Making the state pension sustainable
The UK state pension is unfunded, a pay-as-you-go system funded out of general taxation and the National Insurance payroll tax. Today’s payers-in fund today’s drawers-out. This system is vulnerable to demographic changes. When workers quit school at 16 and retired at 65, the 49 years of contributions could fund the average 2 years of retirement before death. Now that people spend fewer years in work and life-expectancy is just over 82 years, the system is visibly straining and will be unsustainable in future.
Fortunately, there is a model by which it could be saved. In 1994 the Swedish Social Democrats agreed with the four center-right parties to create an entirely new system based on the principle that pensions should correspond to what the beneficiary pays into the system—a system in which the contribution, not the benefits, is defined.
The reforms were designed to make it impossible to run a deficit and pass the costs to future generations. Crucially, the agreement introduced a balancing mechanism nicknamed “the brake.” When the economy is doing worse than expected, pension benefits are automatically reduced, and when the economy picks up again, the brake is released.
Under Sweden’s partial privatization, people were allowed to choose between five approved funds in which to invest a required 2.5% of earnings. They could choose a wide variety of options to invest in within their chosen fund. A sixth default fund was set up by the industry to enroll those who failed to make a choice. They are required to pay a further 16 percent into a state income pension.
The 16% of a person’s salary allocated to the income pension goes to the people who are retired today. Their income pension will in turn be paid for by those who are working and earning money when they retire. Those who have had little or no income during their life, may receive a guarantee pension based on various things including how much income pension they are entitled to and how long they have lived in Sweden.
The returns from the normal income pension is around 2% per year, but from the private accounts the average Swede has made an impressive average return of roughly 10% a year since its inception in 1995, despite the dot-com crash, the financial crisis and the pandemic.
The reform solved the problem of moving to a contribution-based scheme while continuing to pay today’s unfunded pensioners and those who have not had long enough to build up sufficient funds. It made Sweden’s pensions sustainable.
The UK could remodel its state pension scheme to align with the Swedish model by implementing some key reforms. It should move from a defined benefit scheme to one linked to contributions. It should require mandatory contributions to a choice of five approved funds, and have the industry set up a sixth, default one for those who fail to choose one, a government-backed pension fund option with low fees and passive investment strategies. The level of contribution might be set at 2.5 percent of salary as in Sweden.
The percentage of earnings still going into a public system, a notional defined contribution (NDC) account that mimics an investment account but is actually PAYG, would be set at a figure suited to the UK economy and demographics. It might be 16% as in Sweden, or at a different level.
The number of those who needed to be wholly supported from it would diminish over time as unfunded pensioners aged and died.
This would amount for the biggest restructuring since Beveridge, and ultimately to the end altogether of the state pension. Yes it would, and it needs to.
Madsen Pirie