Are young people being short-changed over pensions?

19^th December 2014

Pensions are inherently an intergenerational issue. To a greater or lesser extent, all the different types of pension scheme rely on one generation making a claim upon the productivity of the next one. In his book Good Times, Bad Times: The Welfare Myth of Them and Us, Professor Sir John Hills of the LSE refers to pensions as an “intergenerational game”, in which each generation effectively pays for the pensions of the one that came before it in the expectation that succeeding generations will do the same for them.

These intergenerational commitments take two different forms. As the name implies, “unfunded” pension schemes (such as those in the public sector) have no assets, and rely upon the members of each generation paying in their contributions to belong to the scheme so that the money can then immediately be paid out again to fund the pensions of those who have already retired. Rather than building up assets within the fund, paying in contributions purchases “pension rights” which the next generation of members has a legal obligation to honour. The weakness of such arrangements is that they rely upon each generation being willing and able to pay in enough money to meet the obligations which have already accrued; if the younger generation of members is much smaller than the older generation, or longevity increases, then the next generation will have to pay more, potentially creating intergenerational unfairness.

Even “funded” pension schemes – where the contributions that members pay in are used to build up a fund which then provides a pension income in retirement – effectively represent a claim on the resources generated by the next generation. This is because they are usually invested in the stock market, where returns depend upon the productivity of people who are of working age.

The current generation of young workers in Britain has arguably been placed at a significant disadvantage by demography. Many of them will have had the misfortune to come of age just as the post-war baby boomer generation was looking forward to a long retirement because of the greatly increased life expectancy which they are set to enjoy. Unfortunately, this has to be paid for, and many employers who had previously offered generous “defined benefit” (or final salary) pension schemes to their workers (in which the worker can expect a pension based on a fixed share of their final income for life when they retire), suddenly realised that rising longevity would make this ruinously expensive in the future. As a result, younger workers have found that most of Britain’s larger employers closed their final salary pension schemes to new entrants (Shell became the final member of the FTSE 100 to take this step in 2012), usually leaving them with a less generous “defined contribution” pension instead.

Defined contribution pensions are different to final salary ones in that the employer promises to contribute only a certain fixed amount of an employee’s salary towards a pension, which is then usually invested on their behalf in a fund. Today’s workers have been disadvantaged by this development because it means that they have to carry all the risk of the fund not performing well enough to guarantee them a decent income, while defined contribution pensions are generally far less generous than final salary ones overall (median defined benefit pension savings were £177,900 in 2010, compared with just £29,000 for defined contribution, according to the ONS).

The one employer that still provides final salary pensions to its staff is the government. Public sector pensions are all unfunded, with liabilities being borne by future generations of taxpayers. These are on a vast scale – research undertaken by economist Neil Record for IF found that total liabilities for public sector pensions stand at £1.6 trillion, higher than the official national debt, although he accuses the government of using accounting tricks to make them appear £600 billion lower.

Public sector pensions are currently being reformed, following the recommendations of the public service pension commission chaired by Lord Hutton. This will see most public sector workers having to work longer before they can receive their pensions, and they will now be calculated on a less generous “career average” rather than final salary basis, but, as they will remain unfunded, large liabilities will continue to accumulate which our children and grandchildren will be left to pay off.

Even the liabilities for public sector pensions are dwarfed by the state pension, which is currently paid to all pensioners regardless of how wealthy they are. The state pension is unfunded and paid for entirely by each generation of taxpayers: rising longevity and the size of the baby boomer generation means that its liabilities stood at almost £4 trillion several years ago, on the basis of which almost half of a group of 50 economists who were polled by IF said they thought it would need to become means-tested by 2050.

It remains to be seen whether Britain’s young people will still be willing to keep playing these intergenerational “games” if they increasingly feel they are being given a bad deal.