The UK state pension system is in financial difficulty. Can we remove the problem by moving to a funded basis? Some think we can. They’re wrong, as it would be no solution at all.
The most recent proposal of this kind, covering the UK as a whole, comes from Reform Scotland, which styles itself as an independent non-party think tank. Its Universal Contributory Pension would see employers and employees make mandatory investments in individual pension arrangements, building up earmarked funds to be drawn upon at retirement.
The current UK State Pension system is operated on a Pay As You Go (PAYG) basis, whereby the cost of today’s pensions is met by the current workforce. Pensions from employment (at least in the private sector in the UK) do not typically work in this way, but are instead savings in the real sense, because the contributions made are actually invested (in shares, government bonds, property and so on), thereby building up a fund of valuable assets, held either in common for a group of people or on an individual basis for each contributor. This approach is referred to as a Fully Funded (FF) arrangement.
Before commenting on the detail of the Reform Scotland proposal, it’s worth looking at the bigger (macroeconomic) picture here regarding funding basis. It would be possible – at least in theory – to run a FF state-sponsored pension for the UK, but it would in truth be a smoke and mirrors solution to the current financing difficulty, because moving from PAYG to FF would not alter the nature of the fundamental problem being experienced.
Where the state scheme is run on a PAYG basis, the right to receive a pension is essentially a political right, the terms of which are set out by the state. There is a transparent transfer of value from the current workforce to pensioners.
Under a FF scheme an individual accumulates assets which may be called upon (realised) in the future, i.e. the right to receive a pension is a financial one. The return on the investment is obtained from current economic activity, which means that the materialisation of the pension right is in the form of payments to previous investors by those then economically active. That is the same as saying that the working population subsidises the retired one, i.e. there is as much of a cross-generational transfer going on as there would be for PAYG.
Although there’s no-one suggesting that the UK PAYG set-up be replaced by a single FF scheme (although Bill Clinton did suggest something similar for the US), it’s worth thinking through what it would mean were that idea to be pursued.
The UK public-sector pension liability on its own is equivalent to about 81% of GDP. There’s no corresponding published figure for the State Pension (because it’s viewed as not being a fixed commitment, i.e. not a contractual liability), but we can get a rough idea of scale by noting that current pension payments under it are more than twice those for the public sector. It’s clear that the size of the fund required for a FF scheme for the UK would by some margin exceed the whole of the economic output of the country.
Some of the investment would have to be placed in other countries, leading to potential mismatches between the returns achieved and the rate of growth targeted, overlaid by currency risks. For a country the size of the UK, the management of a fund of the scale in question would be an immense undertaking.
The alternative to a single giant scheme is the replacement of the UK state-sponsored set-up by a huge collection of separate arrangements, covering some groupings of people (typically on an employment basis) as well as bespoke ones for individuals. The point about scale still stands, though: when considering the aggregation of all these arrangements, the investment difficulty is exactly the same as if they formed one mega-fund.
There isn’t much to the mechanics of PAYG: contributions are levied and used to make payments to pensioners. As a result, a large-scale scheme typically experiences administration costs of 3-4%.
On the other hand, privately managed FF pensions typically have administration costs of around 20%.
A 1995 OECD study suggested that “… if … left untouched, the [public] pension schemes … would impose major burdens on their societies in the next century, either through requiring higher taxation or other spending cuts, or by rapidly increasing public debt burdens …”.
That can’t be disputed and it’s as true today as it was at the time. The thing missing from it is that this argument would apply equally if the pension schemes were equivalent FF ones and the level of pension provision were to remain unchanged.
In the US there are funded public-sector pension schemes, such as those operated at the level of a particular State. Many of these have run into difficulty, caused in the main by rising life expectancy coupled with lower than predicted investment returns. In many cases, the only option for recovery has been a bail-out by the taxpayer.
What individuals value about state-sponsored PAYG pension schemes is the pre-determined nature of the benefit awarded. With the typical PAYG scheme, the pension entitlement is fixed according to a scale (contribution-based for the UK); if the total outlay rises (because of changes in the dependency ratio or in the values of benefits), contribution rates for the current workforce must be increased if the scheme is to be restored to balance (and vice versa, of course).
With funded schemes, there is no such benefit scale. The ultimate payment for anyone cannot be known in advance as it will depend on the investment performance experienced during the contribution lifetime. The benefit is simply whatever the proceeds happen to be at retirement, which means that the balance is therefore automatic (in a literal sense). The realisation of their savings by pensioners is linked to the ability (and willingness) of active workers to invest in savings themselves. (If I want to sell my shares, someone else has to want to buy them.) If the population structure ages and there is an increase in the cashing-in by the retired, then either there must be a compensatory rise in the level of saving by current workers or else there will be a decrease in asset values, reducing the worth for pensioners.
What doesn’t get admitted publicly is that the attraction to policy makers of replacing public schemes with private, funded alternatives is all about the politics of presentation. The unspoken advantage is that, in the absence of intervention, the real value of pensions overall finds its own level, matching the available resources. No explicit political action is required to achieve this.
There may be disappointment with pension values resulting from private funds, but there will be no apparent link at the time to any political decision taken. A reduction to a state-sponsored pension, on the other hand, will be blamed on the government of the day.
