David Willetts

In a speech in Boston, David Willetts explained how pensions systems around the world differ, and a few policy ideas on how we deal with our current and future pensioners, and the debts we owe to them.  (Note: this is a transcript of a recording) 

 A Demographic Indian Summer

At the moment, in terms of total dependency, which is both pensioner dependency and child dependency, by and large economies are in a very good position because we are still waiting for the baby boomers to retire but we are not producing children, so at the moment we have an unusually high concentration of people of working age, that is why, in the figures I gave you earlier, there is such a big fall coming. But what we are going to face soon is that we are going to move out of this Indian summer and the potential impact of these changes in the working population are very significant indeed.

Muddling through. Ex Post

Now as a Brit, and as someone who is interested in public policy, I could not analyse the policy framework here without starting off with by far the main British policy solution to any problem, which is muddling through. There is always the muddling through option! With the muddling through, don’t worry, somehow it will all work out in the end. Let me just describe to you how muddling through works. In a sense for those of you who are economists the rationale is ex post everything does equate. There will still be societies in Germany and Italy and Spain and Britain in 2050, let’s hope so anyway, and all the accounting … will still be met so everything will somehow happen. But there is a muddling through scenario in which a series of welcome changes all happen at the same time.

Unemployment falls. Unemployment has to reduce and one of the questions is whether, especially in Euroland where there are problems of over-regulation in the labour market, they are taking the policy measures necessary for that to happen smoothly and painlessly. But unemployment falls.

Secondly, the other thing you might expect to happen is female participation in the workforce to rise. It is very high in the US, quite high in the UK, in other countries it is not so high.

Thirdly, the birth rate improves.

Fourthly, and perhaps most importantly, and I will come to this at the very end of my talk, migration coming in is the variable, people sucked in as a result of these failures in the birth rate.

So somehow there will be a set of adjustments which mean that there will be people around in 2050 and there will still be economies functioning. The challenge for policy makers is to deliver that smoothly and with the minimum of pain.

Economics: claiming future resources

That is the sort of demographic background. Let me now touch very briefly on the economics because what we are talking about here is claims on future resources. We are not talking about resources which do not yet exist, they can’t be physically set aside, we are not storing rice in the storeroom. We are talking about how people are going to register claims on future resources. And conceptually there are two ways of doing it; you can do it by private contractual arrangements, holding shares which give you a stake in the future output in a company via an entitlement to equities and ownership of the capital. Those are private claims on future resources. The other way you can claim future resources is via the State’s power to tax, having political promises from governments that they will extract taxation and contributions in the future to pay you. In a complete static world where there are successive generations coming through you can perfectly well model a scenario in which with either the claims to future resources being levied via taxation or extracted via dividends you end up in exactly the same distribution. The people producing the goods in the businesses either have to pay higher dividends in order to ensure that retirees have an income or they have to pay taxes in order to ensure that retirees have an income. There are those transfers and they have to take place.

So let’s start with a completely static model in which these two different models are identical. Of course in practice in the real world there are differences. One of the reasons why I as a Conservative prefer the claims to be registered as a private contract is that it is more flexible, and I will turn to that in a moment because it is why the debate on pensions takes rather a different form in the UK and the US than it does on the continent. They are more transparent by and large and of course countries can only tax themselves, they can’t tax other countries, whereas you can invest your savings in other countries, you can globalise your savings in private claims, you can’t globalise your tax system. So there are a variety of reasons why I think that you can argue that private contractual claims are a superior way of doing it.

USA

Let’s look very briefly on a very quick tour round. The paradox which you have in the US which I don’t think my friends in America always appreciate is that your social security system is more generous than ours. Your social security system is far more socialist than our social security system. One of the paradoxes of America is that although healthcare is highly private, pensions and education are at least as much public services as they are on the continent of Europe. So you have quite a generous social security system which is why your 401Ks have not been so heavily regulated as in some other advanced Western countries like the UK because the 401Ks are the icing on the case. They are very important and it is very sad for people when they lose them but you are not going to starve if you’ve got social security. Britain is different.

