No pot of money supports the promise of state pensions—the system is unsustainable. A new savings model is needed
Traditionally Christmas is a time for ghost stories. But this year we don’t need invented tales to make us shiver. There are quite enough genuine reasons in the news—enough, in fact, to obscure the really frightening developments which you cannot discern through the fog because they are a little farther off. So wrap your cloak about you and draw nearer to the fire. I want to make your flesh creep.
The largest financial hole facing the UK is not the deficit (£126 billion and sticky)—about which the Coalition is doing quite a lot, though it’s often contradictory. Nor is it the national debt (£1,039 billion and rising)—about which the Coalition proposes to do nothing at all, except increase it. No, the grimmest spectre haunting us is the liability attached to the state pension system. Depending on whom you ask, this is equivalent to possibly £2,000 billion, a figure nowhere incorporated in the public accounts.
We are living longer and we are having fewer babies before we die. Also, we have stopped saving, either because means-tested welfare has made saving irrational, or because low real interest rates have undermined its value, or because we’ve all become short-sighted. It’s probably a mixture of the three.
The state pension is unfunded. No pot of money supports the promises made. Like a vast Ponzi scheme, current contributions from workers finance current payments to pensioners. Thus, as a matter of inescapable arithmetic, if the number of recipients goes up, they receive for longer, and more of them are dependent upon the state because they have no savings of their own, while the number of contributors falls in relative terms, then the burden on the contributors will escalate. And a heavier tax burden on future contributors will leave them with less disposable income, which reduces their ability to save, making more of them dependent upon the state when they retire, which will cause the problem to snowball even faster. Furthermore, this system of dole-pensions carries a high administration cost: to track people, to record their notional accrued entitlements, and then to make small, regular payments to them in their old age.
The system, then, is a recipe for escalating tax burdens which are simply unsustainable. And everyone knows it. The Ghost of Christmas Present is hardly a bundle of laughs, but the Ghost of Christmas Yet To Come offers nothing but Dickensian squalor. Perhaps the natives of Borrioboola-Gha will send us food parcels.
If you wanted to design a state pension for the UK from scratch, you would not do it this way. Every commentator has his own preferred wheeze, with its unique bells and whistles, but across the literature there is a degree of consensus. We want to encourage people to save to provide their own funded pot, so there should be a tax-shelter in which they can accumulate reserves, with a generous annual allowance—something like a super-ISA. In fact, it would be sensible to amalgamate the various forms of tax-favoured saving (ISAs, pensions, etc) which would reduce management costs, and so improve returns and thus the eventual pension paid. Legitimate concerns about pensioner poverty could be addressed by contributions from the Exchequer. My favourite mechanism would be a seed capital contribution to each pension plan, paid at an early age and set at an amount that on pessimistic assumptions about investment returns and optimistic ones about life expectancy, would accumulate over a working life to provide an income at least as high as the state dole-pension would have been. As a nice touch, you might want to exempt the new arrangements from inheritance tax, so that when people die before they draw their pension, or before exhausting their fund, they can pass on their savings to their children’s pension plans. The quid pro quo would be an increase in the retirement age.
It is not very difficult to devise a new form of saving vehicle along these lines. Nor is it too difficult to see that such an arrangement would cost far less than the current system. In hard economic terms there is no difference between paying a dole-pension to a retiree every week for the rest of his life and giving him a one-off lump sum equivalent (currently, at least £60,000). That is the principle behind annuities. However, there is a significant difference if instead you pay a one-off lump sum to a young person so that it can accumulate over his working life to a fund equivalent to a dole-pension by the time he has reached 70. One-off lump sums to a few hundred thousand people born in the same year would cost far less than weekly dole to several million pensioners for as long as they live. Increased tax relief and exemptions would be only a fraction of a fraction, and would be offset by reduced administration costs and the wider benefit of higher levels of saving and investment.
State pensions cost around £100 billion a year, but within a few decades this can be expected to more than double in real terms and to keep rising. The cost of “super-ISA” pensions would depend on the age of the recipients but would probably be about the same as the current cost and, crucially, it would remain stable. (Older people, having a shorter time to accumulate savings, would require a larger seed contribution than younger people, but there would be fewer of them as the grim reaper thins their ranks, so it would most likely all balance up.) Hence, if we had this sort of state pension system, by about 2040 (when I will be collecting my pension) it would save the state at least £100 billion. Which is quite a nice little windfall for our children, don’t you think?
