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The Pensions Crisis - What is it all about and should we be worried?

This Mind your Business article looks at the pensions crisis.

Mind your Business - 03 May 2004

The Pensions Crisis - What is it all about and should we be worried?

The News

In the 'Mind Your Business' article of 29th April 2004, the problem of funding pensions in Europe was mentioned. It is difficult to go anywhere these days without some mention of the pensions time bomb. For young people, the subject seems a long way off and not something that needs to be dealt with as a priority given the competing demands of education, finding employment, getting on the housing ladder and so on.

Having said this, it is an issue that has relevance for us all because not only do we need to think some years ahead about how we are going to live when we no longer work, but it is young people today who will have to take on the burden of paying for an ever growing army of people who may not have sufficient funds on which to live.

The pension crisis can be looked at from several angles.

  • It could relate to the problems that governments around Europe have in funding the state pension schemes that will act as the support to the elderly.
  • It could be looking at the problems firms have in meeting the pension obligations they have in fulfilling company pension schemes.
  • It could be the problems faced by those who have contributed to company pension schemes but who now find that, as a result of the firms they have been working for years going out of business, they do not have access to the pension support they were expecting.
  • It could be the fact that fewer young people seem to have pension provision at the head of their priorities and that this could mean that they are storing problems for their future welfare.
  • It could be the move by businesses to switch from occupational pension schemes - where employers contribute a sum as well and which workers get fixed pension sums in relation to their final income to less attractive but cheaper to the firm non-earnings related schemes.
Pensioners

Increasing numbers of elderly people will put greater pressure on those who are working and paying taxes (the economically active) in the years ahead. © Photolibrary Group

Whatever angle we look at it from, the problem is the same. Countries throughout the world are witnessing a number of trends which will put huge strain on resources in the future - in some cases, the not too distant future. These trends are:

  • The move to postpone starting families until career aspirations have been established - women having children later in life leading to a fall in the birth rate.
  • The move by young people to prioritise things such as house purchase or travel ahead of pension provision.
  • The rise in the number of people in the 65+ age bracket as a result of a falling death rate and more successful health care regimes.
  • The pressure on governments to reduce the tax burden.
  • The increase in the competing demands for government spending.
  • A fall in the population of working age - the ones who pay the taxes that can be used to provide pension payments.
  • The problems of world economic conditions leading to the fall in the value of stock markets around the world.
Stock Exchange, Beijing

Greater volatility in stock markets can lead to falling pension fund values. © Photolibrary Group

Put together these trends mean that there are more people who will require financial support in some form or another but less money available to provide it. It is certainly a very worrying problem. Many have accused the government and all involved that the problem is not being taken seriously enough and that we are putting off difficult decisions that are only going to get more and more difficult as time goes by.

Theory

Why has the pension problem got so serious? To help understand this question, it is necessary to look at how different pension systems work.

  1. Pay-as-you-go systems
    These are systems where the government effectively takes money off one group of people and gives it to another. In such cases, the funds for the pension are derived from those who are in work and paying, in the case of the UK, National Insurance Contributions (NICs). The amount of money available for investment purposes here to generate and build up wealth may be very limited indeed, hence the potential problems being faced when the tax paying population is dwindling but those seeking pension support is growing.
  2. Pension funds
    The role of the stock market is vital in the pension story. Pension funds are a major investor in stocks and shares - one of the so-called 'institutional investors' that seem to have so much power in such markets. The principle is that individuals are unlikely to have the time or the expertise to invest their savings in a way that will bring them a sufficient return to live on into their old age. By taking out a pension policy, the individual effectively begins a lifetime savings plan - along with a host of other people. The pension company takes the contributions individuals make and invests the funds on their behalf. On the elected retirement date, the individual gets the contributions and the earnings generated from the investment, minus the cost of running and maintaining the fund as, possibly a lump sum payment and then an income each year or just an income depending on the type of policy taken out.

For each product, the pension company will have a fund manager who is responsible for the investment and monitoring of that investment on behalf of the company's clients.

The combined contributions can be very large sums and in such cases, can earn greater returns than smaller sums. The funds are invested in a variety of securities representing different risk categories. The skill of the fund manager in reading the financial markets determines how much the pension holder will eventually get in their pension. The problem is that the value of the pension may be determined by the value of stocks and shares in which it is invested on the day it matures. If the markets are in a slump, the value of the pension will be much less than in periods of growth.

