Paying for our pensions

(This post is based on a presentation made at a recent NIESR conference on aging and finance.)

We are once again collectively panicking over pensions. In reality, the outlook is not that grim, and if we are not careful, we could end up making things worse.

There are two main worries, which are linked: demography, and the prospects for growth. But there need be no 'demographic timebomb', and the growth outlook is much more nuanced than we are told.

The public debate is poorly framed to begin with. The conventional view is that pension provision is all about savings. This conjures up a picture of warehouses full of stockpiled food, clothes and all the other things we’ll need when we retire.

There are no such warehouses. The resources consumed by pensioners are produced when they are needed, by people currently in work. Collectively, pension resources are a transfer payment, a redistribution from workers to pensioners.

In the jargon: aggregate pensions provision is 'pay-as-you-go', not 'funded'.

When we save, we abstain from consuming all of what we produce. That frees-up resources to be used by people not at work, including today’s pensioners. In this sense, our savings do provide pensions – but somebody else’s, today, not our own in the future.

Our collective ability to resource future pensions depends not on today’s savings, but on the size of the economy when we come to retire. And despite current misgivings, the drivers of long-term growth are exactly the same as they have always been – namely, the inputs available, innovation, and the learning curve.

Capital is a key input, and so there might be some role for increased savings here – but only if those savings lead to a coincident increase in investment plans, and if those plans turn out to be productive and do actually help make future output bigger.

If we focus only on saving more of our collective incomes – as many policy analysts advise – it may not boost our own future pensions, and the resources available for today’s pensioners could shrink. Less spending means a smaller economy (and when the dust has settled, possibly lower savings in total – the so-called paradox of thrift).

Labour is another key input, which is why demography might matter. If an older population means less labour, then potential growth will suffer. In practice, though, the link between labour supply and the population’s age profile is much looser than the simplistic analyses suggest.

If pensions are about transferring resources, the scale of the transfer needed reflects economic dependency – how many non-workers there are relative to workers. Dependency is driven not just by demography, but by other key variables too – such as participation and employment rates.

When I first looked at the data back in the late 1990s*, I found that economic dependency in the UK had already been higher, in the early 1980s, than it was projected to be in the future, because inactivity and unemployment rates had been a lot higher then. (Incidentally, the number of inactive workers in the UK in the early 1980s was 9 million – the same figure which is causing such concern today, but in the context now of a much bigger population.)

I also found that if participation and employment rates were to rise, economic dependency in the UK and much of Continental Europe could fall, even as the population aged, and with no change in immigration trends.

As things have turned out, labour force participation and employment rates did rise, and Western society has so far coped, despite the disasters predicted by many pundits back around the time of the millennium. Those predictions usually didn’t mention labour utilisation at all, but simply equated demography with dependency.

Of course, having risen already, there is less room for activity and employment rates to rise now. But there are other moving parts in the labour supply calculation. The small increases in retirement ages will have a big effect in lowering projected dependency. So too, if needed, would an increase in working hours (from today’s historically-low levels).

There is no necessary shortage of inputs, then. What, though, about innovation and the learning curve – the prospects for productivity? This has been the source of most economic growth historically, and we all know that productivity growth is over, right?

Not necessarily. Output per person in the big Western economies has slowed, but not stopped. Some of that slowdown reflects an unsustainable starting point – the growth rates of the financially-supercharged ‘noughties. It may also partly reflect the growing difficulty of measuring increasingly intangible and digital economies.

The idea that there are no big inventions left to discover – as the world searches for an energy transition! – is presumptuous and premature. (To be clear: this does not mean all progress is computable… today’s AI and crypto hype is still hype.)

The outlook for collective pension provision, then, is much more nuanced than we are told, and the things which matter most are real, not financial, in nature. The size and asset allocation of today’s pension funds matters hugely to their individual members (and sponsors), but collectively matters not a jot.

It is sometimes argued that the existence of a private pension industry in itself makes economic growth more likely (similarly, it is often argued that a vibrant stock market is also good for growth). I firmly believe in 'markets where possible, governments where necessary', but wouldn’t go that far.

Pension funds are mostly about administering pensions, not resourcing them (and stock markets are mostly about transferring ownership, rather than raising finance). The size of your pension gives you a better place in the queue for those transferred resources when you come to retire, but if there is not much available to redistribute, that’s little consolation. A huge pension pot is not much use if there is little to buy.

^{* As per “De-Fusing the Demographic Timebomb”, a report I wrote at Morgan Stanley in October 1999, and also Chapter 3 in my book “Making Sense of Markets” (Palgrave Macmillan, 2015)}

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