When I’m 65
The origins of state pensions are to be found in market failure. States have intrinsic advantages over companies as pension providers: because they have the power to tax, and are around for a long time, they can count on those not yet born to pay for the pensions of those not yet retired. Today’s contributions are used to pay today’s retirees (a company that did this would be convicted of running a pyramid scheme). In nearly every country state pensions are funded not by general taxation but by a national insurance contribution, in effect a payroll tax. Pensions have become a right, and, in continental Europe, most people depend entirely on state-mandated pensions for their livelihood in retirement. Hence the massive demonstrations and strikes last year in France, Austria, Italy and Germany when changes to the system were proposed.
In the UK the state pension has always been mean and, until recently, the sense of entitlement weak. In most other countries pensions are entrusted to a quasi-autonomous public body which collects insurance contributions – in the US the Social Security Administration has its own board of trustees and staff, including actuaries and economists; in France and Germany pensions are handled by joint committees of employers and trade unions. In the UK, however, they have simply been absorbed into Whitehall and run by the Treasury. Following the hostile public reaction in 2000 to the Blair government’s miserly 75p increase in the state pension, and recent protests about the failure of company schemes, there are signs that pensions policy can no longer be tidied away like this. A combination of low state pensions, weaker occupational schemes and devalued personal savings means that there is now an acute need to come up with something better.
State pension schemes which are run on a ‘pay as you go’ basis are administratively cheap and enjoy a high degree of public support: the fact that every employed person, whether rich or poor, contributes a roughly similar amount, builds up a sense of entitlement. This financing method has become overstretched, however, as life expectancy increases, birth rates drop and the number of workers per pensioner goes down. Governments have rarely directed the dividends from rising productivity to help sort out the pensions problem, so with the first wave of baby boomers set to retire in the next few years, and with life expectancy at 60 rising to more than 20 years, state pension systems will be severely tested.
The British state pension will continue to be affordable simply because it is a pittance – it is currently about 15 per cent of average earnings and, because it is indexed to prices not incomes, is likely to decline steadily. In contrast, the state pension in Germany, Italy and France is worth roughly two-thirds of pre-retirement salary to those on middle incomes. Some entitlements have been reduced in these countries – the retirement age has been raised from 55 to 60 in some public services, for example – but so far this has made little difference to the scale of provision.
The pensions provided by continental European schemes are worth defending, and the main problem with them is an excessive reliance on payroll taxes. As these are paid at close to a flat rate by every employee they take a larger bite out of modest incomes than higher ones. They also amount to a tax on jobs: pension costs now add a ‘tax wedge’ equivalent to a fifth of each employee’s income in France and Germany and the consequent increase in the cost of labour has led to higher unemployment. The proportion of those between 15 and 64 in work in these countries is just under 65 per cent, whereas it is nearly 80 per cent in the US and UK. Unemployment is widespread among the over-50s, and raising the retirement age has become a way of keeping people off the pension register for longer. The governments of these countries, too, need to look for better ways to finance pensions. Unfortunately, they seem to be heading in the direction of ‘implicit privatisation’ – in other words, cutbacks in public provision are obliging those who can afford it to take out private cover.
Ireland is a partial exception. The Irish government has sought to strengthen the state pension and to diversify the way it is financed. With a basic state pension worth 28 per cent of average earnings, Ireland lies somewhere between the Anglo-American and the continental European models. The government plans to increase this to 34 per cent and, as a way of ensuring the future viability of the system, to set up a national pensions reserve into which 1 per cent of GDP will be paid annually. Supplementary payments will be funded not from a payroll tax but from general government revenue, accrued, for example, from the sale of telecom franchises. No other OECD country has shown such foresight and innovation.