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.
Following three years of plummeting stock markets it will take much more than the current mild recovery to replenish personal pension funds, many of which had dropped to between a third and a half of their former value. Last June, Cazalet Consulting reported that the funds of UK life companies, many of which supply personal pensions, had dropped by £50 billion in the previous year. The plight of Equitable Life shows that even the oldest and most respectable suppliers can fail. But such market risk is not the only problem. The cost of customising pensions is always high, and commercial providers spend lavishly on promotion and salaries. Personal pension plans receive generous tax breaks and some of those who retired at the end of the 1990s should have done quite well. Much, if not all, of the money saved by these tax breaks is, however, absorbed by charges; even those who faithfully contribute to one scheme for forty years find that charges reduce their ‘pot’ by about 20 per cent; those who switch providers or interrupt their contributions can lose 40 to 50 per cent. In the UK most of the pot is used to buy an annuity and over the last decade the annual retirement income generated by each £100,000 in the pot has dropped from £8000 to £5000 or less. On both sides of the Atlantic, rising life expectancy and the long-term drop in interest rates are placing huge pressure on pension programmes even if share prices continue to rise. In the US, those clicking on Microsoft’s internet financial adviser are told that a couple would need to contribute $1 million if they were to guarantee themselves a retirement income of $40,000 a year. The average holding in a ‘401(k)’ plan, the most popular savings vehicle in the US, is only $20,000.
The best secondary pensions are still DB schemes, and these remain quite common in the public sector, where they enjoy an ultimate government guarantee, making them much more secure than the company-sponsored alternatives. Whether in the public or private sector, DB schemes are run by the employer, and this can be a problem. In the public sector, it can mean that pensions come out of the same budget as services, salaries and jobs, resulting in undesirable trade-offs. In the private sector, where such schemes are guaranteed only by the employer, the several decades over which a pension is accumulated is quite long enough for a company to change from blue chip to abandoned hulk.
In recent years the corporate sector has offered new employees DC schemes in which the employee not only bears the market risk but the employer contributes much less – say 3-6 per cent of salary rather than the 12-15 per cent in a good DB scheme. Although DC schemes are more flexible than DB ones, which is important if an employee moves job, they are less stable and otherwise inadequate.
Traditional DB schemes remain hugely important, not least because they control large assets – probably around $3 trillion worth in the US and £300 billion in the UK. While employers can try to freeze the schemes or withdraw from them, many were freely entered into by corporations in more expansive times, and legal obligations mean they cannot easily be shrugged off. So considerable are these obligations, indeed, that they pose a real threat to the financial health of some the world’s largest corporations. It has been estimated that the DB pension funds represented on the Standard and Poor stock market index in the US were still underfunded by about $300 billion at the end of 2002; in the UK, the DB pension funds on the FTSE 100 have a combined deficit of £60 billion (on 17 January the front-page headline in the Financial Times was ‘share rises fail to fill pensions black hole’; the impact of low interest rates on liabilities is a major part of the problem). Mature pension funds are often worth as much as, or more than, the parent company: this is true of Rolls Royce and Boeing, Ford and Unilever, and there are many companies whose pension fund deficit is now more than half the market valuation of the company – GM, US Steel, Colgate-Palmolive, Campbell Soup, Lucent, Goodyear, Marconi, ICI and BT. Pension deficits eat away the value of a company’s stock, and funds which might have been available for investment have to be used to reduce the deficit. At companies such as IBM, Verizon and Corus, jobs have been lost and investment programmes slashed. Many members of DB schemes find themselves with a strong claim against financially weak employers: US Steel workers, for example, were asked to dilute their pension rights in order to save their jobs. The flaws in the set-up of DB schemes mean that employees often find it makes sense to comply with such proposals.
All too often, pension figures are manipulated to give a flattering impression of a company’s performance. Actuaries and auditors have allowed UK employers to skip contributions worth £27 billion over the last decade and a half, a sum which, if invested, would have met half or more of the current funding shortfall. When the stock market was booming, trustees who were nominated by companies themselves projected that since pensions funds would continue to rise at an annual rate of 10 per cent, it was fine for employers to take a contribution holiday. Even in the early years of the downturn, auditors continued to allow fund trustees to project unrealistic future returns. General Electric in the US, for instance, went for 13 years without making a payment to its pension fund. While short-termism is partly to blame for such decisions, the complicated rules governing DB funds mean that overfunding as well as underfunding is penalised: regulations against overfunding were put into place to prevent companies using their pension funds as a tax shelter in which to stow away surplus profits, with the aim of drawing on them later.
The British government is now creating an institution which will offer to insure DB pension funds. However, the US equivalent, the Pension Benefit Guaranty Corporation, which was established in 1974 and to which all employers are compelled to subscribe, has not worked very well. Firms in trouble allow their pension funds to go deeper into deficit and count on the PBGC to bail them out. When times are bad, the PBGC’s reserves are quickly used up; it is currently $5 billion in the red and doesn’t have the resources to cover the chronic deficits it has identified at 270 large corporations. In any case, it guarantees only a proportion of pension entitlements. It is intended that the new UK body will do the same.
