Sunday 26 January 2020

Colm McCarthy: Retirement age must rise by eight or 10 years

With a rapidly ageing population here, the pensions crisis requires decisive action

Colm McCarthy

Colm McCarthy

Since 2008, economic policy in Ireland has been understandably focused upon the deflation of the bank credit bubble and its budgetary consequences. But Ireland faces serious economic policy problems which pre-date the financial crisis. Two reports released in recent weeks highlight one of the most serious – the unsustainable current system of retirement income provision. State pension schemes are unfunded (the social insurance 'fund' is just a book entry in the State accounts) and reliant entirely on the health of future tax revenues. If these fail to grow strongly, the State will struggle to meet pension commitments to its own employees and to the wider public who are covered by the contributory and non-contributory old-age pension schemes.

Since 2008, economic policy in Ireland has been understandably focused upon the deflation of the bank credit bubble and its budgetary consequences. But Ireland faces serious economic policy problems which pre-date the financial crisis. Two reports released in recent weeks highlight one of the most serious – the unsustainable current system of retirement income provision. State pension schemes are unfunded (the social insurance 'fund' is just a book entry in the State accounts) and reliant entirely on the health of future tax revenues. If these fail to grow strongly, the State will struggle to meet pension commitments to its own employees and to the wider public who are covered by the contributory and non-contributory old-age pension schemes.

Meanwhile, in the private sector and in commercial State companies, where actual pension funds exist, pension promises have been made that are not matched by the funds accumulated and the contributions being made. Most of these defined-benefit pension funds are in serious deficit and some have been unable to meet their commitments. The problems for both funded and unfunded schemes are exacerbated by the continuing rise in life expectancy.

The current flow of consumption goods to retired people comes ultimately out of current production by those at work. The employed workforce, in effect, provides for the young, the retired elderly and the unemployed. If the number of non-producers is likely to rise rapidly, there needs to be prior provision, through saving (reduced consumption) from those at work, or promised pension benefits may be reneged upon.

There are ultimately just two ways to square the circle. Those currently at work need to set aside more to meet expectations for retirement income, or working lives need to be extended, or both. Retirement at 65 may be feasible, out of a given pot of savings, if people live to be 70, or even 75. If life expectancy at retirement age reaches 80 or 85 and is heading for 90, something's got to give.

According to a recent report by the OECD, 40 years ago the typical age at which Irish workers retired was over 70. It had fallen to about 63 prior to the crisis. Meanwhile, life expectancy was improving rapidly. Fewer years of work were expected to support longer years of retirement.

These contradictory trends are not sustainable unless the employed workforce is accumulating adequate pension savings through hefty contributions from workers and employers, or the State is able to make up the gap from ever-rising tax revenues.

Pension systems have a very long time horizon. A worker who joins a scheme today aged 20 will likely still be drawing pension benefits 60 years from now. It is tempting, especially when schemes are not funded, to promise excessive benefits in the hope that the future will look after itself. Companies which sponsor defined-benefit schemes are tempted to over-promise, sometimes with the tacit collusion of trade unions and trustees. Politicians find temptation even harder to resist and some countries have had to admit that their state pension arrangements had something like a pyramid structure. Rising bills for retirement benefits were being paid by newly recruited taxpayers – the classic structure of a Ponzi scheme.

The OECD report was followed by a valuable study from the Central Statistics Office, updating its projections in the light of the 2011 census. The resumption in emigration has put a stop to rapid population growth in Ireland, despite a rise in births. The recent increase in births was the feature of the CSO report highlighted in the media.

But the most significant material in the report relates to trends in the age distribution of the population and workforce. The population is getting older and at a rapid pace, due to much improved survivorship in the older age groups. If the typical age of retirement stays in the 63-65 range, the numbers drawing pensions will soar while the numbers in the working age groups will not keep pace.

The CSO has projected the population on a range of assumptions. The key ones relate to fertility (the average family size) and migration patterns. If fertility declines from recent higher levels towards the European average, and heavy outward migration eventually turns round into a small net inflow, the resulting projection shows the following picture over the next few decades:

The overall population continues to rise under these assumptions, although at a much slower rate than in recent times.

However, the growth is almost entirely confined to the older age groups. The number over 65 will double by 2036 and go on rising sharply thereafter. Numbers in the school-going age groups rise initially but then fall back, while numbers in the working age group of 20-64 rise only marginally over the period.

In 2011, there were 5.24 people in the 20 to 64 age group for every person over 65. By 2026, this ratio will have fallen to 3.33, by 2036 to 2.66 and by 2046 to just 2.09. The CSO projections reflect the assumptions it has made and it has done the sums on six different combinations of assumptions about fertility and migration.

The figures in the table show the outcome for one set of assumptions but the broad pattern is present in all six of the CSO scenarios.

The population is ageing rapidly and the sustainability of retirement income provision, particularly through unfunded schemes, is threatened. More generally, the re-distributive welfare state requires a balance between contributors and beneficiaries and that too is under threat from population ageing.

The most obvious inference to draw from the table is that the current presumption that people can expect to retire around age 65 is no longer tenable. Many governments around Europe, including our own, have been announcing higher retirement ages for tax-financed State pension schemes. These measures typically involve adding a year or two to the age at which State pensions become payable. It should be clear from the table that these measures are far too tentative. The retirement age needs to rise, not by one or two years but by eight or 10, and sooner rather than later.

In addition, the Irish practice of not making any advance provision either for public service occupational pensions or for the State pensions available to all needs to be reconsidered. The unfunded liability for pensions is not shown on the State's financial books. If the Government did its books properly as a commercial going concern, the annual accrual of extra pension liabilities would be shown as an expense and the Government's budget deficit would be even larger than it appears.

In the private sector of the economy, firms have been moving away from so-called defined benefit pension schemes, abandoning the pretence that retirement benefits can somehow be guaranteed independently of funding adequacy.

The preferred model nowadays is the defined contribution scheme, where each employee receives benefits dependent on accumulated contributions and the investment returns actually earned.

This means that each individual has their own pension fund and is not dependent on the commercial fortunes of their employer. Individualised pensions have the additional advantage of making it easier to change jobs.

The Minister for Social Protection is considering proposals for pension reform. Pre-funding all pensions on an individualised basis is the only sure way to avoid the catastrophes that have overtaken defined benefit schemes in companies that have gone bust. It is also the only way to remove Ponzi finance from the provision of retirement income by the State itself.

Irish Independent

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