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What does one get if one combines the UK’s proclivity for muddling through with the predictability needed by a system for providing security in old age? The answer is: a mess. Over time, piecemeal solutions create new messes.
There are two distinct sets of problems with the pension system of today.
The first is that current and future pensioners now fall into four categories: public sector workers, who enjoy secure, inflation-protected pensions, backstopped by taxpayers; beneficiaries of secure defined benefit (DB) private pensions, many now closed to new contributions and new members; younger people saving in defined contribution (DC) schemes, who bear all the investment and longevity risk; and poorly paid people who will end up dependent on the state pension.
These divisions are, with the exception of the last, arbitrary products of history. Why should the pension arrangements of public sector, and older private sector, employees be so much safer than those of today’s private sector workers?
The second failing is that the pension system fails to make the economy more productive. This is because it is both highly fragmented and risk averse. According to the Pensions Policy Institute, only “18 per cent of UK pension assets are invested in UK productive assets — listed equities, corporate bonds, private equity and alternatives”. Such an allocation is not going to create the thriving domestic businesses on which national prosperity must depend.
Given the legacy of past pension promises, a jump from here into something coherent (and just) is, alas, impossible. So, the question about this government’s plans for reform is whether they will move things in a better direction. The answer is: yes. They are in line with an emerging consensus that has three main components: consolidation; productive investment; and higher savings.
I would add universality. It is wrong, in principle, that risks are now so unequally shared across sectors and generations. This cannot be changed overnight. But over time it should be.
Two recent government papers — the final report of the Pensions Investment Review and Workplace pensions: a road map — outline the intended direction.
In the latter, Torsten Bell, pensions minister, explains that the pension schemes bill will put the outcomes of the review into law. The principal aim is consolidation of schemes, creating “a smaller number of bigger, better governed, better value pension providers investing in a wider range of productive assets”. An important area of consolidation, started by the last government, is that of local authority schemes. Others are of smaller DB and DC schemes.
This broad theme of consolidation makes sense, because there are economies of scale and scope in managing pension funds. Such consolidation will, not least, help ensure better management of risk and so greater investment in innovative investments. Today, according to the workplace pensions road map, 2,000 DB schemes hold a mere £10bn in assets between them. Again, there are currently many DC schemes with fewer than 100 members.
This links to a controversial issue: the role of pension funds in promoting economic growth. There exists a view that there should be no bias towards investment in domestic productive assets. There exists, too, a parallel view that the best thing to do is to invest in index-tracking funds.
I have held such views, but do so no longer in the case of pension funds, for reasons laid out in the road map. Thus, it states: “The quality of our pension system determines our living standards through what we all hope are decades in retirement. But it also underpins our wider economy as one of the largest domestic pools of capital. Those goals, and roles, are not in tension with each other . . . After a decade and a half of stagnation in UK productivity and wages, there is nothing more important for UK workers and pensioners than returning growth to our economy.”
This should be done, albeit with care and caution. But it has to be done. It can only be done by big schemes and large funds able to operate in a highly professional way. These reports are right also to emphasise that a focus on higher returns will deliver better pensions to savers.
It will be necessary to raise savings rates as well. Contribution rates are far, far too low. UK national savings rates are also far too low. Raising the former is a necessary step towards raising the latter. These big issues will be a part of the next stage of the pensions review, which is to focus on the adequacy of retirement incomes.
Turning the UK’s irrational and inadequate pension system into something less irrational and inadequate might be this government’s most important economic legacy. At the least, it is making a sensible start. It has to keep on going.
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