It isn’t easy to introduce a new insurance scheme when the economy is shaky and companies are strapped for cash, so that they find the extra contributions difficult to pay without cutting back on investment and shedding jobs. Governments are understandably loath to step in with public money, but would this in any case be the right thing to do? After all, the members of an occupational scheme whose pensions have been shrunk by 40 per cent are still better placed than many of their fellow citizens, half of whom have no secondary coverage at all. The members of a DB scheme are still better off than the members of a DC scheme, because their employer will have contributed to the fund and because they are guaranteed a pay-out related to salary. But employers do not have to provide DB schemes and there is little doubt that the extra expense of insurance will lead to further closures. As Brendan Barber, TUC General Secretary, has put it: ‘Britain needs a bigger pensions pot, and tweaking at the edges of a voluntary system is not going to achieve this.’
On every side pension arrangements are failing to deliver what they promise. All the schemes around – public, personal and occupational – are badly designed and insufficiently funded. The generous public systems of continental Europe don’t waste money on marketing nor do they depend on the fortunes of single employers, but high payroll taxes on the Continent drive up the cost of labour and hence unemployment. And the situation is worse in the UK and the US, where more than 50 per cent of those retiring will soon find that the ungenerous state pension is their only source of income, while many of the rest will find that their pensions are half what they expected or that their company scheme is in danger of running aground.
What is to be done? First, the nature of the link between employer and pension fund, whether DB or DC, should be changed. Companies that have made DB promises are under great pressure to honour them but often can do so only by cutting back on investment. One important step is to replace single-employer funds with multi-employer funds; companies should also contribute more in good years than in bad. And while taxes should finance a decent basic state pension, a new source should be found to fund a secondary pension for all. Excessive payroll taxes are counterproductive. A new source of finance would preferably not add to labour costs, whether directly or indirectly, since this would encourage unemployment. Furthermore, it would be greatly preferable if any boost to pension funding did not prevent increased spending on education, health or measures to reduce child poverty.
It may seem a tall order to ask for a levy which fulfils these conditions, but Rudolf Meidner, the former chief economist of the LO, the main Swedish trade union federation, and an architect of the country’s welfare state, devised such a measure in the 1970s, anticipating a financial crunch like the one we now face. He proposed that all public companies should be required to issue new shares, equivalent to a fifth of their profits each year, to so-called ‘wage-earner funds’. These shares would be held to defray future social expenses. Unlike corporation tax, the Meidner levy was to make no demands on companies’ cash flow. The funds themselves were to be administered by regional boards on which employees were to be represented. When the twenty family groups who dominate Swedish industry protested, the Social Democratic government diluted Meidner’s proposals and reduced the role of the wage-earner funds. But the scheme still made its mark. By 1992, when the scheme was wound up by Sweden’s Conservatives, the public investment boards owned 7 per cent of the Swedish stock market.
So far as I am aware no other attempt has been made to tax companies by requiring them to give shares rather than cash to public programmes. An asset levy would furnish resources without weakening demand: in economies threatened by deflation it makes little sense to attempt to plug the deficits in pension funding by raising taxation, or obliging corporations to stump up cash, because this simply weakens demand and puts jobs under threat. The asset or share levy approach thus avoids the dangerously ‘pro-cyclical’ features of the DB schemes (the contribution holidays when companies are awash with cash, and the forced contributions when times are bad). Shares raised by the levy would not be sold but held to generate revenue when needed in the future to furnish pensions; the revenue would mainly come from dividend income, which is far less volatile than share price.
The share levy – set to 10 per cent of profits – would furnish assets which could immediately offset pension fund deficits, or boost the holdings of a PBGC-style reserve. As Nicholas Barr points out in The Welfare State as Piggy Bank (2001), pre-funding helps only if it reduces future public spending – for instance, by offsetting the National Debt – or sets aside resources to meet future needs, or helps to raise future output. The proposed levy meets these tests. It would build up social assets which count against the National Debt, transfer claims on future dividend income and certainly aim to contribute to raised output by encouraging effective and responsible shareholding. Whatever dividends company boards decide to pay, a growing proportion would go to pay pensions.
Regional pension boards – either directly elected or composed in part of elected officials – could administer the funds and be encouraged to promote good corporate governance. Commercial fund managers have allowed their customers to become the victims of a share price bubble, a string of corporate frauds and a series of questionable practices, such as ‘soft commissions’ to brokers (i.e. kickbacks), that have led Peter Fitzgerald, a Republican senator from Illinois, to describe the savings industry as ‘the world’s largest skimming organisation’. Pension boards should also carry out their own research, something commercial fund managers too often leave to self-interested investment banks and finance houses. The proposed network of pension boards, with their own staff and specialists, would be accountable to local constituencies but independent of central government.
