Pension policy where have we been, where are we going?

Pension policy where have we been, where are we going? Paul Johnson

Introduction People living longer and incomes in retirement rising Incomes higher than non-pensioners on average Next decade likely to see continued rise in pensioner incomes Longer term future looks less certain Lower state pensions Collapse of private sector DB schemes Falling home ownership Policy on state pensions looks stable Subject to sorting out the triple lock We have got ourselves into a difficult place on private pensions No risk sharing Tax treatment

Good news Life expectancy has been rising unexpectedly

Rapid, unexpected change in life expectancy Predicted life expectancy at birth Projected life expectancy 83 81 79 77 75 73 71 69 67 65 1971 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019

Rapid, unexpected change in life expectancy Predicted life expectancy at birth 83 Projected life expectancy 81 79 77 75 73 71 69 67 1979 1975 1971 65 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019

Rapid, unexpected change in life expectancy Predicted life expectancy at birth 83 81 79 77 75 73 71 69 67 65 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019 Projected life expectancy 2006 2002 1998 1994 1991 1987 1983 1979 1975 1971

Good news Life expectancy has been rising Unexpectedly Incomes in retirement have been rising fast And much more than for working age population

The remarkable catch-up in pensioner incomes 110% 105% 100% 95% 90% 85% 80% 75% 70% 65% 60% chart shows median after housing costs incomes of pensioner households as % of median for non-pensioners (HBAI income definitions)

Income by age 1978-80 to 2012-13 Percentage of overall median income (measured AHC) 140% 120% 100% 80% Median income by age compared to overall median income (measured AHC) 1978 80 2007 08 2012 13 60% Age Source: Figure 3.7b of Living Standards, Poverty and Inequality: 2014 http://www.ifs.org.uk/publications/7274 Notes: Household income is equivalised and measured after housing costs are deducted

Poverty rates by age 1978-80 40% 35% 30% 25% 20% 15% 10% 5% 0% Source: Figure 6.3a of Living Standards, Poverty and Inequality: 2013 http://www.ifs.org.uk/publications/6759

Poverty rates by age 1978-80 2011-12 40% 35% 30% 25% 20% 15% 10% 5% 0% Source: Figure 6.3a of Living Standards, Poverty and Inequality: 2013 http://www.ifs.org.uk/publications/6759

Pensioners doing better before the recession 4.0% 3.0% 2.0% 1.0% 2001-02 to 2007-08 0.0% 0s 10s 20s 30s 40s 50s 60s 70s -1.0% -2.0% Annual real income change by age

...and after 4.0% 3.0% 2.0% 1.0% 2001-02 to 2007-08 2007-08 to 2013-14 0.0% 0s 10s 20s 30s 40s 50s 60s 70s -1.0% -2.0% Annual real income change by age

Male employment rates slumped but have been rising for some time 100 90 80 Employment rate 70 60 50 40 65-69 (LFS) 30 20 10 0 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Male employment rates slumped but have been rising for some time 100 90 80 Employment rate 70 60 50 40 30 20 10 0 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 60-64 (LFS) 65-69 (LFS)

Good news Life expectancy has been rising Unexpectedly Incomes in retirement have been rising fast And much more than for working age population Reflecting rising state and private pensions And also later retirement and increased earnings And our projections suggest continued improvements over the next decade http://www.ifs.org.uk/publications/7251

Equivalised family income projections: 65+ population 60,000 50,000 Real family income ( pa, 2014 15 prices) 40,000 30,000 20,000 10,000 0 Median 10th percentile 90th percentile 2010 2012 2014 2016 2018 2020 2022 Source: Figure 5.1, Emmerson, Heald and Hood (2014) http://www.ifs.org.uk/publications/7251

But are we doing too well? One way of thinking about that is to ask how well off people are in retirement relative to during their working life Traditionally looked at how much of gross final earnings are replaced by pensions This was the basis for much of the Pension Commission s work But is this a good measure? Should be interested in net, not gross incomes Why just consider pensions and not other wealth? And aren t we interested in incomes compared to average over a working life, not just final earnings?

Replacement of average lifetime earnings For couple households born in the 1940s we define: Replacemen t rate = Taking into account household size Consider several Estimated realincome at age65 definitions of income Averageequivalised realearnings age 20-50 Adjusting for inflation; considering average purchasing power Source: Table 6.2, Crawford & O Dea (2014): Retirement sorted? The adequacy and optimality of wealth among the near-retired? http://www.ifs.org.uk/publications/7358

Replacement of average lifetime earnings For couple households born in the 1940s we define: Replacemen t rate = Estimated realincome at age65 Averageequivalised realearnings age 20-50 Percentage of couple with: Total pension income <=67% replacement 20% <=80% replacement 35% <=100% replacement 59% Source: Table 6.2, Crawford & O Dea (2014): Retirement sorted? The adequacy and optimality of wealth among the near-retired? http://www.ifs.org.uk/publications/7358

Replacement of average lifetime earnings For couple households born in the 1940s we define: Replacemen t rate = Estimated realincome at age65 Averageequivalised realearnings age 20-50 Percentage of couple with: Total pension income... plus annuitised nonhousing wealth <=67% replacement 20% 10% <=80% replacement 35% 20% <=100% replacement 59% 41% Source: Table 6.2, Crawford & O Dea (2014): Retirement sorted? The adequacy and optimality of wealth among the near-retired? http://www.ifs.org.uk/publications/7358

Comparing optimal and actual (private) wealth

For the current generation of pensioners A remarkable triumph Despite longer lives and earlier retirement incomes are higher than they were during working life for most Down to a combination of Increasing state pensions More generous means tested benefits Occupational pensions House prices

What about the future? For the next decade at least things still look quite positive Further ahead things may look less rosy Earnings have fallen and savings rates were lower

