The great pension reckoning is coming

pensioners sat on a bench

Larry Fink has this week put his finger on a global problem politicians too eagerly ignore: longer lives means workers may have to retire later in life in order to build up pension pots that will tide them over in retirement.

Here in Britain, the state pension costs the Government (in 2023-24) about £124bn, 10.4pc of its budget and 4.6pc of GDP. It is the second largest budget item after the NHS. In addition, the Government spends £49bn (4.1pc of budget; 1.8pc of GDP) on public sector pensions – the very generous pensions paid to retired government employees. Together (at £173bn) these pensions outstrip spending on the NHS (£163bn).

We now have a triple lock applied to the state pension that guarantees pensioners no fall in their real value of their pensions. Providing a guarantee not given to investors or workers is increasingly unaffordable, though there is no political appetite for change.

Our retirement age of 66 still bears far too much resemblance to those established in the 1940s. Then, a 65-year-old man had a life expectancy of 76, compared with 85 in 2020. A 60-year-old woman had a life expectancy of 79, which has now risen to 87. Importantly, in 1948 many men died before 65 and women before 60 – so the rising financial burden of pensions is in fact understated by these figures.

An increase to 68 by 2044 is necessary, and we must maintain a constant ratio between the number of years of pension receipt and life expectancy (currently 33pc) while ensuring the SPA is reviewed every decade. But the Waspi campaign has exposed the difficulties associated with taking a more radical (or realistic) approach.

What’s more, the retirement age is only one piece of the pension puzzle. Even with the triple lock, the current single UK state pension is £10,600 a year – roughly 30pc of average full-time earnings – and is insufficient to live on for many retirees (particularly renters). There are plenty of studies which suggest that only 50-60pc of average earnings is capable of allowing a retirement in reasonable comfort.

As a consequence, most Western countries view the state pension as the first “pillar” of their retirement systems, with second and third pillars to make up the balance needed. The UK has never formally adopted this tiered approach; instead it has tied non-state retirement income to occupational pension schemes.

Until the 1970s, this was working reasonably well, with a large proportion of the workforce (although still dominated by men) covered by generous final salary pension schemes. These often offered two-thirds of final salary at retirement (index-linked latterly), which together with the state pension meant a really comfortable, indeed in some cases luxurious, retirement.

But the 1970s-90s saw a collapse in the scale and generosity of final salary schemes, as employers discovered how expensive they were turning out to be, and how the funds they had put aside were totally inadequate to cover the pensions promised. Many funds went under. The result was a complete collapse in private final salary (or “defined benefit”) pensions.

But about 20pc of the UK workforce, nearly six million workers, do still get these gold-plated defined benefit pensions, and these are all government employees – doctors, nurses, armed forces, civil servants and teachers. Depending on financial conditions at the time, these pensions can be worth as much as 70pc of salary every year – “worth” being the cost of buying the investments to ensure the future pension is funded in full.

These government pensions, however, are not “funded”: the Government has not put any money aside for them, so all the promises have to be paid for out of current income.

Which brings us on to the funding of the state pension. When it began in the 1940s, it was envisaged that National Insurance (the clue is in the name) would be paid into by way of “contributions” deducted from salary, and a fund would thereby be established to pay unemployment benefit, healthcare and pensions for the contributors.

This noble (and sensible) principle has long since been jettisoned. National Insurance contributions are now a straight tax, and bear no relation to the cost of providing the above services. There is no National Insurance Fund, no money set aside – though rarely do politicians volunteer this information to their voters.

But with the collapse of defined benefit pensions, where does that leave ordinary workers?

Within the last decade, a new pension saving mechanism has been legislated for: the workplace pension. This is a new scheme, not compulsory but heavily pushed, which demands a 5pc of salary contribution from employees, and 3pc from employers. Funds are invested in a wide variety of shares and other investments, each for the individual account of the worker. The fund is “portable” – not a bad idea (although 8pc of salary is way too low for a decent pension). But weren’t NICs supposed to do this?

It is difficult to argue that the UK is in a better position as a result. Successive governments have downgraded the importance of a vibrant and healthy investment market, which is a vital ingredient of pension saving. They have imposed what are, in effect, complex retrospective taxes on pension saving (tax credit abolition; lifetime allowance) to the point where many people rightly no longer trust pension saving as the best route for income in retirement.

There is no cross-party agreement on the lifetime allowance; investment returns both in high and low-risk investments have been poor (and highly variable), meaning ordinary people do not know where to turn.

Allied to this is an alarming lack of interest from a significant proportion of the workforce in pensions. It appears that they imagine the state will somehow look after them one way or another if they don’t bother to save. And this, presumably, is the point Mr Fink was getting at.

Given the nature of welfare, particularly at the bottom of the income scale, we’ve maintained this complacency for years. But it is pulling Britain into a pension hole, from which an escape will be extremely difficult, expensive and politically divisive.

Neil Record is a former Bank of England economist and author of ‘Sir Humphrey’s Legacy’

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