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The illusion of funded pensions

Some people think it is self evident that future state pensions would be more secure if they were funded. This is based on the assumption that a pension fund gives some security that is lacking in the scheme of paying pensions out of current contributions, possibly supplemented by taxation. But the idea that a pension fund gives security is a seductive fallacy.

Before looking at the choices, let us first consider what pensions are. Money, in this context, is inclined to obscure the situation. The practical issue is that older people need to consume goods and services without being able to make a corresponding contribution to the creation of goods and services. Children are in the same boat, but are broadly regarded as the responsibility of their parents. It is a simple fact that the economically active population must somehow provide the goods and services that are to be consumed by the whole population.

Unfunded schemes are largely confined to the various branches of government. In one way they can be viewed as nothing more than putting into cash terms the situation just described. Money is transferred from contributors (the economically active) to the elderly (who are largely economically inactive). General taxation may at times have to supplement pension contributions.

Another way of looking at this is to say that in a society where retirement is an accepted feature of life, there is a general obligation on those who are working to support the whole population. The workers in turn become pensioners and so the cycle continues.

There are real advantages as well as real drawbacks to this approach. One advantage is the very high efficiency of the process. National Insurance (effectively a kind of income tax) raises huge sums of money at very low cost. The distribution of pensions can be achieved at very low cost.

Another advantage, although it has obvious flaws, is that if a democratic society can be supposed to treat the major groups of adults within the population with a degree of fairness, then the unfunded system can be relied on to be adjusted to maintain a reasonable balance between competing interests.

Now consider funded pensions. They have an impact on the economy as a kind of saving, but I will leave aside the economic issues for the moment and return to them later. The idea of a funded pension is seductively simple. Closer examination suggests that the situation is not so simple.

The toughest issue is that there is actually no way to reliably postpone consumption. No mechanism can be relied on to preserve value, let alone enhance it. You cannot, for example, acquire during a working lifetime all the food that will be needed in retirement. It is not practical. The same is true, if less obviously so, for most other goods. And plainly most services have to be consumed at the same time as they are produced.

It is then supposed that the financial system will provide a way to get round this problem. It is not so simple though. Let us run through a few options. We could simply accumulate twenty pound notes and keep them for retirement. That looks a very poor option. If someone on the point of retirement were to have the whole of a year's income from the start of their working life, it would now perhaps be around three months at the basic state pension level. Obviously, inflation rules out this strategy.

Instead, let us consider the various kinds of financial security that might be used. Three major problems arise. One is that costs rise to very high levels. Another is that every financial security has a possible mechanism for its destruction. The third is that large sums of money that are under the control of a small number of people have damaging economic effects.

Look first at costs. The investment vehicles open to pension contributions all involve heavy costs. Numbers sound small but are misleading. It is difficult to get charges much below 1% which may not seem much; often they are much higher but still sound small. But this figure is a percentage of capital, and the return on capital is likely to be well under 10% on average. Costs are very likely to be 10% or more of the income from the fund for all but the wealthiest. Some of this money is consumed by administration costs; some disappears into the pockets of the financial services industry.

Next there is the question of the security of a pension fund. This certainly cannot be taken for granted, as many pensioners will testify. The safest investment option, gilt edged securities, provide a low yield. In any case it is hard to see that building a pension fund of government bonds is fundamentally different from having an unfunded pension scheme. And gilts, or any other security that has a face value in money terms is just as vulnerable to high inflation as cash. Returns offset this to some extent, but generally are low. This has been regarded by pension fund administrators as a decisive reason for investing funds in equities.

But of course equities give no guarantees. They may increase in value, but they may become worthless. As company directors take an ever large slice of the national cake, equities must offer ever poorer returns on average. Equally relevant is the fact that it is not clear that if a flood of money were diverted into equities from unfunded pension schemes, companies would, collectively, have any means to invest it in such a way as to give solid returns over a long period. All the evidence suggests that they would not.

Another critical issue is that the large funds managed by the financial institutions are under the effective control of a small group of people. This provides the source from which company directors are able to pay themselves far more than is justified without any recourse. It also provides the raw material for much financial speculation, which rarely benefits the ordinary person with a pension fund, but frequently causes upheavals that are costly to the general run of taxpayer - the very same person as the ordinary pension fund holder.

Turning at last to the economic issues, opinions are divided, as on most economic questions. It seems certain that a large change in the savings ratio by consumers, resulting from the transfer of pension contributions into funds, would require an economic rebalancing. This could be damaging to the economy, although there are ways in which this could be partially offset. However, the more it is offset, the more tenuous the funding will appear, since there is simply no way to arbitrarily increase the proportion of the economy devoted to investment.

The conclusion must therefore be that the comfort supposedly provided by funded pensions is largely illusory. The comfort provided by unfunded pensions is undermined by the uncertainty of whether governments can be trusted. But the reality is that pensioners have no choice but to trust society to provide for them and to urge us all to maintain a strong belief in our obligations to one another.

#128004 • 14 September 2012 4:36pm by Martin Brampton • Vote: Agree (206) Disagree (190)

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