The Coalition, of course, would claim that they are doing something. They have “faced reality” and “taken the hard decisions”. And in fairness, the Coalition has accelerated the increase in retirement age to 70 and implemented a footling scheme of auto-enrolment for personal pensions. These measures are little different from ideas proposed by Gordon Brown. They still assume that people will save themselves by saving for themselves—even at a time of austerity when it is harder for them to do so. Raising the retirement age by itself will not solve the inherent flaws of the dole-pension, which are a matter of demography. (Measures to reform welfare by tackling its alleged abuse by feckless unmarried mothers seem particularly unfair: the feckless mothers are, at least, doing something to relieve the coming demographic crisis.)
By emphasising the need to control expenditure the Coalition has courted the austere image of Ebenezer Scrooge. That is most undeserved. Scrooge was successful. The Dickens character whom this government most resembles is Mr Micawber, forever hoping for something to turn up. Despite their rhetoric, on pensions Coalition ministers are merely deferring the need to face up to the demographic crisis to a time when they will have moved on to heaven, hell or the House of Lords.
If it is so obvious that a state pension based on lifetime accumulation is better than a retirement dole system, you may wonder why the change has never been made. There is a poison pill at the heart of the current system. A Ponzi scheme only works so long as the music keeps playing and none of the participants wants to withdraw. Current workers pay for current retirees, in the expectation that a future generation will pay for them in turn. If you switch to an accumulation system, older workers will not have sufficient time to build up funds to provide an adequate future income and no one will be picking up the tab for the already retired. That means those groups will have to be compensated by what amounts to buying out their accrued pension promises—at a cost of about £2 trillion. The state, of course, would have to recoup that sum by placing additional burdens upon the current workers, who would end up paying twice. The choice is between throwing granny into the gutter and taxing her descendants into the workhouse.
Nor is it feasible to borrow the funds now and repay them later as the savings are realised. Ignore the minor point that this is not really the time for the Treasury to try to borrow £2 trillion. Even in the unlikely event that rates remained at their present historic low level, the interest charges that would be incurred until the whole debt was redeemed would obliterate any savings from making the change and distort the capital markets in the meanwhile.
So, while accumulation-based pensions offer us a land of milk and honey, no government has risked the trek through the desert to reach it. What is needed is a way to get our hands on all that lovely future money so that we can spend it now. But no one has yet been able to invent a method to do so.
Let us conduct a thought-experiment. Suppose the Treasury knows that, as a result of reforms to the state pension system, it is going to save money. It could instruct the Bank of England to issue a voucher to represent £1 of that money now, to be redeemed later. Since there might be a delay, the face value of the voucher would be index-linked against a sensible measure of genuine inflation such as RPI. So a 2013 voucher for £1 would be redeemable at, say, £1.04 in 2014, or £1.09 in 2015, or whatever. The Bank would issue vouchers and inform participants that they could be used for investment within a pension plan—and only for that purpose. Taxpayers could not turn up at a corner shop and use them to buy cigarettes, for instance.
That would make the vouchers a bit like money, but not money. It would make them rather like the vouchers issued by supermarkets with their loyalty cards, which have a value when used to buy goods from their shops but are utterly worthless elsewhere. Why would the pension providers accept these vouchers? It would have to be a requirement of the new regime that they would have to accept them, and could use them as legal tender at their uprated face value to acquire financial assets (shares, bonds, etc) from financial intermediaries or issuers. To ensure that intermediaries and issuers accepted them at face value they in turn would have to be entitled to deposit them with a bank as if they were cash. Thus, if Jarndyce & Jarndyce plc issued £1 million of new shares it would make no difference whether it received cash or vouchers in exchange.
So these vouchers would be a form of ghost-money, and quicker than you could say “Bob Cratchit” they would all end up inside the banking system. The banks, of course, could not issue them to their own customers, so this ghost-money would not enter the “real economy” but they could use them in dealing with other banks or in their own market trading activities. A bank could hold vouchers as risk-free assets worth their face value, serenely confident in the guarantee of their ultimate redemption by the Bank of England, and behind them the Treasury (and what could possibly be more reliable than that?). But maybe, just maybe, a bank might prefer not to wait. There would have to be a provision that a bank could tender vouchers to the Bank of England as payment for any transaction between them. This willingness of the Bank of England to accept them would be the ultimate underpinning of the value of the vouchers. Quicker than you could say “Tiny Tim”, we could expect the vouchers to have made their way back to where they started, the Bank of England.