Reform Scotland Proposal
I mentioned earlier the recent proposal by Reform Scotland for a move away from PAYG to individual funded arrangements. The current UK pension landscape includes private, funded schemes, but these are in addition to the centrally-provided State Pension, not instead of it. Where Reform Scotland departs from this established orthodoxy is in suggesting that its Universal Contributory Pension should replace the existing National Insurance pension set-up completely.
The argument put forward by Reform Scotland is that people are “totally reliant on politicians and policy makers, as well as the performance of the economy, over the next twenty, thirty or forty years that they are working” and that “politicians can move the goal-posts at any time”. This is all true; but, as explained above, these observations apply equally to a funded set-up.
With a defined benefit PAYG system, there is a benefit scale known to you in advance. Undoubtedly, it will be subject to amendment from time to time, for political or other reasons (see the WASPI discussion, for example), but it is otherwise pre-determined in nature. With a funded scheme, on the other hand, you can never make predictions about benefits with any certainty at all over the medium to long term.
A major defect of funded pensions is, therefore, that there can be no guarantee about the results. The high administration costs, coupled with any prolonged period of low nominal returns, will depress outcomes. Unfortunate investment choices will do the same. If any part of the pension saving regime is voluntary, many – particularly the young and the poor – will make only the minimum allowable contribution. Even where the contribution is compulsory, it will largely be made at the expense of other saving, i.e. it will replace voluntary saving rather than being in addition to it. Overall, the resultant risk is that a significant section of the population will not end up with sufficient to sustain a decent standard of living.
The main fallacy underlying proposals such as Reform Scotland’s comes from a skewed comparison, which is that of a PAYG set-up operating in adverse demographic conditions with a FF arrangement which has the good fortune to experience sustained favourable investment conditions. If instead the PAYG scheme is in balance regarding contributions and benefits then there is no problem. If the economy tanks, there will be a call for pension subsidies, irrespective of the take-up of funded pension provision.
To be fair, Reform Scotland does acknowledge this, by telling us that the state would be providing a safety net, in the form of a “minimum guaranteed income in old age”, in the same way as is done currently via Pension Credit; but, the implications of this caveat are not dwelt on in the report.
No matter the balance between public and private provision, if pensioners do not have enough to live on, it will be the state which will have to supply the welfare underpin. This responsibility cannot be privatised, but will be paid for via taxation by the workforce at the time. (Sound familiar?) Once there is a guarantee of this kind, a funded system is no better than PAYG in terms of exposure to the risk of a demographic time bomb.
Then there’s the “roll back the frontiers of the state” mindset, the latest incarnation of which in the UK is “take back control“. There’s a clear political agenda at work: state provision bad, private good, no matter what the actual outcome might be. (The current debate on healthcare in the US is a great example of that.)
PAYG pension provision is relatively egalitarian. Under FF the benefits are directly linked to the amount invested, which is itself related to income during the period; the result is that the distribution of income for pensioners is highly correlated to the same when working. Woe betide you if you had prolonged periods out of work or even of part-time employment.
The rich stay rich and the poor stay poor. That philosophy shouldn’t be let anywhere near the design of a universal pension system.
Despite the FF hype, the plain truth is that PAYG is the only way to operate state-sponsored pension provision. That’s not to say, however, that the current UK scheme design is optimal. More on that in the next article in this series.
1. Before someone tries to pull me up on this – in the natural world a mirage is not the same as a hallucination, because the image it projects is of something which does actually exist somewhere. Nonetheless, it is still an illusion, without reality in the context in which it is perceived.
2. I acknowledge that I have drawn heavily here on the arguments and discussion documented in the papers published by UNECE (United Nations Economic Commission for Europe) available via this link, particularly regarding the contribution by John Eatwell, the Cambridge economist and Labour peer.
3. As I’ve covered elsewhere, strictly speaking in the UK it’s a benefit rather than an absolute right, as it can be amended by a government at any time. One of the frustrating aspects of the UK’s state-sponsored pension is just how often its terms do get changed.
The fund holds 1.32% by value of the equity shares of the entire world and 2.33% of European stocks. 70% is invested outside Norway.
More than 200 staff are employed in Oslo and another 100 in offices in New York, London, Shanghai and Singapore.
6. Australia provides an old age pension paid from general government revenue. On top of this is a regime of private sector schemes into which are paid mandatory levels of employer contribution and additional, voluntary contributions from employer and employee. More than 90% of employed Australians have savings in such “Superannuation Funds”.
The total value of the assets accumulated comfortably exceeds the country’s GDP, which has led to concern at the impact of any mass disinvestment that might be triggered at some point in the future.
9. The Auto-Enrolment initiative in the UK has resulted in many more people saving towards private pension provision via Workplace Pensions. Despite this success, between 2014 and 2015 the average employer contribution fell from 6.1% of salary to 2.5% and for employees it dropped from 2.9% to 1.5%.
10. Previous incarnations of the UK state-sponsored scheme have included a component related to the income level during employment. This was always in addition to a basic, flat-rate pension entitlement, however.
Likewise, whilst there has always been a contribution record aspect to the basic pension, the point is that once the full qualifying period has been reached the entitlement remains constant thereafter, as well as being the same for everyone.