Factors That Affect the UK Pension Crisis

Factors That Affect the UK meet CrisisInvestigating the factors that affect the UK pension off crisisIntroductionThis review examines the background literature regarding the causes of the UK pension crisis1, and the various measures taken to chip the crisis. In fix up to understand the record of the problem, it is first essential to consider a bit of background on the UK pension system, and UK demographics.There is some study over which types of pensions pay as you go (PAYG) or funded schemes atomic number 18 best. Barr (2006, 2) explains that in a PAYG scheme pensions are paid come forward of current income. In a to the full funded scheme, pensions are paid from a fund built over a period of years from members characters. Virtually all state pension schemes are principally PAYG unavowed schemes are generally funded (though non necessarily adequately). The UK state system is a hard mix of several components, paid for on a pay-as-you-go arse though a mixture of nati onal insurance contri notwithstandingions and general taxation (Hills, 2006, 116). Non-state, voluntary schemes include occupational pensions which may be either defined contribution (DC) or defined benefit (DB) schemes, and reclusive pensions which are usually DC. In recent years the majority of occupational DB schemes in the UK corroborate closed.The demographics of the macrocosm have changed significantly over recent years. Barr (2006, 4) argues that average age at death in the UK (and similarly in other countries) has been rising steadily at to the lowest degree since 1860 Clearly, as more and more hatful live to pensionable age and, having achieved that, live longer and longer beyond that, the costs of pensions rise and, as a proposition in pure logic, rise disproportionately. However, the UK also faces some country-specific pension issues, and these leave be the focus of this dissertation.At the root of the problem with PAYG schemes is the ageing population, but there ar e other factors which affect the supply and demand of funded schemes, and against which policy may be more easily directed. Three of these are drawn out in this dissertation. As much(prenominal), and for clarity, this literature review is structured around the three themes public knowledge and soul of pensions in the UK the level of private savings in the UK and the recent decline of DB schemes in the UK. However, it should be noted that these three factors are interrelated, as will be demonstrated in the analysis that follows. humanity pension knowledgePensions are always subject to a problem of imperfect information when one considers how and how much to turn in for retirement, the decision is made on an estimate (not a certainty) of life expectancy. However, there are further problems in terms of knowledge and understanding of pensions, particularly in the UK. On the microeconomic side, the advantages of consumer sovereignty are predicated on well-informed consumers, a very strong assumption in the eggshell of pensions. Individuals are imperfectly informed, first, because of uncertainty roughly the futureindividuals are not well-informed because nobody is well-informed. Second, they are imperfectly informed in the face of risk (Barr Diamond, 2006, 20).This second problem is particularly acute in the case of the UK. As the DWP (2006, 12) outlines, a long-standing feature of the UK pensions system has been its complexity, which can confuse both employers and individuals trying to throw the best financial decisions for the long term. Hills (2006, 123) confirms this point, and elabo range on it The UK pension system is perhaps understandably brusquely understood, and that understanding has if anything declined in recent years in 2000, only 53 per cent of the population reported at least a reasonable, basic knowledge of pensions, but by 2005 this has fallen to 47 per cent. At the same time, levels of trust in pension providers and financial products are low. Even if deal do realize that their pension will be inadequate, this combination makes it very hard for them to make a plan to do something about it. In addendum to gamey levels of confusion about the pension system in the UK, there is relatively high freedom for the individual to decide how and how much to save for retirement. Banks et al (2002, 16) explain that the UK pension system allows individuals a great deal of choice over how much they save for their retirement and in which form they save.The DWP (2006, 6) claims that it is helping slew to make better informed choices about their retirement, introducing a range of pension forecasts to march on individuals an understanding of the income they are likely to receive in retirement. Since their introduction, the Government has issued full over 20 million of these forecasts and we are developing web-based retirement planning services. These measures may not, however, be sufficient to guide individuals through what remai ns a multiform system. Considering the government also seeks to place the responsibility for pension decisions firmly with the individual2, it is likely that more collects to be done to increase public knowledge and understanding of saving for retirement. Blake (2000, 233), for example, does not view such measures as sufficient. The fact that membership of pension schemes at the second pillar remains voluntary is highly sorry for reasons of myopia and moral hazard. Compulsory contributions are seen as one way of dealing with individual myopia and the problem of moral hazard. Myopia arises because individuals do not recognise the need to make adequate provision for retirement when they are young, but regret this when they are old, by which time it is too late to do anything about it. Moral hazard arises when individuals deliberately avoid saving for retirement when they are young because they know the state will feel obliged not to let them live in dire poverty in retirement. In t he next section, the problem of the lack of private