Pensions #1 – Our Ponzi Scheme

I saw a letter to a newspaper recently that described the UK Government’s pension arrangement as a Ponzi scheme.  It’s an observation that surfaces every so often.[1]  The claim isn’t daft at all, but it’s also not quite the whole picture.

As a response to this, I’m publishing a short series of articles on pension provision in the UK, starting here with an explanation of the workings of the state-sponsored scheme, covering the way it is financed and the nature of the demographic problem facing pensions in the future.

This first post will be a somewhat lengthy introduction to the subject.  I’ll keep statistics and other figures out of the main section to aid readability, but that will mean an extensive set of footnotes to ensure that the detail is captured somewhere.

Further articles will deal with some other topical aspects and then I’ll end with a discussion on pensions in a putative independent Scotland.

Ponzi & His Scheme

Let’s go back to that newspaper letter.  A Ponzi scheme works by persuading people to invest by promising quick returns, which are indeed delivered to begin with.  In fact, the money received is not invested at all, but instead siphoned off by the fraudsters.  The trick behind the initial success is that those “returns” to existing investors are really taken from new money put in by further, new entrants to the scheme.

Charles Ponzi
Charles Ponzi (Boston Public Library)

If there’s a good, expanding flow of new contributions, the scheme appears to work well, in line with the promises made.  The problem arises when the growth levels out, as it must eventually do.  (Even if the scheme expanded to the maximum possible – the entire adult population of the world – where would it go next for new investors?)  The arrangement stops working when there are not enough new members to pay the dividends promised to the existing ones.  By then the original swindlers have long since done a bunk with their ill-gotten gains.

In Puerto Rico there’s a scandal emerging as it has recently become apparent that the Teachers’ Pension Fund, which opted out of the US Social Security set-up, is effectively now operating in this manner and is soon to hit the buffers, financially speaking.

The difference between the circumstances of Puerto Rico dominies and those of UK pensioners is that the scheme for the former group wasn’t meant to end up like this, whereas in the case of the latter the funding is consciously designed along these lines.  There was no intended fraud at the heart of the UK arrangement, of course, which is one way in which the Ponzi comparison falls short; but the essence of the long-term problem is still pretty much the same.

UK National Insurance

In the UK we have something called National Insurance, which funds

  1. the National Health Service (NHS)
  2. the old age pension paid by the Government (now the State Pension)
  3. some other pensions continuing from older arrangements
  4. pensions from public-sector employment
  5. some other benefits (unemployment, sickness, maternity and so on).

We pay National Insurance Contributions (NICs), which are deducted directly from earnings in the same way as Income Tax.[2]  Based on your NIC record, you build up an entitlement to a pension from the UK Government, payable from State Pension Age.  After the share allocated to the NHS is set aside, these contributions are directed to the National Insurance Fund (NIF), which is the vehicle used for the actual payment out to pensioners and others.

National Insurance stamp (1948)

You’d be forgiven for thinking that your NICs are pooled together in some giant piggy bank, with money being withdrawn from this in due course to pay the weekly pension to you after you retire.  In that way, you’d be “saving up” to secure your future comfort in old age.  The truth is very different, however: the NIF is not that kind of animal at all, but does indeed resemble a Ponzi scheme in many ways.

In fact, there is no savings pot built up. Instead, current revenues are used to fund current pensions, i.e. money is taken from today’s working population (new investors) and this is used to pay today’s elderly (existing investors).  The NIF is not a pool of investments, but more akin to a current account to which income is sent and from which withdrawals are made.

The idea underpinning this set-up is that there should be equity over time, which works on the premise that each generation will subsidise the previous one and then in turn will be subsidised by the following one.  This mechanism is referred to as Pay As You Go (PAYG) and is really a transfer of wealth from one generation to another, secured on a promise that the equivalent transfer will happen in the future.  The deal is that you pay for your parents and then your children will pay for you.

(I’ll discuss the alternative to PAYG in a future article in this series – now available here.)

There are other pension arrangements which are the responsibility of the UK Government, namely those for public-sector employees (NHS, Civil Service, teachers etc).  These too are unfunded, i.e. they are also handled on a PAYG basis.  They are yet another responsibility of the NIF.[3]

Where the Ponzi comparison falls somewhat short is all to do with timescale.  For most people, there would be no expectation of an immediate return; instead, the pattern was to be one of paying in over the working life and only after retirement would pension benefits start to be received.  The very early versions of the UK scheme assumed that most people would be receiving a pension for a few years only and indeed that many would not live long enough to receive anything at all.  The inverted pyramid of the typical Ponzi was a long way from the anticipated outcome.

Nonetheless, it should be obvious that the affordability of the PAYG set-up is critically dependent on the relative sizes of the two sections of the population, just as it is for the longevity of a Ponzi scheme.  If there are many workers and few pensioners then the burden on the former will be accepted without protest.  If the position is reversed then it won’t be, which is equivalent to the point at which a Ponzi scheme becomes unstable.

