Factors That Affect the UK Pension Crisis

Factors That Affect the UK Pension CrisisInvestigating the factors that affect the UK aid crisis admissionThis look back examines the oscilloscope literature regarding the causes of the UK award polish off crisis1, and the various measures memorizen to attack the crisis. In order to understand the temper of the riddle, it is jump necessary to furbish up a bit of background on the UK pension ashes, and UK demographics.There is few(prenominal) debate over which types of pensions pay as you go (PAYG) or funded intents be best. Barr (2006, 2) explains that in a PAYG scheme pensions are paid out of current income. In a fully funded scheme, pensions are paid from a fund attain over a period of eld from members contri neverthelessions. Virtually all estate pension schemes are mainly PAYG privy schemes are generally funded (though non necessarily adequately). The UK state remains is a complex mix of several(prenominal) comp mavennts, paid for on a pay-as-you-go b asis though a salmagundi of national insurance contri preciselyions and general taxation (Hills, 2006, 116). Non-state, voluntary schemes include occupational pensions which may be either outlined donation (DC) or defined public assistance (DB) schemes, and private pensions which are usually DC. In recent eld the bulk of occupational DB schemes in the UK fork up closed.The demographics of the existence return changed significantly over recent years. Barr (2006, 4) argues that aver get a commodious age at death in the UK (and similarly in other countries) has been locomote steadily at to the pitifulest degree since 1860 Clearly, as to a greater extent and more people 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 coun picture-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 in that location are other factors which affect the make out and demand of funded schemes, and against which policy may be more easily directed. three of these are drawn out in this dissertation. As such, and for clarity, this literature re eyeshot is structured around the three themes mankind fri wind upship and understanding of pensions in the UK the level of private pitchs in the UK and the recent decline of DB schemes in the UK. However, it should be noned that these three factors are interre noveld, as will be demonstrated in the analysis that follows.Public pension knowledgePensions are al itinerarys subject to a problem of imperfect randomness when one considers how and how much to save for solitude, the decision is made on an omen ( non a reliablety) of life expectation. However, in that location are further problems in name of knowledge and understanding of pensions, particularly in the UK. On the m icroeconomic side, the advantages of consumer sovereignty are predicated on well- intercommunicate consumers, a very arduous boldness in the case of pensions. Individuals are imperfectly informed, first, because of uncertainty closely the time to come one-on-ones are not well-informed because nobody is well-informed. Second, they are imperfectly informed in the face of risk (Barr Diamond, 2006, 20).This help problem is particularly penetrative 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 have both employers and individuals trying to make the best monetary decisions for the long call. Hills (2006, 123) confirms this point, and elaborates on it The UK pension system isperhaps understandably poorly 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 homogeneous time, levels of trust in pension providers and financial products are low. Even if people do constitute that their pension will be inadequate, this combination makes it very hard for them to make a plan to do something about it. In addition to high school 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 election over how much they save for their retirement and in which form they save.The DWP (2006, 6) claims that it is component part people to make better informed selects about their retirement, introducing a say of pension forecasts to give individuals an understanding of the income they are likely to receive in retirement. Since their introduction, the Government has issued just over 20 million of these forecasts and we are develop web-based retirement planning services. These measures may not, however, be sufficient to guide individuals make what remains a complicated system. Considering the government also seeks to place the state for pension decisions firmly with the individual2, it is likely that more demand 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 twinkling pillar remains voluntary is highly worrying for reasons of myopia and moralistic 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 bring in 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 make not to let them live in dire poverty in retirement. In the next section, the problem of the drop of private nest egg will be considered in more detail.Lack of private savings copulation 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 indisputable 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 preferion. 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 close individuals focus on pensions only 10 years ahead of retirement The saving problem may partly be linked to poor schooling. Clearly a lack of easily come-at-able 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 kind security pensions. As in all countries, the scope 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 favourable to private schemes, particularly as a consequence of the rather limited scope of social security on offer and the abil ity of employees to opt out of pelf-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 modify 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 reclusive 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 pet policies, which is damaging the incentive to save. By 2 025, almost twain-thirds of pensioners will be eligible for this means-tested payment, which tops up the meagre basic state pension. Since it is pull away at a rate of 40%, they will thus in effect be liable to the top rate of income tax on their savings income.In order to charge the low levels of saving in the UK, the government has developed various initiatives to promote and encourage saving. fit to the DWP (2006, 15), they are going to introduce low-cost face-to-face 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 modernistic private 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 impact on private savings since, as Hills (2006, 123) explains, savings behaviour does not follow the optimizing recipe predi cted by some economic models. Instead people procrastinate about difficult financial decisions and display considerable inertia. Interestingly, it appears that membership of otherwise like pension schemes in terms of incentives such as employer contributions is much higher(prenominal) 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 sector employees) have been closed to new entrants. This can be seen as a result of two key fruit factors increasing longevity and, more recently, the poor performance of the stock market. 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 righteousness market in the late 1990s pushed costs higher than had been anticipated when occupational pension schemes were designed. This bm has continued, with 2 million fewer 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 hard on investment in the stock market. The Economist (2002), for example, claims that Britains pension coin 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 cautious strategies which put more money into less vapourific 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 older 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. individually 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 intentness level, the pension a person receives depends on his or her wage invoice and on length of service. One feature of this arrangement is that the risk of derivative pen sion 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 actuarially related to his or her previous contributions. However, it can be deomnstrated that DC schemes genuinely tend to be more beneficial for employees who change employers several time 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, contributio n rates into these DC plans tend to be much lower. According to the spine Government Actuarys Department survey, the total contribution rate from employers and employees 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 unite dly to cause a crisis. With an ageing population, the dependency ratio increases to the extent that it is not possible to depose on PAYG schemes. At the same time, the 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. every(prenominal) of these problems are interrelated and it is the combination of them that can be seen as make the UK pension crisis. In the words of Davis (2004, 2 2), the savings gap is aggravated by the deficits and closure of defined benefit funds, loss of confidence in personal pensions and also in life insurance generally following 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 follow 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? capital of the United Kingdom The Pensions Institute, Cass Business School.DWP. (20 06). 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 cock-a-hoop 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 compend and Proposals. Oxford Review of Economic Policy , 22 (1), 114-133.Mullan, P. (2002). The Imaginary Time washout 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 value bearing in mind that the current situation is not nem con 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 pl ans for retirement. The reforms will find out 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 take 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)