As the Swedish LO discovered, such an approach would be controversial. Care would have to be taken that pension funds gain more than they lose from the share levy. Ultimately, the levy would reduce by a small amount the value of existing holdings, but it should be possible to ensure that all bona fide retirement funds receive some net benefit from it. Existing DB schemes, too, could be guaranteed by such a secondary pension fund. The PBGC in the US lacks an independent source of funds, which is why it runs out when times are difficult. Secondary pension boards could also devise ways to encourage employees to save more themselves, with, for example, those who contribute more from their earnings rewarded by a matched contribution boosting their entitlement. The funds raised by the share levy could also be used to make contributions on behalf of care-givers and the unemployed.
There are still many women who don’t receive even a full state pension because they don’t have the requisite contribution record. Funds from a share levy could be used to help fund secondary pensions for all, building on the best features of the old Serps. Any reform less sweeping would fail to tackle the simultaneous crisis of public and private pension provision we now face.
Martin Daunton argues in his review that the measures I advocate are ‘wishful thinking’ and would never win support. My approach, unlike that of the British or American governments, at least faces up to the scale of the problem. If the over-65s make up 25 per cent of the population by 2030 then we should surely plan for them to receive something like 17.5 per cent of GDP. If so, the 5 per cent envisaged by the UK basic state pension, or the 7 per cent envisaged by the US Social Security retirement programme, are paltry. Some of the needed income can come from earnings, but we should bear in mind that annual medical costs for those over 60 are likely to be roughly four times as much as for those under 60. I believe it’s right to aim for a combined pension of 70 per cent of the average wage – a little less for higher earners and more for the low paid – but pensioner organisations would be pleased with 50 per cent. Today the state pension is only 15 per cent of average earnings, rising with means-tested supplements to 20 per cent. Given this yawning gap, my suggested target would need to be met in stages. I do not suggest that much of the extra provision should come from existing taxes but insist rather that the time has come to look at new ways to tax large concentrations of wealth, primarily by means of the share levy but also by a Henry George-style betterment levy, or a tax on increases in the value of commercial land. Of course there will be opposition, but there is also, as we have recently seen in many European capitals, great discontent at a failing pension system.
At one time, income tax was thought to be a threat to morality and good order, or at best an emergency wartime measure. In the US it required a constitutional amendment. But eventually the battle for income tax was won. Sidney Webb’s capital levy idea was taken up by James Meade and Keynes, but not implemented because progressive income tax and death duties were thought to be adequate to meet public needs and promote equality. But this is clearly no longer the case. The rich and the corporations get off very lightly: estate duties are now more or less voluntary and we have no wealth tax.
Governments will sooner or later find that they need either to discover better ways to tax corporate wealth, or to ask the electorate to accept sharp cuts in public services and pension provision. The levy I propose would supply resources in the future but also information in the present. In today’s world of corporate ‘tax planning’ (i.e. tax avoidance) and ‘financial engineering’, any taxing authority needs to employ a variety of fiscal mechanisms if it is not to be continually outwitted. The share levy and its associated network of funds could supply the taxing authority with exactly the sort of information and support it needs – just as an unusually ‘activist’ institutional investor helped to expose huge, questionable payments to Conrad Black and his friends at Hollinger. As Myron Scholes and Mark Wolfson explain in their influential primer, Taxes and Business Strategy, corporate tax planners now have the edge over tax authorities. The planners ‘repackage ownership rights’ at the behest of corporate boards in ways that often diminish share value. Executive stock options, and the use of shares in takeovers, often dilute share value more than the share issues I propose, which would run at about 1 per cent a year. Corporation tax is levied at a higher rate than the proposed levy without causing panic in the boardrooms. If the new levy were less vulnerable to tax planning this would prompt corporate concern, but the great majority of citizens do not have access to tax havens and would anyway find the cost of buying ‘tax products’ prohibitive. Since the levy would not interfere with cash flow, managers whose first concern was running their businesses would be pleased to find that its resources were not reduced. They would in time have to reckon with a more informed and effective institutional investor. Today’s public sector pension funds have a better record as ‘activist’ shareholders than their commercial counterparts: they have tried to encourage good governance and ‘socially responsible’ corporate behaviour. If the expert staff of a growing public sector obliged senior management to be less self-indulgent, then small and medium private investors would also benefit. Is it rational or just that people should pay a tax for owning a home but not for owning a large pile of shares?
While funds should be able to back local development – ‘economically targeted investments’ have worked well in the US – this would be only a small part of a widely diversified portfolio: I’m not, as Daunton seems to think, suggesting investment only in the ‘regional economy’. Of course Daunton is right that such a package of measures would provoke resistance. But there would be many more winners – and a few substantial losers – from a financing regime that would make decent pensions affordable, investment more accountable and allow people more of a say in their own future.