A bigger bowl, the same little spoon

Nick Louth - Fri 09 Dec, 2005

"...Twelve million people do not save enough for retirement. Women who relied on their husbands pension contributions, and then suffer divorce or widowhood, often spend old age in penury. Half of all women dont get the full state pension..."

Providing for a reasonable income in retirement is too abstract and complex a concept for governments to resolve. The standard of living of those in retirement hinges on decisions made decades before. But back then, important facts about demography, life expectancy, inflation, investment returns and GDP were unknown.

So while Britain's current pension provisions are affordable today, they won't be for much longer. Extrapolate into the future, and declining childbirth, increasing longevity and a fixed retirement age will make current pension arrangements, both public and private, unsustainable.

Not only are there fewer workers supporting each pensioner, but those working lives are shorter and the life spent on pensions longer. In 1950, the average worker started at 15 and retired at 65, fifty years hard grind. Many now retire after just 35 years.

Governments wring their hands but shrug aside the blame. Yet today’s crises can almost always be blamed on past governments, while decisions made now often don’t affect pensioners for decades. Reconciling pensioner claims set today on resources that will only become available tomorrow requires flexibility and foresight. Governments are famous for neither.
 
Adair Turner’s Pension Commission report, the main points of which were leaked in the Financial Times a fortnight ago, makes a few sensible suggestions: the automatic enrolment of all new employees in a low-cost portable state savings plan (with an opt out-clause)...the increasing of the basic retirement age until 67 in stages from 2020...and the scrapping of earnings-related elements of the existing second state pension.

But Turner also makes one unsustainable proposal, which is to re-introduce a pensions up-rating in line with both wages and prices. And above all, like all such reports, it peers into a predictive fog and predicates its conclusions on the unknowable.

As neither government nor employers seem up to the task of providing for you in your retirement, Daily Reckoning readers should make sure they have got their own arrangements in place today.

Economic theory, for all its over-simplification, is useful. The retired no longer have direct market power, earned by supplying labour or capital. Therefore they can only consume what those in employment or business are happy to leave unconsumed. A state pension may be £100 a week, but its purchasing power is at the mercy of wage and price inflation.

Likewise, you may get 60% of your final salary when you retire today, but who knows what that will buy in 2025? High inflation is a symptom of irreconcilable claims on resources, reaching equilibrium when all claims set in nominal terms are deflated. That includes state benefits, final salary schemes, annuities and any investments driven by conventional gilt-edged stock.

Economists are surely right to say that inter-generational resource conflict is always won by those whose hands are on the levers of economic power. But the theory is only half right. It doesn’t allow for the power of the "grey vote".

Benefits, state pensions and many final salary schemes have some inflation protection built in. You can buy inflation-linked, unit-linked or increasing annuities, though it means either extra risk or extra cost. And then there are those index-linked public sector pensions. These are claims on resources set in real terms, which cannot be inflated away. However, that still does not guarantee those pensioners a given slice of a growing economic pie, but merely invites them to sup with the same sized spoon as they used in previous years.

In 1980 Margaret Thatcher broke the link between state pensions and average earnings. While the link with inflation was preserved, state pensioners were cut out from two decades of economic growth. Gordon Brown in his 2001 Budget raised state pensions and launched Pension Credit. But he has not so far contemplated restoring an explicit link with earnings.

What would happen if he did? An ageing economy – where the burden of the retired is set as an absolute proportion of the economic cake – might well look like one of Britain’s struggling old industrial companies. Their generous final salary pension schemes are rigid but underfunded. So to fund the deficit, the firm either invests less in today's operations, or offers less attractive wages and salaries to current and new employees, or both.

The pensions offered to new staff would look unattractive compared to those available to existing pensioners, and certainly overall employment terms would be less attractive than with other employers. The net result would be a difficulty attracting and retaining talent, and an undermining of competitiveness.

In national terms, Britain would be forcing the footloose younger generation to subsidise those pensioners destined to remain here. And if current demographic trends persist, the cost-saving benefits of the two-year rise in the retirement age envisaged in the Turner report would be eroded almost as soon as it had taken place.

