Article for Pensions Management April 03

Arguments for a Decent State Pension...

The Government’s aspiration is to reverse the balance of pension provision from the current 60:40 ratio between state and private funding. Though arbitrary, this target is based on the accepted wisdom that funded pensions are superior to “Pay As You Go” (PAYG). Stakeholder pensions were introduced to provide a new investment vehicle to help bridge the gap (at least 2.5%GDP) between what we allocate from taxation and savings and what is needed to afford a decent standard of living in retirement.

Since then, not only has the availability of stakeholder pensions failed to stimulate additional saving but we have seen the declining willingness of employers to provide good quality pensions because of the collapse of the stock market and demographic pressures.

As it becomes clear that the pensions gap is not going to be filled by increased voluntary saving, the Government has reluctantly had to contemplate the option of compulsion. The reason for the reluctance is clear -  if the Government compels people to contribute, it will have to take responsibility for the outcome.  Making employer contributions compulsory carries the risk that employers will simply compensate by cutting jobs or wages.  Likewise, forced employee contributions will reduce the disposable income of low earners but offer no guaranteed outcome.  Worse still, from the Government’s point of view, compulsory contributions will be seen as a tax and will lead to questions about the value for money of compulsory private pensions (which could mean compelling people to make poor investments) compared with that of state provision from taxation. 

Time then to re-consider the assumption that the proportion of GDP to be paid out in state pensions must be held around 5% GDP because provision through PAYG is undesirable?

This is explored in a paper by Christopher Downs published in a recent Citizen’s Income newsletter ( The concept of funding for a social security programme is that assets must be accumulated to match liabilities. This is justified in the case of a private scheme because of the need to cater for the eventuality of failing to enroll new customers whilst still having to pay benefits to its old customers.  In reality, the purpose of pensions is to allow people to carry forward consumption possibilities.  As individuals we may save to buy financial assets but we are dependent on others to provide the goods and services we need when we stop working –or as Downs puts it (quoting Paul Samuelson), if Robinson Crusoe were alone, he would die at the beginning of his retirement.

The only way real wealth is transferred is to build physical infrastructure and human capital.  Today, we are still benefiting from the investment of the past, for example the sewers and bridges built by Victorians and the inventiveness of educated people. Thus a PAYG system in which taxes on younger members of society pay the pensions of older people can be justified on the basis of the past contributions to society of older members.  The costs of organizing the system are also lower due to economies of scale and the fact that there are no costs involved in persuading citizens to sign up to the scheme.

Of course the counter arguments are that productive investment is not undertaken because of crowding out and labour is not applied to produce useful output because of taxes on labour.   However, it can hardly be argued that private saving is being crowded out

and at the same time advocate compulsory pensions savings.  It is also a fact that the Anglo-Saxon equity culture and extensive funding of private pension schemes are actually associated with lower savings rates.  As John Kay pointed out in a recent article in the Financial Times, the main effect of increased demand for equities has been to bid up prices, not create tangible assets that will feed us in 2040.  As for the need to restrict taxes on labour, the advantage of PAYG is that there can be a wider tax base that can include, for example environmental taxes.

Thus I would argue that we need to challenge the notion that a decent state pension system is unaffordable. Confidence in the state as future pension provider has been undermined by the propaganda that PAYG is inefficient and saddles future generations with the costs of the present. But the recent collapse of confidence in private provision should lead us to take a more balanced approach between the risks of market failure and the political risks of relying on future governments to honour the “pensions promise”.   Surely the trick here is to devise a universal system that everyone understands so that state pensions cannot be cut without damaging political consequences?

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