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Willetts: Convergence on European levels of pension spending

Speech to the 20th IEA Conference on the state of the economy

It is a great pleasure for me to be here at this IEA event. What I want to talk about is convergence with Euroland. The way the Chancellor talks about it you would imagine that all convergence is a good thing. But we could be converging on the worst aspects of the Euroland economies. From my perspective, shadowing Work and Pensions, that is exactly what I see. This afternoon I would like to take you through the convergence process in pensions.

What we are seeing is nothing less than the collapse of the Thatcherite strategy on pensions. It had two elements. The first element was to link the basic state pension to prices not earnings. That still rankles with pensioners because it meant that the basic state pension did not rise in line with the growth of the economy. And it would not be acceptable for pensioners to fall further and further behind the living standards of the rest of us. But there was a second strand to the Thatcherite strategy - the expansion of funded pensions. The increase between 1979 and 1997 was dramatic. The assets in our pension funds rose from £42bn to £657bn. Average pensioner income rose during that period by at least as much as average incomes across the country as a whole. The first part of the Thatcherite strategy, keeping the value of the basic state pension linked to prices, was only sustainable because of the other part as well, the boost to private savings.

Now that strategy is collapsing. The Government has not been open about what is happening. Indeed it specifically said in its Pension Green Paper - the first one, that is, in December 1998 - that its aim is to shift the balance of private pensions and state benefits from a 40:60 ratio as it is at the moment, to a 60:40 ratio in the future. I am happy to accept that strategic goal. But the reality is that we are moving in the opposite direction. Both sides of the equation are shifting. Everyone in this room today must be familiar with the collapse of our funded pensions. There are many reasons for this.

Something as significant as this is happening because of a combination of factors. I have compared it to the Hollywood movie, The Perfect Storm. You get the perfect storm when everything - the season of the year, the wind, the temperature, air pressure come together to create something massive. Today's pension crisis is the equivalent of the perfect storm. It's a combination of changes in the labour market, improvements in longevity, the collapse of share prices, new accountancy standards and many other factors as well which help to explain why we have a crisis on this scale.

Those factors are not under the Government's control but that makes it all the more important that the things which Governments do control they get right. Government should at least follow the doctor's precept, first doing no harm, and, if we are really being optimistic, it would be nice if they could do some good. Sadly, the Government has instead made a difficult situation worse.

The notorious stealth tax on pension funds in 1997 has taken £5 billion a year out of our pension funds. That adds up to around £30 billion already. It has had a disastrous effect on the finances of our pension schemes. The Association of Chartered Certified Accountants put it very clearly in their recent submission to the Select Committee on Work and Pensions: 'The withdrawal of the tax credit is, in our view, the most important single contributory factor in the problems which currently afflict both money purchase and defined contribution pensions.'

But the tax is not the end of the story. There is another aspect of the Government's financial relationship with pension funds which matters almost as much, though it has received far less attention in the media. I am referring, of course, to contracted-out rebates. These are rebates on the National Insurance Contributions of employers and employees when there is a pension in place which provides benefits that are at least as good as the State Second Pension. Mercer's estimate that an actuarially-fair calculation of the cost of providing these benefits is £12.5 billion a year. But the contracted out rebate is worth only £11 billion a year. That is another £1.5 billion a year stealth tax imposed when schemes were already on the ropes. It is the extra cost of providing the full benefit which must be provided if a scheme is to contract-out, but which isn't covered by the value of the contracting out rebate. This situation can't carry on. Companies are already starting to contract back in to the State Second Pension with very serious implications.

The effect of all these changes is that the income which we can expect from our funded pensions is declining. Already there is a decline in the number of recently retired pensioners getting a pension from an occupational pension. In 1997/98, 67% of recently retired pensioners had an income from an occupational pension. The latest figures show this is down to 59%.

Michael Howard recently produced a vivid illustration of how someone who had been saving for a personal pension for 10 years would now receive far less than if they had been saving for the 10 years to 1997.

A typical with-profit personal pension will produce a value of less than three-quarters of what it would have done in 1997. Secondly, annuity costs have increased by nearly 50% over the same period. The combination of these two factors mean that pension incomes for a typical pension saver retiring at the end of 2002 are less than half what they were in 1997.

Companies are closing their occupational pensions to new members. Indeed, the latest figures are that 72% of pension schemes are now closed to new members. Many of them are substituting Defined Contribution schemes. In practice they have lower contributions which inevitably tend to yield a lower income for people when they retire.

This is not the end of the story. The next stage is that companies whose pension funds remain under financial pressure could well close their schemes to existing members as well. This will mean that in future their pensions accrue at a much lower rate than they have so far. There is even a nightmare scenario where they might not even get the pensions which have in theory already accrued.

