Philip Coggan: An age-old problem

The corporate sector is already struggling with the cost of providing pensions. Now it is the government's turn to try to cut the bill.

The UK government this week proposed raising the retirement age of civil servants to 65 and switching the basis of their pension from final salary to a career average.

The unions are already protesting, but the package is far less savage than it appears. The switch from final salary to career average is revenue-neutral because, according to Stephen Yeo of Watson Wyatt, a more generous accrual rate will be applied. Civil servants will, initially at least, contribute just 3.5 per cent of their salaries less than many in the private sector. The government's bill will be cut by just 2 per cent a year.

The scale of the taxpayers' commitment to fund public sector pensions has not been widely publicised. The most recent estimate (March 2003) by the Government Actuary's Department was that unfunded liabilities were £425bn. But Watson Wyatt has estimated that the figure has since risen to £580bn, or about £10,000 for everyone in the country.

That may not be the full extent of the government's pensions bill. It is easy for governments to say that the corporate sector has to look after itself. But when companies go bust and workers are left with a fraction of their pension rights, people demand action. Pressure forced the government to stump up a “financial assistance scheme” to help workers whose employers went bust between 1997 and May 2004. But the £400m fund is widely seen as inadequate.

The government's other measure has been to create the Pension Protection Fund, a scheme that will allow the pension sector to “self-insure” itself, with all premiums being paid into a central pot.

The difficulties in devising such a scheme are legion. At one extreme, there is the moral hazard problem of the strong subsidising the weak. At the other, if a lack of financial strength caused payments to rise, there is the danger of a downward spiral for the weakest groups.

But the more immediate problem is that the collapse of T&N, the insolvent car parts maker, could land the fund with an £875m bill before it even starts. Such a shortfall is not fatal because the cost is spread over decades the equivalent scheme in the US is heavily in deficit but the risk is that employers may balk at the scale of the premiums and close their schemes instead.

Furthermore if the PPF went bust, would the government really be able to walk away? It seems unlikely that they could desert so many voters.

All this is a foretaste of the longer-term battle, outlined in Adair Turner's Pensions Commission report released earlier this year, between a shrinking workforce and a fast growing pension population. Turner's report suggested four solutions to the problem. Pensioners will become poorer, taxes will rise, savings will rise or retirement ages will rise.

There will inevitably be a tussle between the generations as this becomes clear. The elderly will have the advantage of their sizeable electoral clout, boosted by their higher propensity to vote. The young will have the advantage of labour scarcity, which will push up their real wages.

Quite how this battle will be resolved is hard to tell. The old could use their votes to push up taxes so they receive their desired rate of benefits. The young, however, have the theoretical advantage of mobility. They could emigrate to another country where taxes are lower. The snag is that most developed countries have a similar ageing problem. There could be some interesting cross-border population flows as some countries opt to attract the young and others to cosset the old.

But will one of Turner's four solutions, raising savings, actually work? Only if those higher savings result in higher gross domestic product, and the example of Japan is not encouraging.

Any kind of savings a bond or an equity is simply a claim on wealth. If the elderly want to redeem that claim, they will have to sell. But to whom? The only way the younger population could buy those assets is by saving an even larger proportion of their income. But are they likely to do so? It seems more likely that asset prices will fall and that the claims of the elderly will be devalued. After all, without some phenomenal improvement in productivity, overall economic growth rates will be lower.

Are there any easier options? One theory is that we could “hitch a ride” on the back of countries with more favourable demographic trends, investing our savings in higher-growth economies. The problem, as Turner has pointed out, is that many Asian countries, including China, will face their own demographic problems in coming years. Indeed, falling birth rates and improved longevity tend to be the consequence of prosperity. So that leaves us with the option of investing in less than prosperous areas such as sub-Saharan Africa.

To add to the difficulty, investors have the problem of turning the rapid economic growth of emerging markets into portfolio profits. The past decade of emerging market crises has shown how difficult this can be. Furthermore, one would need quite a large asset allocation in emerging markets to make a big difference to portfolio returns; and how many individuals or pension funds are willing to take that risk?

Another theory, referred to earlier, is immigration. Nations could import the younger people necessary to do the work, pay the taxes and pay their pensions. The US is better off demographically than Europe because of its more relaxed immigration policies. The trouble is that this would require tens of millions of immigrants to solve the problem and, even if it were possible to attract them, it would probably not be politically acceptable.

So we are left, probably, with a combination of solutions. Taxes will be higher. Some elderly people will be worse off, notably the middle classes who previously benefited from final salary pensions. And we shall all have to retire later. I look forward to writing The Long View in December 2029.

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