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We need to reform pensions – here are some ideas

8 January 2014

6:22 PM

8 January 2014

6:22 PM

The government is facing a fiscal crisis. In the face of that crisis David Cameron has promised to continue to raise pensions in real terms. The biggest item of welfare spending – it makes up around half – is therefore set to get bigger. Indeed, over the next 50 years, pensions spending will rise by £330 billion (in today’s prices) partly because of an ageing population, but also because of the coalition’s populism.

It’s likely that the only safety valve left in the system – raising the state pension age – will be used more and more by the government to balance the books. As the IEA’s latest research Income from Work – the Fourth Pillar of Income Provision in Old Age demonstrates, there is plenty of scope to raise the state pension age much faster than the government intends. Indeed, if the government kept the lid on pensions benefits, abolished the winter-fuel allowance and free bus passes and raised state pension age more quickly, it could easily achieve George Osborne’s proposed welfare savings and have money left over for meaningful tax cuts.

Over the last generation we have been living longer, living healthier and retiring much earlier. The employment rate among men aged 55-59 decreased from over 90 per cent to less than 70 per cent between 1968 and the end of the 1990s. Employment amongst those aged 60-64 fell from around 80 per cent to 50 per cent and for those aged 65-69 fell from 30 per cent to about 15 per cent.

We are retiring earlier and yet living longer. In 2006, a man aged 65 could expect to live for over four years longer than he could in 1981.

If things are bad here, they are much worse in continental Europe. Around 60 per cent of Italians between the ages of 55 and 64 are not active in the labour market. Broadly, this means that around half of Italians are expecting to be retired for a long as they work.

Of course, if people wish to work like mad, save like a squirrel hoarding nuts for winter and play golf from the age of 50 at their own expense, then nobody could object. However, our state pension system strongly encourages people to retire at state pension age and the first proposal of this paper is to raise state pension age rapidly and then link it to life expectation. The coalition – following an earlier proposal from the IEA – proposes to do the latter but not the former: state pension age will rise, but only slowly. The pension system should then be privatised along Australian lines. This system requires people to save a given proportion of their income whilst in work and only provides a pension to those with limited resources. People can then take their own decisions about when to retire and face the costs themselves – for a given size of pension fund, earlier retirement would mean a smaller income.

However, it is generally found that simply raising the age at which people receive a state pension leads people to leave the labour market in other ways. Also, there is little point not paying people a pension if they cannot find a job and they end up on means-tested benefits.

We should therefore keep reforming disability benefits so that they provide a route back into work rather than a permanent form of income. But, most importantly, it is important to reform labour market regulation.

The evidence is very clear that employment protection legislation damages the employment prospects of older people who are looking for a job because it raises the risks of taking somebody on. The government should remove employment protection legislation for people within five years of state pension age and bring in a regime of no-fault compensated dismissal instead. This government has a terrible record on labour market regulation. A U-turn in this area would be welcome.

What is needed is a coherent strategy across all areas of policy involving deregulation, cutting government spending and privatisation. At the moment, the government is getting all the flack and none of the benefit from its piecemeal, minimalist approach to shrinking the state. The areas identified by this research would be a good place to start.

Prof Philip Booth is Editorial and Programme Director at the Institute of Economic Affairs

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