All this adds up to a grim picture. Funded pensions, a great British success story, are now in headlong retreat. The value of the assets in our pension funds are falling. For the first time in our economic history we may find that successive generations of pensioners don't retire with a higher funded pension than their predecessors. Instead they could be retiring with a lower income from their funded pension than previous generations. The golden age of British funded pensions through the 1980s and 1990s could be coming to an end. It means that one of the fundamental challenges for my Party is to look at ways in which we can restore our funded pensions to health, and rebuild our savings culture and reform our benefits for pensioners. It is one of the most important tasks on which we are working in opposition.

As our funded pension savings decline, so what takes their place is more dependence on state benefits. We don't want millions of our pensioners to be struggling on incomes way below those of the rest of us. One of the automatic stabilisers, if you like, is that more pensioners become entitled to benefits. The Government has reinforced this trend by a big expansion of means-tested benefits. The number of pensioners in receipt of means-tested benefits in 1979 was 57%. By 1997 this was down to 40%. The House of Commons Library estimated in a letter to me that by mid-2003 that would rise to 57% again. What we have got is a clear and dramatic trend. Funded pension savings are declining and dependence on means-tested benefits is rising. This is not my vision of the right direction in which we want our society to be moving.

Today I want to focus on the implications of this, and I want to share with you something that has long puzzled me. It has not been much remarked on. At the moment these statistics appear to show that we devote approximately 5% of our entire national income to benefits for pensioners. And do you know what the Government forecast it to be in 2030 or 2040 or 2050? You guessed it. About 5%. Most economists take the Government's figures at face value and say that the evidence is that Britain can afford its pensions in the future. The level of spending is, they say, sustainable. International organisations, by and large, take their cue from the British Government. If you look at forecasts from the OECD, the European Commission or the IMF, they all have this miraculously stable figure of 5% for state expenditure on benefits for pensioners from now until kingdom come. Every other country shows an increase, and of course it is an increase from a higher base than here in Britain. But somehow Britain is immune.

But just take a step back and think about this. Over the next 50 years the number of pensioners is going to increase from 10.8m to 15.1m. Over the last 20 years there has been virtually no increase in the number of pensioners but when the women from the very first baby boom generation, born in 1945, reach the age of 60 in 2006, we will see the first increase in the number of British pensioners since the early 1990s. Then the men will reach the age of 65 in 2011 and afterwards there will be a steady increase, only partly offset by the increase in the female pension age from 60 to 65 that takes place after 2010.

This demographic shift makes the Treasury's forecasts for future expenditure on pensions even more incredible. We have got funded pensions in crisis. We have got a significant increase in the number of pensioners. We have got every other advanced western country predicting an increase in pension expenditure, yet somehow all that passes us by. We plod on with 5% of GDP going in state benefits to pensioners from now until kingdom come. What is going on? I have been puzzling over this. I would like to offer this Conference today my preliminary conclusion about why our pension forecasts for expenditure are so extraordinarily low. There are at least six different ways in which these forecasts are artificially held down.

The first explanation is that the figures are already out of date. Gordon Brown has been changing the system of benefits for pensioners so much with so many extra payments, the Winter Fuel Payment, the free TV Licence for the over 75s and the introduction of the Pension Credit this autumn, that some of the international economic bodies simply can't keep up. Their forecasts do not take account of the changes in benefits policy for pensioners over the past few years. Perhaps I can quote from the footnote to an OECD table:

'For the United Kingdom, pension projections

do not cover the Minimum Income Guarantee and

they assume that the existing old age pension will

remain indexed to prices.'

And a letter to me from the OECD states:

'Indeed, I think it fair to say that the UK has

recently changed pensions policy so dramatically

that I would not be confident of the continued

validity of any of our assessments of future UK

pension spending.'

There is a second reason for higher benefits spending than is currently predicted - companies are contracting back into the state second pension. Every time a firm announces the closure of a final salary scheme, it is actually in practice announcing more contracting back in to the state second pension.

And, whilst ministers may be happy to receive and spend this extra cash, they are storing up a serious long-term problem. Every time someone opts into the state second pension, the Government's long-term pension liabilities grow.

This is not the way to run the Government's accounts - taking extra money today to boost cash flow, but at the price of building up a bigger liability for the future, and one which doesn't even appear on the Government's balance sheet.

The sums involved are huge and they radically alter the Government's complacent assumptions on the cost of state pensions.

There is a third problem too. Many of the international definitions of public expenditure on pensions measure specifically age related benefits which are exclusively for pensioners. For most countries the main benefit for pensioners is the contributory social security pension. It is sufficiently generous that very few pensioners are entitled to any other assistance. They don't include welfare payments which they regard as very different, irrelevant to most pensioners, and which anyway don't have an age test. But Britain is most unusual. Contributory social security expenditure for pensioners - the basic state pension and the state second pension - is only part of the benefits bill for pensioners. The basic state pension is so low that many pensioners are also entitled to what most other countries count separately as means-tested welfare. That means that important elements of British benefits expenditure for pensioners, such as Housing Benefit or Council Tax Benefit just don't appear in all the expenditure forecasts. But they are a significant part of public expenditure on pensioners and they are likely to grow.

