Response to Pension Commission First Report

by Dr. Ros Altmann

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I just wanted to give you some of my thoughts on Pension Reform, by way of response to the Pension Commission report. I found the analysis in your report excellent, thorough and well-presented and was very impressed with the subjects covered. My response focuses on the issues relating to compulsory pension saving, although, of course, issues such as the movement away from traditional defined benefit pension provision are likely to prove some of the most intractable pension problems we face. I have not addressed these here, but would be happy to talk to you about these. My main points are:

1. I do not believe there really is a 'muddle through' option.
2. Radical state pension reform is urgent, abandoning mass means testing.
3. Phasing out contracting out could pay for a resident's pension for all.
4. Compulsion is not an answer.
5. Better and fairer incentives are required, both for individuals and employers.
6. Pensions, alone, cannot finance an ageing population. We need to re-think retirement.

1. There is no 'muddle through' option.

I do not really believe there is a muddle through option. We cannot keep going as we are. The current policy mix is unsustainable going forward and radical changes are urgently required. In the absence of radical reform of the state pension system, it is impossible to see how private pensions can improve.

2. Radical state pension reform is urgent, abandoning mass means testing.

It is urgent for the state system to be re-designed, to overcome the disincentive effects of means testing, which will increasingly continue to undermine private pensions. If 75% of future pensioners will have to claim pension credit, then it becomes impossible for financial advisers to safely advise the majority of the population to contribute to a pension. It is not true to say that pension credit 'rewards' saving, it penalises saving. It may penalise saving by less than the previous system ('only' 40% penalty rather than 100%), but many individuals, especially women who do not have a full basic state pension, still lose £ for £ and find their whole pension savings have been wasted. Such mixed messages are very dangerous for private pension sustainability. Furthermore, from a practical point of view, it is difficult to see how the DWP can be expected to reliably deliver the administrative systems which will correctly oversee the means test and pay the right benefits to so many millions of people. The costs and risks of trying to do this, coupled with the imperfect take-up, means that pension credit will not necessarily succeed in reducing the numbers of older people in poverty in future. Even if take-up rises to 90%, there will still be over 1 million pensioners in poverty in future. With 15 million people over age 65 by 2030, of whom 75% will be eligible for pension credit, if 10% of these do not take up their entitlements, this leaves 1,125,000 people in poverty. So after all the cost, expense, complication and risk of undermining private savings, which are associated with the pension credit policy, the policy will still leave a huge problem of poverty in the UK. Radical reform of state pensions is a necessary condition for improving private savings, but is not a sufficient condition. The current complicated state pension system, with its over-reliance on means-testing, and lack of clarity, is undermining private pensions.

3. Phasing out contracting out could pay for a resident's pension for all.

One of the most complex parts of the UK state system is contracting out and it is often not delivering pensions at a high enough level to replace state earnings related entitlements. The cost of contracting out is huge - £11billion a year - and this money has operated as a subsidy to private pension providers, but not delivered good value to individuals in terms of adequate pensions. This money could more usefully be diverted to current pensioners, to finance payment of a resident's pension for all, at the level of the pension credit guarantee credit (currently £105 per week). This would provide a clear division between what the state will pay as a pension - a basic minimum - and what individuals can then freely do for themselves on top of this, without penalty from the Government. It is not clear to me that the state should be providing earnings related pensions at all. Just because someone earned more when they were working, why does that mean that the state should give them extra when they are no longer working? Surely, those who have higher earnings can afford to save more for themselves. I would be in favour of just a flat rate state pension, paid at a basic minimum level to allow people to escape poverty. This would then allow financial companies and advisers to give a clear message to people. 'This is what you will get from the state - it is enough to live on, just, but if you want more, you will need to do some saving on your own to be able to afford life's luxuries. Whatever savings you do make, will be yours, with no penalty from the State.' This clear message cannot be given at the moment, because no-one knows what people will actually get from the state pension system and also cannot be sure that they will not be penalised by the pension credit if they do save.

