Mature policy pays dividends

Richard Disney argues that the UK, unlike its international competitors, is not facing a crisis from an ageing population thanks to radical cutbacks in social security provision and the increasing role of private pensions

The prospect of an ageing population is now upon us. The statistics are dramatic. In the period 1975-95, there were four people aged 65 and over for every ten aged 15 to 64 among the population of the richer industrialised nations. Projections by the United Nations suggest that by the year 2025 there will be 8 people aged 65 and over for every ten people aged 15 to 64. The doubling of this ratio has arisen because birth rates have fallen in many countries and average longevity has increased. But the rapidity of this phenomenon varies widely: for example, in the UK, the proportion aged 65 and over is expected to rise by about 25 per cent from 1990 to 2025, whereas in Japan the increase is about 60 per cent and in Italy it is 75 per cent.

Much of the concern about the "demographic time bomb" has focused on the impact of increased dependency on the social welfare budgets of Organisation of Economic Cooperation and Development economies, notably on the provision of state pensions and of expensive health care for the very elderly. Social security budgets have been under pressure in all countries, with serious pension scheme deficits in the US and many European countries, while demand for health care has far outstripped supply. And it is natural to associate these deficits and crises with demographic ageing.

My own view is that the crisis of social welfare provision arises from factors intrinsic to its financing, rather than from ageing per se. Indeed ageing populations have had the salutary effect of bringing home to policymakers and, ultimately, to voters, the need for reforms of these financing processes. Typically, social security programmes have been financed on what is known as a "pay-as-you-go" basis: current contributors pay current beneficiaries. In the UK, for example, there is no National Insurance Fund in which current contributions are accumulated: everyone's payments towards their pensions are immediately paid out to current pensioners. Contrast this with funded schemes in which contributions are accumulated: typically private pensions such as occupational pensions in the UK are of this form. When state pay-as-you-go schemes were established, early contributors were given "accelerated benefits": they did not have to wait 40 years to receive full pension benefits. Later generations have tried to replicate these high returns by building into their pension entitlements claims on future generations which were unsustainable when the scheme reached maturity.

The UK is somewhat unusual among OECD countries in having pared back its social security budget (if not its health care budget) such that it can rule out financing crises in the foreseeable future. Indeed the government actuary forecasts that the National Insurance contribution rate needed to finance state pensions in 50 years' time will be exactly the same as it is now, and will fall once the baby boom generation passes on. This resolution of the demographic time bomb arises because of cutbacks in social security provision - state pensionable age will be equalised at 65 early in the next century, the basic state retirement pension continues to fall as a proportion of real earnings (because it is only uprated in line with prices, not earnings growth), and the additional state earnings related pension has been radically trimmed.

In addition it has not always been noted that the pension scheme has moved from pay-as-you-go finance to advance funding by the back door because almost a quarter of the working population has been persuaded to leave the State Earnings Related Pension Scheme and buy a personal pension since 1988. This model of contracting-out funding of pensions is now attracting a good deal of interest in other OECD countries as a way of overcoming financing problems.

What does this presage for the future living standards of pensioners? Increasingly, countries are moving to a welfare floor coupled to private funded provision of pensions and other benefits to supplement this floor. Those pensioners with access to second tier funded pensions will be reasonably well-off in the future. Take for example a person with a 60 per cent of final salary pension. Since final salary may be at least 50 per cent higher than average lifetime salary, since pensioners have typically paid off mortgages and their children have left home, they could well have a higher standard of living in retirement than in work. That is why many people have taken early retirement through their company pension schemes in the past two decades. Roughly 75 per cent of workers in the UK can now expect at least some form of private pension in retirement in addition to their social security, even though we can expect greater pressure for such people to purchase medical insurance against long-term health care needs late in life.

This conclusion is of less comfort to those with interrupted (or non-existent) work histories and little in the way of additional pensions. Pensioner lobbyists point to the position of many people, particularly widows aged over 75, who remain reliant on Income Support and other means-tested benefits. Indeed inequality among pensioners has widened in the 1980s in the UK and the US. In general, the less generous the state pension scheme and the higher the average private component of pensioner income, the higher is inequality among pensioners. This growth in inequality is likely to continue and raises a central concern of how generous to make the income "floor" for pensioners without destroying incentives to private saving and coming up against budgetary constraints.

Another puzzle concerns the apparent prevalence of age discrimination against the elderly who wish to continue to work when the size of the youth cohort is declining. Is this myopic behaviour among employers, or unrealistic aspirations, particularly concerning wages, among older potential workers? In an ageing society, older consumers have more spending power and they consume different commodities. It would be a convenient resolution of this issue if it could be shown that the goods (and, more particularly, services) purchased by older consumers were produced to a comparative advantage by older workers. Unfortunately this solution is probably too glib, and policy interventions may be required, such as government-subsidised retraining to assist the re-employment of older workers. If taken seriously, such policies may not come cheap, but a careful analysis of training needs and effectiveness is required.

Richard Disney is professor of economics at Queen Mary and Westfield College, London. His book Can We Afford to Grow Older? is published by MIT Press in October, Pounds 24.95