The first task of policy in a public health crisis is to save lives. The second is to try and mitigate the economic damage. The coordinated monetary and fiscal stimulus announced this week by, respectively, the Governor of the Bank of England and the Chancellor is the right course. But there will be side-effects, and they will persist. One of particular gravity is the contribution to an emerging crisis in Britain’s pension provisions.
Pundits, including me, often point to the economic burden placed on young people by the high costs of housing and transport. This is a pressing concern but it’s going to be compounded by a problem of pensioner poverty over the medium term. Governments need to take bipartisan steps to head off this crisis too.
As the coronavirus crisis has spread over the past month, financial markets have experienced extreme volatility. Stock markets have plunged; yesterday the FTSE100 index fell by almost 11 per cent, in its biggest one-day drop since Black Monday. Meanwhile, bond yields have fallen to historic lows. The pressure will be felt in private pensions.
The precipitous decline in gilt yields means a big expansion in the deficit for traditional occupational pension schemes. The Pension Protection Fund estimates that aggregate shortfalls in Britain’s 5,422 defined-benefit schemes rose from £75 billion to £125 billion just in February. If the Bank of England, in common with other central banks, is going to persist with near-zero interest rates and unconventional measures of monetary stimulus then these DB schemes, which are committed to paying out a set level of benefits to pensioners, will struggle to fill these shortfalls.
The long bull market in bonds since the financial crisis of 2007-09 has caused this predicament. Government bonds just don’t yield enough for DB pension schemes to be able to fulfil their obligations. If you’re lucky enough to have one of these “gold-plated” pensions, and aren’t prohibited from doing this (as many public-sector workers are), you could get a huge transfer value if you wished to get a cash payment for it.
Meanwhile, the more typical type of occupational scheme is suffering. These are defined contribution schemes, in which workers pay a particular sum each month and have their contributions invested in the financial markets. Employers typically match these contributions up to a certain level and the government gives tax relief on them. It’s an efficient way of saving. The potential problem is that, under the reforms enacted by George Osborne and the coalition government in 2015, people over the age of 55 can now take their money out of these schemes rather than be required to invest it in an annuity when they reach retirement age.
It sounds a good thing to have control over your own savings. As a liberal, I instinctively sympathise with this system. Yet, when it comes to saving, most of us don’t actually know our best interests. Pension products are more like medicines than consumer goods in that respect: we need expert advice to guide us. The past month is the first time since the Osborne reforms were introduced that equities have entered bear market territory. I’m convinced this will speed an outflow of funds from older workers who want to preserve the value of their savings.
I can’t know what will happen to stock markets in the short to medium term but this outflow will definitely be costly. Withdrawing funds and putting them in a bank account, at near-zero interest rates, will guarantee that their real value will be eroded by inflation over time. Pension freedom will in practice mean impoverishment for many in old age.
What’s the solution? One idea, proposed recently on CapX by George Maggs, is to take pensions out of the tax system altogether and allow withdrawals to be tax-free, like ISAs. I don’t think this will work. If a pension is like an ISA, with no tax payable on withdrawals, then there is no deterrent to taking the money right now. That’s the opposite of what’s needed, which is to encourage people to build up long-term savings.
It’s best to recognise that, even for market liberals, there’s sometimes a case for paternalism. So it is with pension provision. Annuity rates are pitiful, given the prolonged low interest rates of the past decade, and pensioners shouldn’t be compelled to buy them on retirement. But if pensioners are to enjoy the freedom to draw down their savings, there should be minimum and maximum permitted annual withdrawals, as a proportion of their pots. There should be a maximum so that pensioners aren’t peremptorily left with too little capital to keep them. And there should be a minimum so that pensioners don’t literally starve themselves for fear of eating up their family’s inheritance.
Both sides of the political divide have got pensions wrong. Labour sees pensions as a contractual arrangement that it’s the state’s obligation to accede to. That’s false: state pensions are a benefit, paid by today’s taxpayers. There’s no pot of money that national insurance contributions build up over decades.
But the Conservatives are wrong in thinking that devolving the decisions to individuals and private provision is the answer. Rather, the state needs to be involved in financial planning. The pension system is almost certainly about to experience a flood of withdrawals, causing avoidable hardship for pensioners over the next couple of decades. It’s predictable and it’s a failing of capitalism. It should be a matter of cross-party consensus to try and fix the system.
Click here to subscribe to our daily briefing – the best pieces from CapX and across the web.
CapX depends on the generosity of its readers. If you value what we do, please consider making a donation.