savings will be considered in more detail.Lack of private savingsRelative to many other countries, there is a lack of private saving in the UK. As the DWP (2006, 11) explains, retirement undersaving has arisen for a variety of reasons because individuals have not trusted private pensions, because suitable savings vehicles have not been available to them, and because, in the face of a historically complex pensions system, financial short-sightedness and inertia have left inaction as the default option. This demonstrates the interrelationship between public knowledge of pensions and retirement income and levels of saving (eithrer through pensions or otherwise). This point is reiterated by Davis (2004, 22) who claims that surveys suggest there is a major underestimation of saving needs for retirement and most individuals focus on pensions only 10 years ahead of retirement The saving problem may partly be linked to poor information. C learly a lack of easily kind and comprehensible information has contributed to the low levels of private savings in the UK. However, there are also other reasons.In addition to understanding how the system works, it is necessary that individuals are presented with the right incentives to encourage private saving. Davis (2004, 4)explains that essential background for evaluating private pensions is provided by the structure of social security pensions. As in all countries, the reach for developing funded private pensions in the UK is conditional on the nature of compulsory, pay-as-you-go social security pension provisions. Broadly speaking, the development of social security in the UK has been roaring to private schemes, particularly as a consequence of the rather limited scope of social security on offer and the ability of employees to opt out of earnings-related social security pensions.However, in practice, low levels of private saving suggest that such incentives have not been sufficient. In addition, there are various disincentives to save for retirement and, indeed, there are disincentives for financial advisors to provide advice on retirement savings to those with low incomes. This is due to the risk that by the time they retire, their savings will disqualify them from certain means tested benefits to which they would otherwise have been entitled. Davis (2004, 10) argues that in the UK a systemic incentive problem is that income support has a non-pension income test, such that benefits are indrawn when incomes accrue, which discourages saving by low-income workers, and may also discourage membership of pension schemes. In a similar vein, the Economist (2005) argues that much of the blame lies with the pension credit, one of Labours dearie policies, which is damaging the incentive to save. By 2025, almost two-thirds of pensioners will be eligible for this means-tested payment, which tops up the meagre basic state pension. Since it is withdrawn at a ra te of 40%, they will thus in effect be liable to the top rate of income tax on their savings income.In order to combat the low levels of saving in the UK, the government has developed various initiatives to promote and encourage saving. According to the DWP (2006, 15), they are going to introduce low-cost individual(prenominal) accounts to give those without access to occupational pension schemes the opportunity to save. People will be automatically enrolled into either their employers scheme or a new personal account, with the freedom to opt out. Employers will make minimum matching contributions. By creating a scheme into which people are automatically enrolled unless they opt out, this is likely to impress on private savings since, as Hills (2006, 123) explains, savings behaviour does not follow the optimizing pattern predicted by some economic models. Instead people procrastinate about difficult financial decisions and display considerable inertia. Interestingly, it appears th at membership of otherwise identical pension schemes in terms of incentives such as employer contributions is much higher when people are automatically enrolled into them, with the right to opt out, than when they have to make a conscious decision to opt in.The closure of defined benefit schemesTraditionally, the UK has had a high level of private pensions as the state pension was meager and most employers offered DB occupational pensions. In recent years, however, most DB schemes (at least for private area employees) have been closed to new entrants. This can be seen as a result of two key factors increasing longevity and, more recently, the poor exercise of the stock mart. According to the DWP (2006, 10), since the 1970s, employers have been retreating from occupational pensions as rapid increases in life expectancy and then the end of the high equity market in the late 1990s pushed costs higher than had been anticipated when occupational pension schemes were designed. This tren d has continued, with 2 million hardly a(prenominal)er members of open private sector occupational pension schemes in 2004 than in 2000. The relatively poor performance of the equity market has certainly had a major impact on the nature of occupational pensions since funded pension schemes in the UK have traditional relied very heavily on enthronement in the stock market. The Economist (2002), for example, claims that Britains pension funds have punted heavily on equities for many years. That strategy has paid off handsomely, but it does expose them to greater risk in the short term than more materialistic strategies which put more money into less volatile bonds. The bear stockmarket of the past two years has hit pension funds hard and brought home to companies the investment risk that they are shouldering. At the same time they have become more aware of the risk of rising life expectancy at senior(a) ages, which increases the cost of a defined-benefit promise. These two issues combined have led to the closure of many schemes, and by the end of 2002, many schemes were running with large deficits (Davis, 2004, 12).The closure of so many DB schemes is deemed to be a contributing factor to the pensions crisis for two main reasons. The first is that the alternative usually an occupational DC schemes is considered more risky for individuals. The second is that there is generally a lower take up of DC pensions as compared with DB schemes. Thus, in effect, the switch to DC schemes is discouraging saving. severally of these two reasons will now be examined in turn. As Barr (2006, 2) explains, in a DB scheme, often run at the firm or industry level, the pension a person receives depends on his or her wage history and on length of service. One feature of this arrangement is that the risk of differential pension portfolio performance falls on the employer, and hence is shared more broadly than with DC arrangements. Second, the pension a worker gets is not fully a ctuarially related to his or her foregoing contributions. However, it can be deomnstrated that DC schemes actually tend to be more beneficial for employees who change employers several times over the course of their career (since such employees are effectively punished for each switch of employer in the DB system). Since most individuals these days do change employer at least a few times, this provides a strong argument for the case that a DC pension can be at least as good as a DB pension. Turning to the second reason, there is indeed evidence to suggest that individuals take up DC pensions at a lower rate than DB pensions. According to the Economist (2005), when companies close their DB schemes, they typically offer a defined-contribution plan, in which employees build up their own pot of pension money. However, contribution rates into these DC plans tend to be much lower. According to the GAD Government Actuarys Department survey, the total contribution rate from employers and e mployees into DC schemes is 8.9% of earnings compared with 18.8% into the private DB schemes.This problem again relates back to the problem of lack of public knowledge and understanding of pensions. If DC pensions can be shown to be at least as good as DB pensions for the majority of employees, and yet the take up rate is lower, there must be a problem of information or incentives. In order to combat the so-called problem of the closure of DB schemes, therefore, it may be more important to improve information about, and incentives to take out, DC pensions, rather than to try to resurrect the system of DB pensions. In the words of the Economist (2002), the way forward is not to lament the demise of final-salary schemes but to make DC plans work.ConclusionAt the heart of the UK pensions crisis are two issues which work together to cause a crisis. With an ageing population, the dependency ratio increases to the extent that it is not possible to rely on PAYG schemes. At the same time, t he level of savings within the UK is too low for the retired population to be able to rely on funded pensions. The low level of savings can be seen as caused by a number of factors, including a lack of clarity and information on pension requirements and choices, a lack of trust in the financial services sector and the information it provides, as well as certain disincentives which discourage individuals, particularly in the low income sector, from saving. The closure of DB schemes has interacted with the poor information and lack of trust to discourage certain people (who would previously have enrolled in a DB scheme) from enrolling in the DC alternative. All of these problems are interrelated and it is the combination of them that can be seen as causing the UK pension crisis. In the words of Davis (2004, 22), the savings rupture is aggravated by the deficits and closure of defined benefit funds, loss of confidence in personal pensions and also in life insurance generally followi ng(a) mis-selling of personal pensions. As such, it is a combination of policies that is required to tackle these problems.BibliographyBanks, J., Blundell, R., Disney, R., Emmerson, C. (2002). Retirement, Pensions and the Adequacy of Saving A Guide to the Debate. capital of the United Kingdom Institute for Fiscal Studies.Barr, M., Diamond, P. (2006). The Economics of Pensions. Oxford reassessment of Economic Policy , 22 (1), 15-39.Barr, N. (2006). Pensionse Overview of the Issues. Oxfor Review of Economic Policy , 22 (1), 1-14.Blake, D. (2000). Two decades of pension reform in the UK What are the implications for occupational pension schemes? Employee relations , 22 (3), 223-245.Davis, E. P. (2004). Is there a Pension Crisis in the UK? London The Pensions Institute, Cass Business School.DWP. (2006). Security in retirement towards a new pensions system Executive Summary. London Department for Work and Pensions.Economist. (2002, February 22). End of the party How bad for employees is the decline in final-salary pensions? The Economist .Economist. (2005, June 23). Pension reform The shape of things to come. The Economist .Hills, J. (2006). A New Pension Settlement for the Twenty-First Century? The UK Pensions Commissions Analysis and Proposals. Oxford Review of Economic Policy , 22 (1), 114-133.Mullan, P. (2002). The Imaginary Time Bomb Why an Ageing Population is not a Social Problem. London I B Tauris.Footnotes1 While discussion of the UK pension crisis is very common, it is worth bearing in mind that the current web site is not unanimously viewed as a crisis. Barr (2006), for example, argues that a problem exists but not a crisis. Mullan (2002) does not even consider it to be a problem.2 We need to be clear that individuals must be responsible for their own plans for retirement. The reforms will ensure the provision of high-quality savings vehicles, and a solid state foundation to private savings. But the choice of how much to save, the level of risk to ta ke with investments, and how long to work must be available to the individual. That provides the right balance of choice and support for individual responsibility. (DWP, 2006, 22)