4. Compulsion is not an answer

On the question of compulsion, it is not clear to me that there is any evidence that this really works in terms of increasing the overall level of savings. There are a several potential drawbacks to compulsory pension saving. Firstly, it is not clear that compulsion actually delivers higher overall savings levels. In other countries where compulsory pension contributions have been introduced, savings seem to have been diverted from other sources into pensions. Secondly, many lower paid individuals take on extra debt, to make up for the loss of income which is being diverted to pensions. Thirdly, there is doubt about the level at which compulsion should be pitched. If it is pitched too low (perhaps around 5-10% of salary) then it will not deliver good pensions, if it is pitched at a more adequate level (around 20% of salary) then this will be too high a level to be politically acceptable. Fourthly, compulsory pension saving would be have a negative impact on economic activity, as Australia found when workers suddenly diverted substantial amounts of their income away from consumption and into saving. Of course, if a higher level of state pension is paid, as of right, the need for compulsion will be minimised, since the consequences of inadequate pension saving will not result in higher state spending on means tested benefits. Having said this, however, it is clear that it would be preferable for individuals to decide to save, if they can possibly manage to do so, in order that they can enjoy a higher standard of living than the basic state-provided minimum in later life. This would be better for consumption and economic growth, as the population ages. Auto-enrolment and schemes which divert future pay rises into a pension, rather than sacrificing current income, are likely to be far preferable to compulsion. It would still then be an individual's choice as to whether to put money into a pension, rather than being compelled to do so. Finally, in the current environment, compulsion should not be considered at all, because pension credit has made pensions an unsuitable investment for a large proportion of the population. If they risk be penalised by at least 40%, then they may be better off saving in a different form. So reform of the state system is essential before compulsion could be safely considered - but then once a radical reform of state pensions has been introduced, of course, compulsion would no longer be so necessary.

5. Fairer and better incentives are required, for employers and individuals

Fairer and better incentives to save are required. Given the extremely low levels of confidence in long term savings, I believe that the Government needs to introduce better incentives for both employers and individuals to contribute to pensions. The current system of tax relief is unfair, regressive, opaque and inefficient, as a means to encouraging those on basic rate tax to contribute to pensions. The highest incentives are going to people who need them the least and those who find it hardest to save are not receiving enough encouragement. A system of matching incentives would be far better than the current tax relief system. People would understand it, there could be the same level of incentive for the same level of contributions and the costs could be controlled by changing the annual limits on contributions.

6. Pensions, alone, cannot solve the problems of financing an ageing population. We need to re-think retirement.

We have to recognise that, in truth, at least 80% of the population can probably never be expected to save enough during what we currently consider to be a 'normal' working lifetime, to provide what would be considered an 'adequate' level of pension income for the current idea of a 'normal' period of retirement. I believe that only the top 10-20% of earners can truly put enough money aside for 30 - 35 years of work to provide a good income level to live on for 25-30 years of retirement. However, the opportunities for a social revolution in attitudes to work offers a possible win-win solution. I think there is a whole new phase of life out there, waiting to be grasped, which previous generations could not even dream of. The period after full time work, when people are still working, but part time, either in the same job or a different line of work, but still earning money and contributing to both their own and the wider public economic welfare. Why are we paying so many people not to work? Why should people who are fit, healthy and mentally alert - as most people in their 60's and even 70's now are - expect to sit at home without working? This is a huge waste of resources. We need a social revolution, whereby employers make work available to older people on a part time, job sharing or mentoring basis and individuals plan during their lifetime for what they would like to do, once they stop full time work. This would mean that pensions need to last for much less time and also need to be at a lower level, to supplement earnings, rather than replace them. This could be a realistic solution to the problems associated with an ageing population, both in terms of overcoming labour shortages and making the financing of older populations more affordable. Such a social revolution has been achieved for women in the past few decades - the majority of young women, even with young children, now work. Thirty years ago people would have said that this could not happen, but it has. I can envisage the same changes occurring for older people, who will be able to continue working well into their 70's, at least on a part time basis and then have far more income to live on and enjoy their extra leisure time with. This is a positive message. Pensions alone can provide decent incomes for 5 or 10 years (which was their original intention) but not for 20 or 30 years. It is not healthy for individuals to suddenly stop working at any particular age and a flexible band of gradual retirement would be much better for the individual and for society as a whole.

This represents a summary of my views on pension reform, as relates to the issues surrounding compulsion. On a wider note, I do believe that the issues surrounding the movement away from traditional final salary scheme coverage are important and the investment of pension scheme assets needs careful attention. I do not believe that merely moving from an over-reliance on equity investments, to an over-reliance on fixed income investments, is necessarily optimal. In order to manage a liability-focussed asset allocation, it is important to recognise that fixed income investing cannot match defined benefit pension liabilities perfectly and bonds still contain downside risks. In fact, I would argue that moving away from over-reliance on equities and reducing the risk of relying on just one source of investment risk premium, should be done in a way that minimises the loss of expected return. This would not be achieved by switching into bonds. A more diversified asset allocation, trying to capture returns from a wider range of asset classes and taking advantage of uncorrelated assets or different potential sources of alpha and beta, would deliver a more efficient long term portfolio. I would be delighted to discuss these issues, if you wish.

I do hope these thoughts will prove helpful to you in your work.

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