Let us take an example:

Assume there are 10 people in the fund each contributing £200 per month as their pension contribution. The fund manager has £2,000 per month to invest. She invests it in two stocks - BP (current share price 500p) and Costain Construction (current share price 200p). She buys 200 shares in BP and 500 shares in Costain.

Over the period of the months and years that the fund is active, the dividends provided by companies in the fund are added to the value of the fund, for the sake of simplicity, we will ignore this in this example. Let us assume that in 1 year's time, the share prices of BP and Costain have improved and are now worth 600p and 300p respectively. The value of the pension fund is now worth £1,200 and £1,500 respectively - total £2,700. If the pension were to mature at this stage, the participants would each get a share of the £2,700.

Obviously, over a period of 45 years of working life, the contributions are going to continue to rise and the value of the fund will also, hopefully increase. This does serve to show how the value of the fund is dependent on the direction of movement in share prices. If share prices fall - for example, over the last two years the price of WH Smith shares have fallen from around 700p to 260p - then the final value of the fund may not be as large as expected and as such the annual pension received by the individual not as healthy as they would like.

With occupational pensions, the situation is slightly different. Here the contribution is taken directly from the worker's salary and an additional contribution is made by the employer. These are part of the 'hidden costs' of employing labour that employers often complain about. The funds are again invested but this time; the pension received by the employee is based on the final salary and the number of years worked by the employee. The longer the time, the more contributions, the higher the pension fund, etc. It may be that a guaranteed final income pension will amount to a third of the final salary - this might not sound much but it does give a degree of certainty to the retired in planning their future.

The black hole arises when the company calculates the amount of money needed to pay the final salary schemes and compare that to the amount of money currently in the fund. If the amount needed to cover the employees' pensions is less than that in the fund - you have a black hole. The question then is who should make it up?

Tasks

  1. Consider the pay-as-you-go scheme. Many European countries are facing problems in meeting their pension commitments in the coming years. What solutions might there be to this problem?
  2. Some people feel that pension saving is too risky and unpredictable to be a reliable provider of funds for retirement. What other method might they employ to help provide for old age?
  3. What strategies could governments use to persuade individuals of the importance of preparing for their retirement?
  4. Should the state pension be means tested? (A means test is an assessment of the wealth of an individual to determine whether they should be eligible for state benefits).

Related Web sites for research

Mark Scheme

  1. Consider the pay-as-you-go scheme. Many European countries are facing problems in meeting their pension commitments in the coming years. What solutions might there be to this problem?
    If you have looked at the information and the research sites suggested, you will have worked out how the state pension is paid. The main problem is that the funds available for pension provision are not generating any wealth - they are simply taken from working people in the form of taxes (NICs) and given to the elderly - a transfer payment. The smaller number of tax payers and the growing number of those eligible for pensions is the main cause of the problem so your answer has to deal with these two sides in some form or another. As a hint, you could increase NICs for example - but what impact would this have? For each suggested solution, try to think of what the implications will be. Think also about the age at which the pension can be claimed!
  2. Some people feel that pension saving is too risky and unpredictable to be a reliable provider of funds for retirement. What other method might they employ to help provide for old age?
    We all need some amount of money available to live on after we have stopped being economically active - i.e. earning money to pay the bills, etc. The answer here therefore is to think about what other means of saving for the future people could employ. To direct your thinking, look at what is happening in the housing market at the moment! Again, try to think of the impact of the method/s you identify - not just on individuals but on relevant markets and the economy as a whole.
  3. What strategies could governments use to persuade individuals of the importance of preparing for their retirement?
    The guide here is to think of legislation - effectively forcing people to save, persuading people to take out their own private pension policies (privatising pension's provision), and floating ideas about the age at which people are allowed to retire in an attempt to make people really think about their future.
  4. Should the state pension be means tested? (A means test is an assessment of the wealth of an individual to determine whether they should be eligible for state benefits).
    This is a question requiring you to make a judgement. Means testing has been a way of sifting out those who don't need state benefits from those that do. Some see it as being very unfair in that everyone should be entitled to the same amount. Clearly some people may have savings or wealth and do not really need the state pension as well - should they therefore have to give up the right to have it even if they have paid into the system all their working lives?

    If, however, it was means tested, more money would be available for those that really do need it - the most vulnerable in society. Such is the nature of making judgements in economics and business. There are rarely right answers so you will have to think about the relative costs and benefits to the individual, to society and to the economy and make your judgements based on your analysis of such issues.
Submitted by aashwin on Mon, 03/05/2004 - 12:00