New thinking on old age

Nov 30th 2005
From The Economist Global Agenda

Britain’s Turner Commission has recommended raising the retirement age to 68 and introducing a new type of savings scheme. Across the rich world, governments are searching for ways to ensure that their citizens are taken care of in their old age. Can lawmakers fix their pension problems before it is too late?

NOTHING, said Benjamin Franklin, is sure in this world except death and taxes. These days, however, many in the rich world are faced with another certainty: old age. This has left politicians struggling to work out how society should take care of this rapid surge in geriatrics.

Britain is the latest country to search for an answer. On Wednesday November 30th, the Turner Commission, which was charged with finding ways to make the pension system more robust, released its report. This urged the government to make sweeping changes that would force people to save more, and to remove the perverse incentives not to do so.

Under the Turner plan, everyone would feel the pinch of putting Britain’s faltering retirement system right. The commission recommended slowly raising the state pension age, preferably to 68, by 2050. This would not be popular with pensioners. It would also be hard for the government to defend, given that it recently cut a deal to let those already working in the public sector retire at 60.

The report also endorses a new voluntary savings scheme, into which workers would put at least 4% of their wages, with employers contributing 3% more and a further 1% coming from the government in the form of tax relief. While the system would be voluntary, the commission suggests making it “opt out” rather than “opt in”, meaning that workers would be automatically enrolled, but could choose not to contribute if they wished. Recent research indicates that “opt out” systems substantially raise the rate at which workers contribute. This does not exactly please companies, which are complaining that the new plan would put thousands of small firms out of business.

Britain’s Treasury would also take a hit. The current system contains perverse disincentives to save for middle- and low-income workers, because supplemental benefits are means-tested (handed out according to income and other resources). The commission wants the government to reduce means-testing by beefing up the basic pension, including indexing benefits to wages, rather than consumer prices, which tend to rise at a slower pace; continued price-indexing would steadily erode the benefit as a proportion of average earnings. But wage-indexing will not be cheap. While Tony Blair, the prime minister, has already come out in support of the plan, Gordon Brown, the finance minister (and Mr Blair’s presumed heir as Labour leader), has dismissed it as too costly. The plan’s defenders argue that Britain’s current system is unsustainable; workers are not saving enough, meaning that the government will have to bail them out somehow.

Continental crunch

Britain is not the only country trying to figure out how to support the elderly in an era of ever-lengthening lifespans. Continental Europe’s lavish government benefits guard the old against poverty, but are threatening to bankrupt the states that offer them; the French finance minister told parliament this week that the government was looking at an unfunded pensions liability of €900 billion ($1.1 trillion) on top of already record levels of public debt. Forced savings schemes have become more popular, but the amounts are often too small to substitute for a traditional pension.

The big question for all governments is who should provide for people in their old age: businesses, governments, or the citizens themselves? Individuals are best placed to gauge how much retirement income they need to live comfortably, and when they are really too old to keep working; one-size-fits-all benefits encourage people to leave the workforce before they need to. But individuals are also the most prone to, and the least able to withstand, bad investment choices. And low-income workers often can’t save enough.

Employers are better at investing. But pensions require them to make promises that come due half a century later—when market conditions may have changed radically. This is what is now devastating America’s carmakers and big airlines, and why companies in Britain and America are feverishly switching their workers out of defined-benefit pensions into voluntary savings schemes. Moreover, employers are often tempted to overestimate the returns they will get on their pension-fund investments and shrug off the liability in bankruptcy if things go wrong; thanks to such behaviour, America’s government-chartered pension insurer, the Pension Benefit Guaranty Corporation, looks increasingly likely to require a costly bail-out. And having your retirement dependent on the same firm that provides your pay cheque puts all your financial eggs in one basket—a violation of basic investment principles.

So are government pensions the answer? Unfortunately, they have problems at least as large as those of private schemes. Government systems are generally pay-as-you-go (PAYG), taking benefits for retirees out of current workers’ benefits—in contrast to private pensions, which generally pay benefits out of investment earnings. PAYG schemes work very well as long as the workforce is steadily growing. Throughout the rich world, however, the pyramid scheme is rapidly running out of new victims, as birthrates fall well below replacement rates, particularly in Japan and continental Europe.

Ironically, government pension schemes may be victims of their own success: new research suggests that generous public pensions actually encourage people to have fewer children, since they no longer need offspring to care for them in their old age. But because none of today’s lawmakers will be present when the pensions time-bomb finally explodes, they often give into the temptation to put off painful changes to the system. Those public pension schemes left unreformed will eventually blow up, and the resulting mess will be extremely difficult and expensive to sort out. And unlike individual or corporate pension disasters, their failure will engulf the entire nation.

Britain is not the only one trying to get its citizens to work longer and save more. George Bush’s partial-privatisation scheme for Social Security is intended to make America’s beleaguered welfare programme more stable in the long run by setting up a forced savings scheme that would give workers a separate source of income. But the president’s plan would cost a great deal of money now; predictably, it has stalled in Congress.

Pension reform is also on the agenda in Italy. Last week, the government finally pushed through a pension reform bill that extends the retirement age to 60 for many workers, encourages them to save more, and tries to make them invest their severance pay in private pensions. However, this is at best a partial solution to Italy’s pension problem. Furthermore, in order to ease the pain, the government has agreed to delay implementation for two years, until 2008, which gives the bomb longer to tick.

The problem, in a nutshell, is that governments have simply promised pensioners more than a shrinking workforce can realistically deliver, and even now few of them are facing it square-on. Fixing the problem means big bills—to deliver on promises to current retirees in the PAYG systems, and to put new workers into schemes that are more actuarially sound because they rely more on growth-enhancing investments. This would enable the economy to support more retirees per worker. But it remains to be seen whether politicians are any more willing than their voters to delay gratification.

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