How Can Anyone Afford a Pension?
Nigel Williams, 22 September 2011
This is part of a short series looking at questions raised by the Civitas publication “You’re On Your Own“, by Peter Morris and Alasdair Palmer.
Life’s an expense and then you die. The Office for National Statistics’ estimate of life expectancy for children born from 2007 to 2009 was 80 years, four years more for women than for men.
Earning, except for the cute ones with modelling contracts, does not begin immediately. By the time those children reach 18, they will have known only mandatory education to sixteen, with a requirement to continue some training even if they are in employment for the next two years. For illustration, let us assume that earning potential begins at 16. Until then they are dependent on others’ earnings.
Earning potential may last until 66 years but is difficult to stretch further. Current expectations of life free from disability (disability free life expectancy or DFLE) are around 68 for women and 66 for men. Budgeting for longer than that starts to look imprudent.
These are average figures. Other questions to consider are whether jobs will be available for that whole time; whether the pension needs to be able to provide for more than just the average twelve years for which working opportunities are restricted. The idea of a pooled pension scheme is that the risks, if longevity may be called a risk, should be shared out between the members. Where people are reluctant to take on other people’s risks it becomes necessary to budget individually.
As a first illustration, let us consider someone that leaves school at 16 and takes a minimum-wage job for 50 years, retiring at 66. If the job pays £10,000 a year, that is £500,000 of income. Leaving aside adjustments for inflation and capital-growth through deferred enjoyment, that half a million has to fund a lifetime of expenses: food and housing for 64 years, funding for dependants for sixteen years each. Awkwardly, this new generation also has to fund the pension promises made in the past to older generations. At current rates of tax, £2,500 per year is above the threshold and pays 20 per cent, leaving £475,000. £3,000 is subject to NI at 12 per cent leaving £457,000. Whether that gets made up by the generation that follows depends in part on whether they are able to meet their own expenses. As public debt increases, that becomes less likely. Debt interest payments currently amount to £31 billion per year. Fifty more years of deficits could raise that further. To reduce it requires an increase in the amount taken in tax or an increase in the things the wage-earner must pay for individually, instead of seeing them provided by the state. It is prudent to budget only with that £457,000.
The fortunate workers on the minimum wage that remain in employment for the full fifty years have something under half a million pounds to spread over sixty-four years. Buying a house will be beyond typical means, so their living expenses will not drop markedly during that period. To preserve a level income for fourteen years of retirement, the wage-earner needs to do without £2,000 each year. There could be a long spell in which family responsibilities bring excess demand. Taking a “pension holiday” and living off the full income for twenty years would afterwards require annual saving of very close to £3,000 each year. Take home pay is not £176 each week but £120. This is based on saving a fund of £87,000 to pay for fourteen years of retirement.
Collective schemes have their value. If saving were wholly individual, a person unable to find work for ten of the fifty years but living twenty-eight years beyond retirement at 66 would be funding 78 years on forty years of work. Without spending extra on family responsibilities, that allows £90 each week. Allowing for no saving during twenty years of child-rearing, it falls to £61. Clearly there is something to be said for sharing the risks. The fortunate individual, who dies on reaching retirement after working continuously at the minimum wage, could spend £176 each week. A responsible average of £120 is not great wealth but is preferable to £61.
There are some sources of more money for these pensioners. Three obvious ones are richer people, the following generation, and clever savings vehicles. The first category has its own need to save and its own expenses, as well as its own preference for where to spend the money. I shall examine their case in a subsequent article. The second will have the consequences of our present deficit, after a further generation of spending. Despite it being the original basis for funding old-age pension, it does carry unfortunate elements of pyramid-selling schemes.
I have left the basic state pension out of my assumptions. That is not through any wish to see it diminished but only out of a recognition that dependence on the state pension alone has never delivered a luxurious standard of living. Morris and Palmer explain this further in “You’re On Your Own”. Currently, the state pension is worth a little over £5,000 per annum, or just over half my assumption for the minimum wage. It is hard to live on that alone, especially for anyone still needing to pay housing costs. Whether it is still even at that level when future generations retire is, at least in part, conjecture. My illustration shows the proportion of income that needs to be set aside to preserve living standards in retirement. It is possible that extra may be found from a collective purse, but it is equally possible that extra will also be taken from the individual to fund that collective purse.
The third source, savings vehicles, is the only one with a chance of bridging the gap. Earning money now but saving it for later has the potential to increase its value. We are used to the concept of interest and always hope that an investment will keep pace with equally-familiar inflation. Accountants have a further concept of present value. When considering a scheme, money in the hand at a later date is considered less valuable than the same amount of money now. It is discounted at a rate of so much per year. It is common practice. Government impact assessments do it. Calculations for the burden of student loans allow them to look less expensive because the repayments are deferred by several years. A career-long contributor to a pension scheme could be offering not to spend the money for the difference between the mid-point of employment and the mid-point of retirement. In the example above, that is thirty-two years. It is not a perfect representation of the pattern of regular payments into the fund followed by rapid taking out, but it is a close enough approximation. A discount rate of 2.2 per cent, used in student loan illustrations by the government, means that the pensions savings should be worth twice as much after an average of thirty-two years. The calculation is 1.022 raised to the power of 32. However basic the investment vehicle, it needs to maintain the same present value in real terms. In cash terms, money saved for that long should count double. On that basis, level income is possible at £154 each week, saving £1,100 a year. Even with twenty years of raising offspring before starting saving, leaving only 22 years for investments to grow, a steady income of £136 per week is possible. That is similar to the earlier figure that allowed neither for present value nor for raising a family.
The key point is that the individual needs to demand that the present value be maintained. It is not something for nothing. It is a fair reward for doing without money at an early stage in life and letting someone else have the use of it meanwhile. A contribution paid today should instantly be regarded up-rated on the basis of 32 years of being set aside. That is not allowance for inflation, which needs to be extra, nor for risky investments, which ought to balance out over time in a zero sum. It is purely recompense for spending several decades without access to a portion of one’s income.
I have not assumed that incomes will rise in the course of a career. For my example at the low-waged end of the employment range, it may be more realistic to plan for shorter periods of employment than the fifty years that I have assumed.
Neither have I mentioned tax relief or inflation. Quoting contributions in one year’s prices but payouts in inflated prices of later years is a way to make a pension scheme appear unreasonably cheap. My illustration leaves out inflation, but carries the implicit assumption that invested savings must keep pace with inflation, as well as preserving the present value. It is rare for an individual to benefit from any changes to a tax regime after economic equalization has set in. Some other way is found to take the money back again before the individual receives it. In pension terms, one might think it reasonable that the money should be taxed either when first earned or when paid as pension, but not both. Gordon Brown’s innovation was to tax the savings vehicle in the period when value was accumulating inside the fund. This is mentioned in “You’re on your own”, which speaks also of the compound-interest blindspot. The public is very slow to spot how an annual percentage charge can continue to slice away at a fund, whether the charges come from the tax man or from a fund manager. Illustrations of value in pensions need to remember that there is a long period between making the contribution and receiving the benefit, so that the contribution may typically be regarded as having twice its face value. If that fact is forgotten, the pensions saver may just be throwing half the contributions away.
Allowing for maintaining present value, sums to be saved are still substantial. My illustration shows that preserving a minimum-wage income for fourteen further years after fifty continuous years of work requires 12 per cent of take home pay, or 22 per cent if saving does not start until after a twenty year “holiday” for raising a family. Most people have more sense than to spend £40 each week on lottery tickets, so it may be better to see retirement planning as taking from half to a whole day’s work out of every five-day week.