What would happen next? Nothing. Individual citizens would have paid-up pension plans with real financial assets inside them. The vouchers (assuming that anyone bothered to print them, instead of using electronic registers) would sit inside a vault in Threadneedle Street until such time as hard cash arrived in the Exchequer. Then the vouchers would be redeemed, the Bank of England’s corresponding liability to the Treasury would be liquidated, and the value created when each voucher was issued would be withdrawn from the economy. The ghosts would have dematerialised. Job done.
Now, a few awkward types might have objections. You might say, for example, that this is simply an exercise in make-believe, with the vouchers only having a value because the government has arbitrarily decided they should have that value, and everyone else decides to play along with them.
Yes—and what do you think money is?
You might argue that it is nonsense to claim my vouchers would not somehow get into the “real economy” and that the process is nothing more than a government printing money and unleashing inflation.
Not really. We could expect a rise in the price of financial assets and a boost to investment. A slump is a good time to have those. Our ghost-money would not be haunting the shopping malls. The process is self-correcting because the value of the vouchers is clawed back when they are redeemed.
You might claim that this is nothing more than quantitative easing by another route.
That’s fair. The comparison favours my thought-experiment. Under quantitative easing the Bank of England has pumped £375 billion (so far) into the financial system, inflating asset prices but otherwise without any clear idea what has been achieved, who has benefited and how we are going to exit from the process. Under my vouchers value would be pumped into the financial system, inflating asset prices, hiking the amount of saving in the economy, giving everyone the assurance of a reasonable retirement which was not dependent on the generosity of future politicians, partially recapitalising the banks, escaping the effects on the public finances of the coming demographic crisis and with a clearly defined exit via redemption.
You might object that since the vouchers are a liability on the public finances, this idea represents a not-very-well camouflaged explosion in the National Debt.
Well, they are only debt in a Pickwickian sense. The vouchers do not actually add to the liabilities which the public finances have to support. Successive governments have had these obligations since 1946 when the current state pension was adopted. The only difference is that successive governments have not bothered to admit this. If a company treated its pension fund in the same way as the government, its directors would be guilty of false accounting. Through the vouchers an open-ended, unfunded and unquantified liability would be changed into something that is capped in real terms, hard and marketable and used to fund personal pensions for everyone. To that extent, the financial engineering involved could be called Qualitative Crystallisation.
From there, it becomes a numbers game. This is how the transition would be managed.
First, pick a starting date, such as April 6, 2013. Next, pick a starting age, such as 20. Everyone who was that age on the starting date would receive vouchers with a value projected to accumulate over 50 years to a fund that could generate an income equal to the state pension for 30 years. (We might as well assume that everyone is going to live to be a centenarian—a nice margin for error.) Individuals, and their employers, could add further contributions, but even if nothing else was saved a decent retirement income would be available. In the following year, the next cohort of 20-year-olds would be brought into the new system.
The final parameter is a threshold age, such as 45. Everyone who was 45 years or older would remain within the existing dole-pension arrangements, which would survive for as long as the group does. That leaves a broad band of people who are aged 21-44 on the starting date and who would be brought into the new system gradually, receiving an amount of vouchers depending upon how old they were at the time of receipt. Phasing would allow the Treasury to regulate the total value of vouchers outstanding at any time. At some point cash savings would start to flow through and could be applied to redeem vouchers, and eventually it would no longer be necessary to use vouchers for the seed contribution. We would have made it through the wilderness. Then (if not before) the government could reverse £100 billion of tax increases.
Christmas and New Year is supposed to be a time for taking stock, for renewal and for new hope. But making resolutions to be better are worthless unless they are kept.
Since the credit crunch of 2008 we have heard a lot about “zombie banks”, institutions which are functionally insolvent but which stalk the earth in a living-dead state (by concealing the truth about their finances). In the UK we have a zombie state pension, sustained by a zombie ideology. We no longer believe in the ideas of 1945. They do not work. They never will. So why are we putting ourselves through such pain trying to make the unworkable work?
The time to exorcise this problem is now. If we do not sort out the state pension while we have the chance then we face the prospect of ever-rising deadweight taxation and cheese-paring meanness towards our elderly. Third-rate provision amid a second-rate economy.
Alternatively, of course, you could always pray for a massive outbreak of pneumonia.