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Last Updated: Tuesday, 12 October 2004, 09:43 GMT 10:43 UK
Pensions: How much trouble are we in?
Pensions protest in Brighton
Amid much talk of crisis, Adair Turner, ex-CBI boss and head of the government's Pension Commission, on Tuesday reported on the scale of the nation's retirement savings shortfall.

But just how worried should we be? E Philip Davis, professor of economics and finance at Brunel University*, takes a dispassionate look at the issues.

The UK pension system has traditionally been seen as successful.

High take-up of voluntary private pension schemes and a low burden of social-security pensions are rightly seen as major advantages, compared with the generous but unsustainable social security pensions offered in France and Germany.

Britain is also ageing more slowly than much of Europe, which eases the provision of retirement income during the coming demographic transition to an older population.

Not everything is rosy, however. There are widespread deficits in final-salary schemes following the collapse in share prices earlier this decade, and many such schemes have been closed to new entrants. Companies are tending to offer vastly inferior money purchase plans to new staff, to which companies contribute far less.

There is also ongoing adverse publicity from the mis-selling of personal pensions and the more recent failure of Equitable Life.

Ups and downs

Little wonder, then, that there has been a loss of public confidence in long term saving, which is resulting in inadequate provision for retirement. Many people appear to be taking risky bets on house price trends to "assure" their pensions.

There is at least some relief: a recovery in share prices and sufficient topping up by firms will eliminate the current deficits, and memories of current scandals will fade.

But my analysis suggests that there are longer-term weaknesses of the system.

At the root of the problem are two factors: an excessive reliance on voluntary funded schemes, the result of inadequate public pension; and state reliance on means-tested benefits to assist those on low retirement incomes.

Means to an end

It is easy to see how these long term weaknesses are aggravating the current malaise.

Retirement incomes are highly exposed to asset price volatility, as revealed by the current deficits. Furthermore, since funded pensions are so important they have to be price-indexed, the burden of which further encourages firms to abandon the final-salary model.

The many elderly who rely on low state pensions, but who resist means testing, suffer incomes below the poverty line.

Worse, there are major disincentives to save for those likely to be affected by means testing in future, since the better-off will lose state benefits. Means testing even deters financial institutions from selling low-income households pension products, lest they be accused of mis-selling in the future.

Reform to perform

Although there have been some reforms, such as stakeholder pensions, they have been insufficient. More fundamental reform is also necessary. Two alternatives should be widely considered:

  • A boost in the basic state pension to levels typical of countries such as the Netherlands and the US - roughly 30-40% of average earnings. This would be combined with an elimination of means testing, which would boost voluntary pension saving.

    Although the overall cost of universal provision would be higher, the income tax system would return much of the benefit from higher income earners to the Exchequer and there would be large reductions in administrative costs. Also, retirement ages could justifiably be linked to longevity, reducing fiscal costs.

  • Compulsory contributions to private pensions, including compulsory and sizeable employer contributions. Switzerland and Australia are among those that adopt this approach. Compulsion is needed if individuals otherwise fail to be look ahead in their pension saving. Besides mandating saving, compulsion would also avoid the biases in coverage of high-quality private pensions (towards men, high earners and so on) that tend to occur when schemes are voluntary.

    To be successful, any such reforms would need bipartisan support and stability, which have been absent to date.

    Successful reform would require an overall view to be taken of the impact of government policies on pensions, which also appears sadly lacking at present. For example, the high student fees now being introduced may deter individuals making sensible savings decisions at the beginning of their working lives, particularly in money purchase schemes where early contributions are the most remunerative.

    * E Philip Davis is professor of economics and finance at Brunel University, West London. He is also a fellow of City University's Pensions Institute, a visiting fellow at the National Institute of Economic and Social Research, an associate member of the Financial Markets Group at the London School of Economics and an associate fellow of the International Economics Programme at the Royal Institute for International Affairs.

    His working paper, "Is there a UK pensions crisis?", can be accessed via the link on the right-hand side of this page.

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