The purpose of a pension is to ensure we can have “a reliable income from the time you retire until the time you die”. If we continue to save the same amount for our retirement then, if we are all living longer, we need to raise retirement age to maintain the same pension, or reduce pensions in payment if we are going to have a longer period in retirement.
But the bigger problem, and the one we have not solved is that, however long we live on average, none of us know the day of our death. So how are we to judge how much to set aside for an income in retirement. The only way to solve that problem is to buy an annuity, but by common consent annuities are very expensive. If you work in the public sector, or are still subscribed to a DB pension in the private sector, (which few people still are), your employer will underwrite the pension promise. But aside from these alternatives, British people no longer have access to a private pension system. Instead, most of us will have to draw down from personal savings, a solution that works for those people whose assets are large enough that they will never run out of savings. But those of more modest means have no way of ensuring a “reliable income from the time you retire until the time you die”.
That is a huge gap in social provision.
As someone who, like many readers of Pensions Age, has worked for much of my life in the UK private pension system, I find it shaming that, for all our expertise, for all the resources of the private pension system, we have abandoned DB, and failed to develop a system where ordinary citizens can buy a pension.
How could we have come to such a pass? I believe it is because we have failed to design our pension system with purpose in mind. The purpose is to create a reliable income, in circumstances where we do not know how long we will live. From a technical point of view, we know that issue can be resolved, (to some degree) by managing the dependency ratio, and allowing us to share individual longevity risk. We therefore need institutions which are designed to do just that.
We are perfectly capable of doing so if we have the political will. For example, we have, through auto-enrolment, addressed an important corollary question; that is how can we develop a saving system that will encourage people to set aside enough money to be able to afford a pension when they retire. This savings system has had some success. The problem is that there is no well-designed pension to buy with the money people to set aside.
The answer is some sort of collective arrangement, where those who live for a shorter period of time, ‘subsidise’ those who live longer. But all know they will have an income until they die. Unlike annuities, such pensions would be invested in real return-seeking assets, not just in low yielding bonds. They need to be well governed, with trustee management, in order to avoid the unfortunate fate of ‘with profits’ savings, where in the good years, the insurance companies sponsoring them saw fit to syphon policy holders returns.
One could add to the list of the institutional characteristics needed for a good pension system, many of them entirely familiar to pension savers in Holland and Denmark, in Canada, and now under discussion in Australia. Study after study has shown that such collective arrangements will give pensions that are 30-40 per cent higher than the best equivalent annuity based solution, and that, if they are managed through large low cost institutions, the pension uplift is higher still.
To give some perspective on this, today, in Britain, we set aside about 6.5 per cent of the GDP into private pensions. With properly designed institutions we could create a productivity increase equivalent to 2-3 per cent of GDP; about the same contribution as from North Sea oil.
How could we, as professional pension managers, have allowed our industry to be regulated in such a way that this huge prize, so simple to secure, has been lost. At heart it comes to our failure to start with asking the purpose of the pension system, and design a set of institutions to fulfil that purpose. And it behoves us as professionals to ensure that that question is never again overlooked.
Written by David Pitt-Watson, Executive Fellow at London Business School