Incomes are dipping 800 700 Real household income ( per week, 2011-12 prices) 600 500 400 300 200 100 1940s 1950s 1960s 1970s 20 25 30 35 40 45 50 55 60 65 70 Age Source : Authors calculations using FES/EFS/LCF, various years

As are savings rates 60 40 Real household saving ( per week, 2011-12 prices) 20 0-20 -40-60 -80 1940s 1950s 1960s 1970s 20 25 30 35 40 45 50 55 60 65 70 Age Source : Authors calculations using FES/EFS/LCF, various years

What about the future? For the next decade at least things still look quite positive We can model incomes really quite well that far ahead given what we know about pensions, health, working patterns etc Further ahead things may look less rosy Earnings have fallen and savings rates were lower The state pension is becoming less generous for many The single tier is worth less than basic pension plus SERPS/S2P

Male median earner who works continuously up to his state pension age 80% Percentage of age-50 earnings 70% 60% 50% 40% 30% 20% 10% 0% 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 Year of birth Basic state pension Second-tier pension Single-tier pension Excess (single-tier transition) Source : Authors calculations using earnings profiles from FES/EFS/LCF, various years

Recent cohorts are also less likely to own a home Born 1963 67 Born 1973 77 Born 1983 87 80% Homeownership rate (%) 70% 60% 50% 40% 30% 20% 10% 0% 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 Age

Declining private sector DB coverage Active members of private sector defined benefit schemes 6 5 Closed Open 4 Millions 3 2 1 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Occupational Pension Scheme Survey.

Employer contributions to pension funds in constant prices terms Source: Office for National Statistics

Pension costs have played a big role in average wages rising less quickly than productivity http://www.resolutionfoundation.org/wp-content/uploads/2015/09/productivity-briefing.pdf

To recap... The current generation at and near retirement are doing very well To some extent at the expense of younger generations Who can expect lower retirement incomes What about policy?

The recent history of state pensions SERPS was introduced in 1978 Governments have spent the whole period since un-introducing it A long and tortuous path given the complexities around contracting out Any link between contributions and entitlement has effectively ended The single tier is the logical final step Very close to a flat rate citizens pension based on history of residence Note that it reduces expected future generosity for almost everyone

Legislation to increase pension age Age Legislated 66 2020 67 2028 68 2046 69 70 71 72 73 74 75

Legislation to increase pension age Age Legislated Population variant central 66 2020 2020 67 2028 2028 68 2046 2036 69 2049 70 2063 71 72 73 74 75

Legislation to increase pension age Age Legislated Population variant central high 66 2020 2020 2020 67 2028 2028 2028 68 2046 2036 2031 69 2049 2034 70 2063 2037 71 2040 72 2045 73 2051 74 2057 75 2064

Remaining policy issues Pension age Rising over coming decades We know that increasing female SPA is increasing employment http://www.ifs.org.uk/publications/7323 Commitment to raise with life expectancy so people live a third of adult life (over 20) in retirement Level and indexation Triple lock adds 15bn to costs by 2050 relative to earnings indexation Introduces an element of pure randomness into pension level Makes no sense as a policy

Effects of triple lock and pension age on spending

Recent history of private pensions Regulation and demise of private sector DB schemes This looks irreversible Spread of DC Introduction of auto-enrolment Successful so far (but minimum default contributions very low) Ending of compulsory annuitisation Effects unknown Chaotic changes to tax treatment And continual change to tax treatment of other forms of savings

Policy priorities for private pensions Risk sharing No risk sharing in DC schemes None now in retirement without annuitisation This CANNOT be optimal In my view the overwhelming priority must be to find some way of achieving more risk sharing Defined ambition? Also to limit the windfall to those with accrued rights Move from RPI to CPI indexation (note this was easily the biggest change to public service pensions) http://www.ifs.org.uk/budgets/gb2012/12chap5.pdf

The formula effect [http://www.ifs.org.uk/publications/7513]

Urgent need to sort out tax regime Annual allowance cut in stages to 40,000 and lifetime allowance cut to 1 million Raising c. 5 billion a year From April 2016 annual allowance phased down once income exceeds 150,000 reaching just 10,000 when at 210,000 Introducing very high effective marginal rate No attempt to tackle the genuinely generous parts of the system The tax free lump sum NI treatment And now consultation on the whole structure This is no way to make policy in an area where stability and certainty matter a lot

What should be done? Unambiguous conclusion about what an efficient, neutral tax treatment of pensions should be Contributions exempt from tax, returns free of tax, tax paid on withdrawal (EET)

Cost of tax relief HMRC says 35 billion = Tax relief on contributions, + tax relief on investment returns, + NI relief on employer contributions, - Tax paid on pensions in payment True cost against an expenditure tax benchmark is closer to 16-17 billion 14 billion of NI relief, + Cost of tax free lump sum perhaps 2.5 billion but, bizarrely, not published by HMRC

What should be done? Unambiguous conclusion about what an efficient, neutral tax treatment of pensions should be Contributions exempt from tax, returns free of tax, tax paid on withdrawal (EET) From current situation that means: income tax treatment makes sense (other than lump sum) NI treatment much too generous Treatment at death bizarrely generous and distorting Focus of consultation elsewhere entirely Move to TEE (unlikely to happen) Move to flat rate relief Which would be redistributive but move away from rational tax system

Policy conclusions State pensions Stick with single tier but move away from contributory fiction and make dependent on, say, 30 years residence Get rid of triple lock: link to earnings, raising in line with prices when they rise more but claw back later Raise pension age at least in line with longevity Private pensions Focus on finding a way to reintroduce some risk sharing Consider reducing DB benefits by enforcing CPI indexation Move to rational, stable EET tax system Over time increase employee auto enrolment contribution rates