In Britain our level of state contributory benefits is far lower than American social security with the result that we need our funded pensions, not to boost people into prosperity, we need our funded pensions just to give people a basic income. If you only have your state contributory pension you will be dependent on welfare in the UK, you will be receiving means-tested benefits because the income is so low. So that what we have, and what has been the bane for the industry in past decades, is that our funded pensions have almost become part of the welfare state, the regulatory framework and the tax framework embraced by the Department of Social Security as it was, the Department for Work and Pensions as it is now, is because these are part of the basic income for retirees, they are bread and butter, they are not icing on the cake. But at least in America you have been fortunate in building up large assets, and so have we, almost 100% of GDP at their peak, though in the past few years those figures may have fallen somewhat.

Europe

In Europe it is rather different. In Europe there is much more of a philosophy that you register your claims on future resources via the state’s power to tax, a contract between the generations, and a generational contract delivered via an extensive social security system, and this will come under enormous strain as the baby boomers retire. Fritz Bolkerstein, one of the EU Commissioners, observed very shrewdly, that the real test of the euro will be when the baby boomers retire because one of the normal devices for governments to take when they face excessive claims on resources, they inflate the claims away, the normal device that governments used over centuries when the people have been promised too much cash, they print the money so it isn’t worth as much as the people first thought it would be, but with the ECB it is much more difficult to do that. They can try to raise the taxes but the figures are pretty dramatic for the tax increases necessary. They might want to borrow the money but that puts new pressures on the European Stability Pact. They are trying in several European countries to move to more funded pensions, they tried in Germany and the Riester reforms which were very interesting and imaginative proposals but sadly have not yielded quite the benefits that people hoped.

UK

The UK is very unusual because for us as funded pensions are under pressure as never before because of the falls in asset prices; our problem for the future is not excessive promises to pensioners, our problem is going to be, and is now, pensioner poverty. When you see all those OECD figures about how modest is future public expenditure on pensioners in the UK, and think what an achievement, let me tell you it goes back to 20 years ago when I was in the Treasury and we cut the link between basic pension and earnings, any rise in line with prices, that is why it is so modest. That was in a way a kind of default on the public expenditure promise to pensioners. But you can’t in reality in a democracy expect large numbers of people to live on incomes way below that of the working population, it is politically unsustainable. So what is going on at the moment is a default on the default. What is going on now is the gradual reinvention of benefits for pensioners because otherwise they would have such low incomes. For Europe the position is exactly the opposite. There the public  is very generous, I heard a guy from Moodys at a conference we were both addressing saying the only reason why he rated Euroland  debt so secure was that he was assuming that faced with a choice between defaulting on the promises to their pensioners or defaulting on their obligations to the capital markets, European governments would choose to default on their promises to their pensioners, but that is a decision few would take.

Policy Responses

What are the policy responses? 

First, raise the pension age. But of course pension age is not retirement age. Pension age is a thing that governments control, retirement ages are a complicated phenomenon in the labour market. The nightmare scenario is to raise the pension age but for the retirement age not to move, and for people to end up dependent on welfare, so we have got to look at why retirement age is so low and in Britain in particular that raises a host of complicated questions including the role of final salary pension schemes.

Secondly, changing the shape of occupational pensions, certainly moving from DB to DC, very important changes going on now. Companies all think this is marvellous because they are finally chrystalising the obligation, there is no further debts they have got, they know where they are with a DC pension. I would just observe that looking at the cultural and political environment in which companies work, that if you are employing people and you are paying them £50,000 a year and they retire and their DC pension fund is only going to yield them an annuity worth £10,000 a year, is it going to be easy to get them to retire, especially after the EU Directive in 2006 which ends age discrimination. My view is that in practice, and on a 10 or 20 year view, these DC schemes are so modest that companies are going to find it impossible to get their staff to retire on them, and they are going to have to put together packages to get them to leave so even DC schemes are to some extent taking liabilities off balance sheets without being publicly recognised.

Thirdly, we need measures to restrain the growth of public expenditure.

Fourthly, compel people to save. If we oblige people to save, easy to say, harder to do, what are the incomes of these people who are saving, can we reasonably expect them out of their modest incomes to save, and you can compel people to save gross but you can’t compel people to save net. What if they just borrow the money in order to save? What we are interested in is net savings and there is no device I know where governments control net savings. So there is a fallacy sometimes. People think gross when they really want to control net.”