that the best way of alleviating pensioner poverty while holding taxes below mainland European levels was to keep basic pensions at “pocket-money levels” and to give decent-sized benefits only to those with hardly any saving. As saving rise, benefits drop. That means, in effect, marginal tax rates of 40-91% for people with no more than moderate savings: for every £1 they get in income from what they put aside, they lose somewhere between 40p and 91p in forgone benefits. Faced with such sums, no rational person would save (one as to save around £106,000 for it to be worth saving, the average id £30,000), so here is c classic case of government failing whilst trying to correct a market failure as people are now caught in the benefits trap, with little or no incentive to act for themselves, since the government’s proposed savior, the Stakeholder Pension if failing to evoke sufficient response, the Economist estimates that unless the current system is reformed, 2/3 of Britons pensioners will be on means-tested benefits in 20 years’ time.

Current fall in saving coincides with rises in consumer debt which has broken the £1 trillion barrier fueled by the recent low inflation and nominal interest rates and since 2000, many individuals have purchased so called but-to-let houses as a form of investment which may contribute to retirement income but this risky because it is widely suggested that house prices are strongly overvalued, while supply of rental homes exceeds demand. With high leverage (often 90% or more) on such purchase, there is a danger of negative equity if prices fall or at least negative cash flow if interest rates rise (base rate risen 5 times since November 2003 to 4.75%- get proper figures). There are also taxes on rents and on sales of second properties, hence such investment are seen as inferior to pension fund investment (Pension Institute).    

So should Government take a more interventionist approach?

Should the government impose stricter rules on the pensions industry and force individuals to save more by pursuing a policy of command and control to correct this worsening market failure? Well, pensions are regarded as a normal good therefore if real incomes rise, the demand for pensions increase, so with that in mind, it might be reasonable to suggest that the government should focus on polices that will improve the supply side of the economy. Rising targets levels of Gross Domestic Product will lead to increase in the demand for labor and the unemployment rate will fall. Consequently, fewer individuals will be claiming benefits whilst at the same time National Insurance Contribution (NIC) will increase. The alterative is for government to increase National Insurance contribution and income tax, so that the increase in tax revenues can be used to pay higher state pensions to retires; it would cost nearly 3p extra in tax on every pound earned to raise the basic state pension from £80 to £105 a week (The Economist). However, critics would argue that if the UK wants to compete internationally, it needs to operate as a low-tax country and as the graph below illustrates, the overall tax burden is already quite high, roughly equal to 36.7% of GDP (get graph for Condrens Report, pg 11)

Tax increases might lead to disincentives to work, those on low incomes might feel they would be better off claiming benefits after the tax deductions. Others may find that the marginal benefit of working an extra hour doesn’t exceed the marginal benefits of an extra hours leisure time. Individuals may therefore not work as hard, so an option is for the government to hypothecate the “jobs tax”. In this way workers would know that the funds raised from higher NIC’s or higher rates of income tax were going directly towards increasing old people pensions, a benefit that they may have to rely on in the future.

Regulation and Retirement Age

A sensible option would be to raise the age of eligibility for the state pension. The current age for men was set in 1925, when life expectancy at 65 was 11 years (now it is 16 years- The Economists), but the government is afraid of attaining the tag that it wants to make the public “work till they drop”.

Recent scandals justify the need for a certain degree of regulation in the pension industry. Legally enforceable protection for schemes and benefits would reward employers who make decent provision for employees’ welfare and remove the opportunity for bad employers to plunder employees’ retirement income. Treating pension contributions deferred pay, bestowing on them the same status as pay in employment would go a long way to restoring consumer confidence in pensions. However, policy makers must bear in mind that too many imposed restrictions on pension providers could stifle competition by creating barriers to entry in the industry thereby making consumer worse off in the long run. However, empirical evidence has shown that leaving pensions provisions to the market results in miss-selling and under consumption by individuals who fail to realize the long-term benefits of saving for the future. Clearly, a fine balance needs to be struck between supply side policies that encourages a competitive market and the use of regulation to protect society from the miss-selling and misappropriation of funds.

Boosting the Workforce

Both workers and pensioners can have the consumption they expect if productivity rises sufficiently. EU enlargement will allow more immigrants to undertake many of the lower paid jobs available in the UK. This could lead to increased productivity as well as increased NIC and the extra revenue generated could be used to support pensioners. However, the immigrants will eventually retire themselves and their addition to the labor market will put extra strain on public services and finances. This policy relies on and necessitates a steady inflow of immigrants, which also raises social cohesion issues.

Increasing the domestic supply of younger workers i.e. having more babies– could also be desirable and if current trends continue, probably necessary. But the government will have to tread warily here. Whether or not to have children is one of the most private of all decisions, and the coercive social-engineering schemes should be repugnant to any liberal democracy. Nevertheless, the reason for plummeting birth rates in Europe may have something to do with the choice already forced on too many young women: start a career and put off childbearing until much later in life (which leads some to forgo it altogether) or have children but miss out on the chance to compete in the workplace. Removing the obstacles to women having children and pursuing a career simultaneously, through changes to the tax system and employment law, would not only help the next generation of young women and their children, but eventually their parents and grandparents as well.

Conclusion

The problem faced by society when it comes to funding retirement stem from a number of demographics, economic and social factors. Given today's increasing climate of uncertainty and the lull in pension consumer confidence, the pension crisis poses a serious and tricky problem for the government. The government needs to be firm in their response and by creating the Pension Commission to look into the pension crisis, and awaiting their recommendation (due to be published after the 2005 General Election), it shows that they want to resolve the situation.

The government has the option of making contribution to private schemes compulsory or they should look at pursing more affordable housing so that individuals have money to put in saving accounts after they have met their mortgage re-payment. Companies should be encouraged with incentives to offer final salary defined benefits schemes and the government should protect promises to pay by laws so that individuals will be certain of what to expect when they retire and will therefore be more confident to participate.

Although stakeholder pensions are cheap and flexible they have not been sold hard enough in the UK and the reality is that individuals will face poverty in their old age unless they save has not been communicated to the public well enough, government should alert people of the need to save more and local authorities should be encouraged to get the message across.

It could increase the state pension to a reasonable level, so that people could choose either to live in it or save in order to supplement it. It could carry on with means testing but make some retirement saving compulsory. Either of those would be unpopular because the first would jack up taxes and the second would have much the same effect. So a balance needs to be struck between raising the tax burden and raising the contribution and saving levels and workforce in the population.

To most people especially the younger generation, pensions schemes are too complex and there is a lack of trust in the industry. Getting advice from a financial adviser can be costly. Perhaps local authority officers should offer a free service educating the younger generation about the importance of saving and how best to go about it. Financial intelligence is what the government should be encouraging so that individuals are confident that they are saving and investing their money in the most efficient way possible. Demographic changes present a real concern and needs to be taken seriously but by gradually increasing the retirement age and pursing the right balance of command and control, market based incentives and public information and incentives, combined with some supply side policies, it is not unreasonable to suggest that the pensions demographics time bomb can be defused.