Then there is a fourth omission - disability benefits. There has recently been some horse-trading at the European Commission about all this. They insisted, rightly, that the Treasury should include more of their means-tested welfare payments to pensioners as part of their expenditure forecasts. The Treasury reluctantly agreed. But they made a corresponding adjustment. They excluded payments of disability benefits from their expenditure forecasts. One estimate was that this removes 0.8% of GDP from their spending forecasts.

When you have a system where so much of state benefits to pensioners are means-tested, the exact assumptions that you use in predicting the level of income from other sources become very important indeed. This is the fifth reason for artificial underestimates of our spending on benefits for pensioners. If you assume a buoyant income for pensioners from funded savings, then you can hold down expenditure on means-tested benefits. If you have a more pessimistic, dare I say more credible, set of assumptions about income from other sources, then there is a significant increase in expenditure on benefits for pensioners. If you look in the Treasury forecasts of future expenditure on benefits for pensioners, you find a crucial assumption - that income from other sources rises in line with earnings. In other words the Treasury is assuming away the very problem that we all know pensioners face.

I have tried to do some preliminary estimates of the impact of these omissions. My aim is to produce a forecast of expenditure on all benefits for pensioners by 2050 assuming that at best their income from funded savings only rises in line with prices. My provisional calculations suggest that this comes to something more like 10% of GDP. It is a lot higher than the 5% you see in the official forecasts though significantly below levels of continental Europe. 10% is a minimal credible figure for public spending on benefits for pensioners in 2050. It excludes my sixth and final reason for not believing the Government's forecasts. My calculations so far just take the existing benefit regime and trying fully to account for its costs including an assumption that income from funded savings rises in line with prices not earnings. But it excludes the biggest imponderable of the lot. This is the understandable political pressure which any government would be under if there were millions of pensioners whose incomes would be falling behind the rest of us because of the crisis in funded pensions. They will exert enormous political pressure for increases in benefits at least so as to offset their dashed expectation for income from funded savings. The Treasury model assumes no new benefits are offered to pensioners over the next 50 years. But in the past 5 years Gordon Brown has already introduced, for example, the Winter Fuel payment and the free TV licence, between them at a cost approaching 0.2% of GDP, (incidentally, one of the other ways the Treasury has fiddled the figures is by assuming there is no further increase in the value of the Winter Fuel payment - it steadily loses its value in real terms over the next 50 years and ends up like the Christmas bonus today) . I leave you to judge whether all this is credible but I for one simply don't believe it. I very much hope that those economists who confidently go round repeating the Government's figures claiming that they show how sustainable our public finances are will treat them with far more caution in the future.

There are several implications of this analysis. It shows first of all that in the long run means-testing benefit is not saving us any money. What it is doing is making the future levels of benefit expenditure more sensitive to levels of income from funded savings. Indeed it creates a vicious spiral. In the long run this amount of means-testing reduces the incentives to save and that in turn pushes up spending on means-tested benefits yet further in the future.

It also shows how important it is that we tackle the crisis in our funded pensions, and why the Government has been so strangely complacent. Last year I showed that the figures for assets in our pension funds were all over the place and that they had massively overstated the annual contributions that we are putting into our pension funds. This should have made Ministers more wary of the assumptions that they use about income from our funded pensions in the future. But they are still producing forecasts which assume that the income from our funded pension savings just carries on rising the way it did in the 80s and 90s. No wonder Treasury forecasts don't show there is a problem. It is eliminated by assumption before they start.

Let me recap. It is conventional wisdom that the cost of providing benefits to older people in the UK is going to remain stable at around 5% of GDP, while the figures for our continental European neighbours show their costs rising from around 12% to 15% of GDP by the middle of the century.

But the Government's figures for the UK are wrong. They exclude some of the benefits which pensioners claim. They ignore the large number of people who have joined the State Second Pension because contracting out is no longer a fair deal. And they make the wildly optimistic assumption that pensioners' incomes from funded pensions will rise in line with earnings.

The Chancellor is fixing the answer at 5% of GDP even before he has asked all the questions.

I estimate that expenditure on benefits for older people could well double to 10% of GDP by 2050. This is a £100 billion a year increase in today's money. And that is just if current benefits are maintained. This figure will itself only be sustainable if there is a healthy level of private pension provision.

These figures show that means-testing benefits does not save money in the long-term. It makes state spending on pensions even more sensitive to the collapse of funded pension savings.

Finally, I am struck by one irony behind all this. The Government proclaims that one of the aims of its health policy is to bring our health spending up to continental European levels. Tony Blair famously went on the Frost programme and announced this as a policy goal. Their policies are delivering a similar convergence with European levels of spending on pensions. We are still lower than Continental levels even on my estimates, but we do catch up on them. Yet the Government is strangely coy about this convergence on Euroland's levels of pension spending. Is it perhaps because it means they would have to admit that we are converging on European levels of tax and social security contributions as well?

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