LONDON / The Economist / Special Report / Pensions / April 7, 2011
A special report on pensions
People in rich countries are living longer. Without big reforms they will not be able to retire in comfort, says Philip Coggan
WHEN GERTRUDE JANEWAY died in 2003, she was still getting a monthly cheque for $70 from the Veterans Administration—for a military pension earned by her late husband, John, on the Union side of the American civil war that ended in 1865. The pair had married in 1927, when he was 81 and she was 18. The amount may have been modest but the entitlement spanned three centuries, illustrating just how long pension commitments can last.
A pension promise can be easy to make but expensive to keep. The employers who promised higher pensions in the past knew they would not be in their posts when the bill became due. That made it tempting for them to offer higher pensions rather than better pay. Over the past 15 years the economics of the deal have become clear, initially in the private sector, where pensions (and health-care costs after retirement) were central to the bankruptcy of General Motors and many other firms.
There are big national differences, but in most developed countries the bulk of retirement income (around 60%, according to the OECD) comes from the state. Most countries offer some kind of basic safety net for those who have no other income. In addition to this, they may have a social-insurance scheme to which workers and employers contribute. Despite the insurance label, these are essentially pay-as-you-go (PAYG) systems in which benefits are paid out of current taxes.
In some countries workers also have pension rights that are linked to their employment, whether it is in the public or the private sector. Such schemes can be funded (as in America, Britain and the Netherlands) or unfunded (as in much of Europe). In some cases the state has required such schemes to cover all employees. Australia, for instance, has turned itself into the world’s fourth-largest market for fund management by setting up a compulsory national pension scheme for its 22m people. On top of that, people accumulate savings (sometimes called pensions and sometimes not) that they expect to draw on during their declining years.
The four challenges
Pension provision is higgledy-piggledy and often complex, but most rich countries are having to deal with four main underlying problems. This special report will analyse these in detail and suggest ways of tackling them. The first is that people are living longer, but they are retiring earlier than they were 40 years ago. A higher proportion of their lives is thus spent in retirement. Second, the large generation of baby-boomers (in America, those born between 1946 and 1964) is now retiring. But the following generations are smaller, leaving the children of the boomers with a huge cost burden.
Third, some employees have been promised pensions linked to their salaries, known as defined-benefit (DB) schemes. In the 1980s and 1990s the true cost of these promises was hidden by a long bull market in equities. But the past dismal decade for stockmarkets depleted those funds and left employers on the hook for the shortfall. Private-sector employers have largely stopped making such promises to new employees; the public sector is beginning to face the same issues, particularly in Britain and America.
Fourth, private-sector employers are now providing pensions in which the payouts are linked to the investment performance of the funds concerned. These defined-contribution (DC) schemes transfer nearly all the risk to the employees. In theory, they can provide an adequate retirement income as long as enough money is paid in, but employees and employers are contributing too little. Both sorts of funded schemes, DB and DC, essentially face the same problem. “The aggregate amount of pension savings is inadequate,” says Roger Urwin of Towers Watson, a consultancy.
Estimating the cost of pension provision has proved enormously difficult. People have consistently lived longer than the actuaries have expected. In 1956 a 60-year-old woman retiring from a job in Britain’s National Health Service had a life expectancy of just under 20 years; by 2010 she could expect to live for another 32 years.
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