Wednesday 9 November 2011

It’s demography stupid!

The protestors on the streets of London, New York, Madrid and Tel Aviv do not understand the economic and political problems they face.  The developed world is suffering from a demographic crisis.  Railing against financiers and the richest 1% misses the underlying cause of the crisis: the costs of paying for their own parents' and grandparents' retirements.


The vast majority of the debts the western economies are not managed by banks, they are not included in most measures of national debt.  The biggest debts, the debts that are crippling the governments of Europe are unfunded state pension liabilities.  For example, in the UK the state pension is funded through national insurance contributions.  When national insurance payments by workers are greater than the amount paid out, the excess is saved into a trust fund.  A recent review of the national insurance fund assumed investment return of 2% and a real earnings growth of 2%, and projected the fund to grow to around £1.2tn in 2060.

However, these assumptions are not realistic, in the last decade real earnings growth has been below 1%, and real earning are currently falling at 3% a year.  The fund is invested in UK government debt, at best this offers a return of 0.5% after inflation.  This means national insurance payments into the fund are currently lower than the amounts paid out in benefits, so the value of the national insurance fund has fallen from £53bn in 2009 to £37bn today.  It appears unlikely the fund will cover its future liabilities.

So how are our politicians responding to this demographic crisis?

In the most recent British election, Nick Clegg proudly trumpeted his triple lock for the basic state pension.  The basic state pension will increase by the higher of 2.5%, inflation or earnings.”  Since the election, the coalition has introduced the guarantee.

Government actuaries estimate that implementing the triple lock will reduce the national insurance fund by a further £3bn in 2012.  The costs to the fund will be compounded every year thereafter.  Nick Clegg and the coalition have not set aside any money to pay for these increases.  Similarly the previous administrations' pensions reforms of 2007 which were expected to increase the UK’s spending on pensioners by £80bn or 2% of GDP a year by 2050.  But since 2007 the expected size of the UK economy in 2050 has dramatically fallen, whilst pension liabilities have remained the same size.

One way to think about the cost of the basic state pension is to calculate how much an annuity equivalent to the basic state pension would cost.  The basic state pension pays £5,311 a year and is guaranteed to increase at least as fast as the retail price index, an annuity paying as much would cost £135,000.  Over the next few years the first cohorts born in the baby boom after the Second World War will retire.  These pensions will be paid to many of the 800,000 who reach pension age each year.  This implies a cost of up to £100bn a year solely from the basic state pension.  This is equivalent to the amount spent on the NHS, or the more than is spend on education and the military combined.

How will these increases in spending on pensions be paid for?

One way is to reduce other services: the coalition is cutting educational spending by 16% in real terms over the course of the parliament.

A common justification for the basic state pension is that it promotes equality, providing benefits to poor pensioners by taxing today’s employees.  However, this is too simplistic.  People from less affluent areas have much lower life expectancy than people from wealthy areas.  Therefore the basic state pension transfers income to those who live longest.

A man from Kensington and Chelsea might expect to live for 20 years after retiring at 65, whereas a Glaswegian might only live for another 6 years . The Kensigntonite would receive about £100,000 in state benefits whereas the Glaswegian would only receive £31,000 in current terms.  One of the main proposal for controlling the costs of the basic state pension is to increase the eligibility age.  The recent delay in increasing the state pension age by a single year cost the government £1bn, twice as much as the annual cost of the educational maintenance allowance.  Increasing the state pension age will make the basic state pension even more regressive.  If the state pension age was raised to 68, the Glaswegain would receive about £16,000 and the Kensingtonite would get £90,000.

Is the basic state pension the most regressive government policy?

If politicians were actually concerned with pensioner poverty, they would increase means tested benefits rather than benefits paid to poor and rich alike.  One means tested benefit is the pension credit, which guarantees a minimum income to pensioners with insufficient pensions.

An alternative justification transferring income from the young to older people, is that pensioners are relatively poor compared to the rest of society.  However, the proportion of pensioners with income 60% below median income after housing costs has fallen from 36% in 1995 to 8% in 2010, whereas the working age adults has fallen by 23% to 15% and the number of children has fallen 37% to 18%.  Pensioners are now less likely to have low income than younger people. 


It seems wrong to expect a generation with such a bleak future to pay for increases to state benefits for generation that hasn’t saved for them: for today’s young people to pay more to their elders with little expectation that similar benefits will be paid to them when they retire.  The protestors of today need to understand why services are being cut, why tuition fees and taxes are being raised.  Unfortunately it’s not quite as simple as blaming Wall Street and the bankers: the protestors might need to take a closer look at the costs of their own parents' and grandparents' retirements.

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