To Hell In A Hand-Cart

Back to the National Insurance Fund, which in its current form dates from 1992 and which is as explained above effectively a current account.  The income put into the NIF consists of the NICs from employees, employers and the self-employed, plus interest made by investing its current working balance (which is lent to the Treasury on a short-term basis).

From the mid-1990s onwards, the fund had been in healthy surplus, as the revenue from NICs was greater than needed to pay for its outgoings; but then this position began to worsen, until it was projected that the NIF would move into deficit about 2015.  At that point, a subsidy from central funds was arranged to cover the shortfall and such a transfer continues to be in place for 2017.[4]

1908 Old Age Pension Act
1908 Old Age Pension Act (Liberal Monthly)

When I was in my twenties, the rule of thumb was that every pensioner was being supported by four people of working age.  Now, as I approach retirement age myself, that ratio is down to 3.3 (even after some increases to the pension age).  It’s not just that there are more pensioners; they are claiming benefits for longer too, resulting in a double-whammy impact.  As the ratio of retired to working increases, keeping the pension promises to the former will mean that the overall subsidy from the current earnings of the latter has to rise in tandem.  (The only alternatives would be to increase borrowing, which is not sustainable in the long term, to reduce spending on other public services or doing both of these.)

Given the continued aging profile of the population as a whole, because of falling birth rates and increased longevity, the funding problem is set to get increasingly worse, not better.  That’s what is meant by the “pensions demographic time bomb”.

The deal has become that you are paying for not just your parents, but also your grandparents.  The danger is that your children will be expected to support three previous generations. If we had enough youngsters in productive employment then that would be okay, but we don’t.  The growth is in the retired age groups (existing investors), not the working population (new investors).  The Ponzi collapse has arrived.

Taking Back Control

In the run-up to the 2015 UK General Election, both the Conservative and Labour manifestos undertook not to increase NIC rates during the lifetime of the new Parliament.  That promise came back to bite Theresa May’s government, when it was forced to backtrack on a proposed increase to NICs for the self-employed.

If tomorrow’s workforce refuses to reduce its consumption level in order to pay more towards meeting the unfunded promises being made today, then there are only two possible solutions:

  1. Pensions must be cut in future.
  2. The working population has to increase, by
    • encouraging a higher rate of labour force participation (reduce unemployment, increase retirement age, lower school leaving age) and/or
    • importing labour from elsewhere.

UK Governments have already trimmed away at the benefits by increasing the retirement age (particularly for women) and raising the qualification period for full entitlement from 30 years to 35.  For public-sector occupational pensions, there has been a move away from a final salary basis to a career average one, the measure of inflation used to calculate pension increases has been changed and the contributions required from employees have been raised.

Whilst these reforms have helped to reduce current costs, the longer-term problem remains unsolved.[5]  There is a clear risk that future generations will decide that the expectations of their parents will simply have to be steered downwards drastically.  That brings us to the second of the two measures set out above.

BBC Question Time

There’s a truth that no-one seems to want to challenge the Question Time audience with, which is that either we grow our own workers to provide more support for our future pensioner population or we have to import them.[6]  The complaint most often aired about immigration is that it puts pressure on public services.  The counter should be that, without it, our pensions will become unaffordable in the foreseeable future.

Immigration is vital if we are to increase the workforce and lower the population’s age profile.  In the absence of a new indigenous baby boom, we need the children born to foreign parents to stay here and become economically productive in time.[7]  That’s the only way we’ll be able to fund your pension and mine.

Immigration is not enough on its own, however, to avoid a re-appearance of the financing problem.  New workers will become future pensioners in due course, thereafter requiring support by the future workforce.  Rather than a continuing Ponzi scheme, requiring ever greater expansion of the working population, it’s vital that a balance is established, i.e. that we ensure that the pension benefits granted are fully supportable by those employed at the time.  The argument in favour of immigration now is about getting us out of our current hole.

The ultimate answer has to lie in economic growth and improving productivity.  Investment in education and training would be a good start.





1.  In 2010, the Public Sector Pensions Commission (sponsored by, among others, the Institute of Economic Affairs and the Institute of Directors) described the existing approach to UK public sector pensions as an “unstable Ponzi scheme“.

2.  Purists will insist that the National Insurance Contribution is not a tax, because it is not available for general expenditure by the Government, instead being earmarked solely for the combination of the NHS and the National Insurance Fund.  As the remit of the annual Finance Bill specifically excludes anything other than general taxation, National Insurance has to be dealt with elsewhere, thereby reinforcing this distinction.

