Pension reform. A brighter future for pensions

But will Labour go for it?

A YEAR ago, the Pensions Commission concluded that the pension system was heading for trouble. Without sweeping changes, future generations of pensioners would get an ever rawer deal. On November 30th, the government-appointed body, chaired by Lord Turner, a former head of the Confederation of British Industry, set out a new destination, and charted a course to get there.

The central problem is clear. Over the next 30 years, the number of pensioners will jump by 45% as the post-war generation of baby-boomers retires; by 2050 the increase will reach 55%. If pensioners are to maintain their living standards in relation to the rest of society, the share of GDP transferred to them will have to rise sharply, from 9.4% today to 14.5% in 2050.

Yet if things carry on as now, neither tax-funded spending on pensions nor private retirement saving will fill this gap. The government expects its outlays on pensioners to stay roughly the same as a proportion of the economy. It hopes that rising income from private pensions will make up the difference. But as more and more firms have shut their final-salary-linked schemes to new members this has become a vain aspiration. With no sign that individuals are doing more to provide for themselves, the commission says that voluntary pension provision is "in serious and probably irreversible decline".

So what is to be done? There are no soft options, only hard choices and tricky trade-offs. The most obvious yet highly unpopular response to the demographic challenge is to raise the state-pension age, currently 65 for men and 60 for women (though set to go up to a common 65 between 2010 and 2020). The commission then wants it to rise by a year a decade, so that it would reach 68 by 2050.

This taboo-breaking reform will make a big difference, provided that it also raises the age when people actually retire. If it has this effect, then the increase in the state-pension age will provide half the shortfall. However, that still leaves a sizeable gap: 2.4% of GDP. Much of this must come from higher public spending on pensions, says the commission. It reckons its proposals will raise government expenditure by 1.6% of GDP by 2050 (see chart).

Asking future taxpayers to stump up for tomorrow's pensioners is as unpalatable as raising the retirement age. But the commission thinks the current policy of keeping a lid on state-pension spending by concentrating it on poorer pensioners will be more expensive than the Treasury thinks and unworkable in the long run.

Pride of place in the government's strategy, not least since it is Gordon Brown's pet idea, is the top-up means-tested pension credit, which helps poorer pensioners. The snag is that it creates a disincentive to save, since for every additional pound of retirement income people will lose at least 40p as the credit is withdrawn. Financial advisers fear that if they sell pensions to people on average earnings they will subsequently be accused of misselling. Worryingly, more and more people will be affected: as many as 70% of pensioners could be eligible for the pension credit by the mid-2030s.

If people don't save, they will fall back on the government, which will push up spending anyway. That's why the commission wants to reform Britain's two-tier state pensions so that they provide a minimum adequate benefit for everyone. The most important tier is the flat-rate basic state pension (BSP). This has steadily lost value in relation to overall living standards since it was linked in 1980 to prices, which rise more slowly than wages. The commission wants to restore the link to wages, as soon as 2010 if possible. Meanwhile, it wants to speed up reforms already planned for the second state pension so that it will become a flat-rate benefit like the BSP by around 2030.

The aim is that, together, the two flat-rate state benefits will provide a pension worth about 30% of average earnings. That will curb the need for means-testing but it's hardly a princely amount. So the commission wants to boost it with more private retirement saving through a new national scheme aimed at employees on low to middle incomes.

The idea is that employees will be automatically enrolled into the scheme - while retaining the right to opt out - at a contribution rate of 5% of salary. Companies would then have to chip in an additional 3%, resulting in an overall rate of 8% of salary, with total contributions capped at GBP3,000 a year. The money would be collected through the tax system but individuals would own their pension nest-eggs and decide where to invest it, with an automatic option for those making no choice.

The singular virtue of the proposal is that it avoids compulsion for individuals, yet is likely to boost participation rates greatly - if experience with some pioneering American employer plans is anything to go by. It will make employers cross at first as they will have to contribute their whack if employees stay enrolled. But despite their harrumphing they should eventually be able to pass on the cost to workers by paying them lower wages.

The scheme will also drive down charges, which can eat into the value of individual saving. Through cheap collection and administration, and by exploiting its power as a bulk-purchaser of fund management, the scheme should be able to bring down the annual charges from 1.3% for a low-cost stakeholder personal pension to 0.3%. This should push up its eventual value to long-term savers by something like a quarter.

The national savings plan will generate extra resources of 0.7% of GDP for pensioners by 2050, so closing the shortfall when combined with the higher state-pension age and increased public spending. The Turner commission's proposals thus set out a new direction for Britain's pension system: a more generous state pension at a higher age; a move away from means-testing; and an ambitious attempt to promote more retirement saving without compelling individuals to do so.

The recommendations seek to spread the pain between the generations. Future pensioners will have to work longer and save more; tomorrow's workers will have to pay more tax. But the immediate pain will be political. Having set up the commission, Labour has got to decide whether or not to follow its advice.

The auguries are unpromising. The Treasury's briefings after the report suggest that it will oppose many of the recommendations because of their cost. Yet Tony Blair and the work and pensions minister, John Hutton, have broadly welcomed the report, though stressing that it must be affordable. The temptation to resist hard choices may be all but irresistible.

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