Breaking the pension promise
Pensions are essentially promises – save today for the promise of an income in the future. But are they a promise governments can no longer afford to keep? FNZ’s Nick Sherry examines the options for global pension reform.
Pensions: a short history lesson
Pension policy is one of the biggest areas of debate and change across the world – but why do pensions need to change, and what might be the consequences of that change?
Pensions are basically a promise to pay a modest income to people unable to work due to age or illness. Introduced in many developing countries around 100 years ago, initially most people didn’t live long enough to receive their pension. The concept was later expanded to include a higher payment, usually related to income and based on compulsory or voluntary contributions. This could be delivered by government, or through private providers like insurance companies or pension funds.
Pensions have changed, slowly but significantly, for two main reasons:
Longer, healthier lives
Life expectancy has increased at the rate of 1 – 2 years each decade. In 1900, the average life expectancy in developed countries was around 60. By 2014 it had risen to 81 in the UK and Germany, 84 in Japan and 79 in the USA. Funding this extra 20+ years of pension provision is becoming more and more costly.
Declining birth rates
Working people support those in retirement, so developed countries need an average birth rate of around 2.1 children per family. In the UK the number is currently 1.8, while in Japan and Germany it’s 1.4.
Pension Reform: the options
It seems clear that governments can no longer afford to keep the promises made 100 years ago. Reform is needed – and it comes in three broad steps:
1. Increase the retirement age
The most obvious, simplest option is to extend the age at which an individual can claim their pension. Since the 90s the pension age has increased by an average of 5 years across most developed economies. It continues to rise: the current global average pension age is 65.5 for men and 65.4 for women but this will rise to 68 in the UK by 2046. In Australia, it will rise to 67 in 2023, then to 70 by 2035.
2. Cut payments
It’s unusual, but it does happen. Greece has cut their payment level, while Australia has means-tested retirees since 1984 – some 20% of Australian retirees don’t get any pension, while a quarter only get a part pension.
It’s also possible to change the level of any future increases. Pensions usually increase in line with inflation, wages, or both. In the UK the ‘triple lock’ means pensions payments are guaranteed to rise by a minimum of 2.5 % per year. The Conservative Party have pledged to remove this.
Governments can also limit total savings in a pension to a specified value, and place yearly limits on contributions – this happened recently in the UK and Australia.
3. Part replacement of defined benefit by defined contribution
Part replacement of defined benefit means a pension is guaranteed at a set age after a defined contribution is paid into a members account and invested on the member’s behalf. Returns are added to the pot, minus fees and charges. This moves at least part of the pension risk to the individual rather than the government – as we all know, investments can go up as well as down, and this way governments aren’t ‘on the hook’ to make up any shortfalls. We’ve seen recent examples of this in Hong Kong and New Zealand.
As people live longer and healthier lives, a global pensions reform is needed.
Pension reforms vary from country to country. But they all have significant consequences for private sector service providers, regulators and the parallel non-pension financial sector. We’ll explore these in a future issue.
The Honorable Nick Sherry, BA FAIST is Chair of FNZ APAC. With over 30 years’ experience in pension policy and operations, he served as a Senator in Australia for 22 years, where he oversaw legislation for the foundation of the modern Australian pension system.
He became Australia’s first Superannuation Minister in 2007 and also served as Assistant Treasurer. After retiring from politics, he became a global pension advisor for Citigroup and EY and Chairman of FNZ APAC.