It may be a technical fact, but in reality it’s a fiction.  NICs are a tax by any other name.  There are differences between the NI rules and those for Income Tax, but there’s nonetheless a levy being applied to income.  For those earning between £11,000 and £43,000 pa, the effective marginal rate of tax on employment is therefore more than 45% (if you include the Employer NIC).

Everyone is liable to Income Tax, whereas NICs are paid only by those working.  This gives rise to the anomaly that some people do not help to pay for the NHS, including its biggest users, the elderly.  It would seem more equitable to source NHS funding from general taxation, with a secondary benefit that the full amount of NICs would go towards the NIF.

3.  In 2014-15, the UK Government made pension payments totalling £127 billion, £89 billion in state pension benefits and £38 billion to former public-sector employees.  This represented about 1/6th of the total expenditure by the Government.

Because the State Pension is deemed to be non-contractual (as it can be changed at any time), it does not appear as a quantified liability in the Government’s accounts.  (Among other things, that means that it is not included in the published figure for the national debt.)

The public-sector pension liability, being derived from a set of firm promises, does get recorded, however: it is now the single largest liability on the balance sheet, constituting 42% of total liabilities and being equivalent to about 81% of GDP.  This represents the current value of all of the projected future payments from the schemes, i.e. it is equivalent to the size of fund required today if there were to be a move away from PAYG to pre-funded arrangements.  The net outflow each year (i.e. pension payments made less contributions received) is about 1.6% of GDP.

The burden has been compounded by the decision to take on historic pension liabilities so as to ease the path to privatisation (£40 billion in the case of Royal Mail), to allow staff transferred to the private sector to retain a public-sector pension (some 25,000 people currently) and even to extend the access to public-sector schemes to other employers, to avoid smaller external providers of services being at a competitive disadvantage.

4.  As the NIF has no borrowing powers, it is targeted to maintain a working balance of at least 1/6th of projected annual benefit expenditure (i.e. approximately two months’ worth).  If NICs are not sufficient to achieve this, the Chancellor invokes the Treasury Grant mechanism, thereby diverting money from general tax revenue in order to make good the shortfall.

This Treasury Grant for 2015-16 amounted to £9.6 billion (10% of total NIF expenditure), double that for 2014-15.  The expectation was that no grant would be required for 2016-17, but as a contingency a provisional facility of £4.8 billion was agreed with the Treasury.   We’ll need to wait till later this year to find out if any of this was actually used.

The latest published balance in the NIF can be seen at this website (use the dynamic link at the bottom of the page).

5.  The Government Actuary’s Department suggests that, in an extreme scenario, the State Pension Age would have to be 68 by 2030 (bringing forward the already-planned move by as much as 16 years) and thereafter rise to 70 by 2054.  The first of these would affect those now in their late 50s; the second would apply to those born from 1986 onwards.

The Cridland Review, prepared by former CBI head John Cridland, suggests that the move to a State Pension Age of 68 should take place by 2039 (a seven-year advance) and also that the “Triple Lock” commitment regarding pension increases should be scrapped during the next Parliamentary term.  (I’ll discuss the Triple Lock in a future article – now available here.)

Life expectancy has risen by more than 50% since the old age pension was first introduced a century or so ago.  Recent experience has been that people are living for about 20 years after retirement.  Latest policy thinking is to build this expectation into the system, by linking the State Pension Age to officially determined life expectancy, with periodic reviews of SPA for the purpose of maintaining the expected retirement duration as 20 years.

6.  Perversely, at the same time as the UK Government is hell-bent on Brexit, it seems also determined to ensure that there will continue to be a need to supplement the workforce with people brought in from elsewhere.  The change that just been implemented to the tax and benefit system, limiting support to 2 children only, is a case in point.

The challenge the Brexit mindset represents to our future is the failure to appreciate that a reduction in immigration will simply make things worse in the short to medium term, not better.  There’s a paper published last year which lays this out in some detail.

7.  The Vital Statistics published for the UK reveal the following: –

For England & Wales:

  • Based on the 2015 data, the Total Fertility Rate (TFR) was 1.82.
  • The TFR represents the expected average number of children born to a woman over her lifetime.  The “replacement rate” required to ensure population stability for a country such as the UK is a TFR of about 2.1.
  • 27.5% of the live births in 2015 were to mothers born outside the UK.
  • Fertility is higher for foreign-born women than for those born in the UK.
  • Analysis of the 2011 Census data indicates that the gap in TFR between the two groups (UK natives & others) had narrowed since 2001.  The Office for National Statistics suggests that a contributory factor may be that the current UK-born childbearing population includes second and later-generation migrants.
  • In any event, there was a further drop in overall TFR between 2011 and 2015.

For Scotland:

  • Based on the 2015 data, the TFR was 1.56.
  • This is the lowest for any of the constituent countries of the UK by some margin.
  • 16% of the live births in 2015 were to mothers born outside the UK.

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