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.