Living longer and healthier is wonderful. Forget the caveats and the doomsters, we should enjoy it while we can. And the government's actuary has just bumped up the life expectancy of men aged 65 from 17.8 to 19.4 further years of life. Back in 1950 it was just 12 years. For women the figure has risen from 14 in 1950 to 22.1 today.

Yes, these are projections. And yes, modern medicine and sixty years of peace can take the credit. But longevity is not a one-way street, as the existence of bird flu, global warming and Osama bin Laden should remind us.

In the 1980s and '90s employers thought soaring stock markets were a one-way street, and took extensive pension contribution holidays. We’re still living with the fall-out from that today. FTSE 100 companies share a combined pension deficit of £40bn (projected). Linear projections starting from the present have a habit of being wrong.

It is easy to get steamed up about other people's pensions. While many in the public sector have full inflation protection, those of us in the private sector will find that rights accrued after April 2005 only have to be protected up to inflation of 2.5%, half the maximum level protected from 1997-2005.

But the "Yes Minister" types, so vilified for their cushy civil service terms, are actually a tiny minority. Most public sector workers earn less than their private sector equivalents, and a better pension is scant compensation. Even with it, many hospital cleaners, council workers and teaching assistants still qualify for pension credit or minimum income guarantee at retirement.

The debate about retirement ages is equally flawed. When Pension Secretary Alan Johnson last month agreed to let three million existing public service staff retire at 60 on existing terms, he actually had little freedom to do otherwise. Employment contract law covers pension accrual rights, and once the money is in the pension pot, those rights are fixed. It is only further contributions whose terms can be varied.

Yes, Johnson could have stopped 21-year olds retiring at 60 in 2044. But that wouldn’t solve the funding problem that's going to arrive a decade or two earlier. Changing the pension destination when workers have bought their ticket and are already on board is always troublesome. So inevitably, it is new staff who wait on the platform.

This is true in private sector firms, where final salary schemes are replaced by money purchase for new recruits. It's also true in the public sector, where new hires will work to 65 to get their full entitlement.

Yet the real scandals of Britain's pensions crisis lie elsewhere. Twelve million people do not save enough for retirement. Women who relied on their husband’s pension contributions, and then suffer divorce or widowhood, often spend old age in penury. Half of all women don’t get the full state pension because a full National Insurance contribution record is incompatible with motherhood. Pension entitlement is still not fully ring-fenced when employers collapse.

To really solve the pension crisis you need to build in flexibility from the ground up.  Professor Nick Barr of the London School of Economics described a sliding scale of pension rights and retirement ages. This has the effect of moving ‘normal’ retirement ages up, but allowing a trade-off for those who want to retire either earlier or later against adjustments in pension entitlement.

A normal pension age would be set by date of birth, not the previous expected retirement age, and would be adjusted annually to smooth entitlement. This would have the effect of externalising the effect of longevity to pension providers with a consequent cut in costs. Applied to both state and private entitlements, it would allow us to make transparent work and life choices, knowing the effect on our incomes. We haven’t yet seen the final Pension Commission report, but we must hope that some of this flexibility finds its way in there.    

All that is still in the future. For you in the meantime, protecting your standard of living in retirement involves having your wealth tied up in real assets. Owning your own home is the obvious starting point. Shares in companies with control of real resources – such as the utilities, miners and oil firms recommended in the Fleet Street Letter portfolio – are a tremendous bulwark against inflation. They also offer good returns in real terms.

If you have a hefty holding of gilts, make sure some of them are index-linked. And if inflation really picks up, don’t be in too much of a hurry to pay off that mortgage. A debt is a claim set in nominal terms, and will be easier to repay after even two or three years, so long as you have taken the precautions to make sure your own income is not left behind by inflation. Be sure you use tax-protected wrappers like SIPPs and ISAs, too.

Finally, the old investment adages apply perfectly for your pension. Start early, contribute steadily and get the best returns you can.