All Commentary
Sunday, May 1, 2005

Britain’s Pension Problem: Government Failure

Privatizing Social Security Gives People Better Options

Proposals to privatize part of Social Security have met with an outcry from predictable quarters. Many articles have referred, unfavorably, to British experience and suggested that the United States may simply be following the same failed route as Britain. As a British observer of that debate, I am not alone in finding the parodies of the British pension system, as described in the American media, seriously wanting. There is no question that the system is in deep trouble. But the problems are not caused by privatization. The government has regulated and taxed private pensions to such a degree that companies and individuals no longer find it worthwhile to invest in them. Furthermore, the government provides “means-tested” benefits for over 50 percent of the retired population and has sent a strong message to the populace that increased saving will merely increase their tax bill and reduce their welfare entitlements.

Advocates of private pensions in the United States often suggest that private provision, through stock market–invested accounts, will lead to greater returns from given levels of contributions. This is because in the long run, shares will outperform the government bonds in which Social Security contributions are implicitly invested. In Britain this argument tends to be downplayed by private-pension advocates, who are more willing to accept the possibility that risk-adjusted returns on different types of assets will, in the long run, be equal.

Some proponents also suggest that private provision will rectify the United States’ apparently low savings ratio. Again, this argument is weak. Private provision may increase pension saving but not necessarily overall saving.

The alternative, much stronger arguments for private pensions are arguments about social justice and the security of property rights. (I rarely use the phrase “social justice,” but here it is perhaps appropriate.)

The social-justice argument should be clear. Social Security, a “pay-as you-go” system, involves one generation voting to provide itself with future pensions that will be paid from the taxes of a coming generation. That coming generation is likely to be too young to vote and may not even be born. As a population ages, taxes become a greater burden on the shrinking workforce and conflict opens up between the decreasing numbers paying for pensions and the increasing numbers receiving them. These conflicts cannot be resolved through the ballot box because the pension recipients become so numerous and powerful at elections. The concentrated power of pensioner lobbies makes it extremely difficult to rectify problems in state pension systems. The conflicts can then be played out, sometimes violently, in the streets, as frequently happens in continental European countries with high state pensions (most notably in France and Italy).

In private systems, conflict between pensioners and workers is avoided because pensioners invest for their retirement when they are working. An invested fund provides security for the contributor through property rights in stocks and bonds. The investments in the fund serve to transfer resources across time. Generations of pensioners who have saved in their youth will then draw down their savings when they retire.

Problems in Britain

There are serious problems in the British pension system. People are saving very little through pension schemes; pensioners’ incomes seem inadequate; and a tiny minority of private schemes have become effectively insolvent. Remarkably, in an attempt to justify attacks on reform proposals in the United States, these problems are attributed to the private element of the British system. One article, by Norma Cohen, published last February in The American Prospect, appears to be a convincing piece of journalism. The historical description is clear, although a more thorough research of the history of British pensions would have established that the “contracting out” of government pension schemes started in 1959, not in 1988. Her conclusions are clear too: “America contemplates replicating this [British] disaster.”

It is impossible, with any objective and serious analysis, to conclude that the system of “contracting out,” or privatization, of state pensions, whereby individuals receive a rebate of social-security contributions in return for forgoing the accrual of a state benefit, has anything to do with Britain’s pension problems. Yet this seems to be the implication of the critics of the British system.

Cohen says that “on average, fees and charges can reduce pension lump sums by up to 30%.” (One can only speculate precisely what she means by on average, can, and up to in this sentence. Normally an “average” would refer to the middle of the distribution of charges, “up to” to the highest level, and “can” to one possible level of charge.) It is true that horrendous levels of government-imposed regulation in the United Kingdom do mean that charges on investment funds are dramatically higher than in the United States. But the rebates of social-security contributions that people receive make allowance for charges.

Serious research on comparative total costs (direct and indirect) in state and private pension schemes certainly does not suggest that state schemes are cheaper—the results are ambiguous. We need to remember that many of the costs of state schemes are hidden because they are imposed on private firms (for example, collection of payroll taxes). State schemes don’t have to be marketed because they are compulsory. They rarely communicate with their members—what is the point if their members cannot leave them? I regularly receive one or two updates a year on my pension entitlement in private schemes I have left. My wife, who left the state-run teachers’ scheme ten years ago, has never received any communication. Perhaps most important of all, state schemes have no investment costs because they have no investments. Cars without engines are cheap; pension schemes without investments are cheap.

Cohen also levies the charge of “mis-selling” against British institutions selling private pension products—a consequence, she believes, of the privatization initiative. This argument has been used by others opposed to privatization reforms. It must be refuted, and to do so an important subtlety must be understood. The concept of mis-selling relates to a situation where an individual is advised, against his best interests, to buy a financial product by a financial adviser. Under UK law, such an individual must be compensated. Some $25 billion in compensation has been paid to people who were advised to buy personal pensions in the late 1990s. But were these people tempted out of the state scheme and into private pension schemes against their best interests? The answer is no. In fact, they were enticed into personal pensions from their company-run schemes, which provided better benefits than both the personal and state plans. That is, they were advised to move from one alternative to the state pension to another.

But that is not the end of the story. Most people in company-run schemes had previously been required by their employment contracts to join their occupational schemes. This was a private, paternalistic arrangement that had existed since the nineteenth century. When the government allowed contracting out of the state pension scheme through individual retirement accounts, it also retrospectively removed from privately negotiated employment contracts the clauses that had required employees to join their company pension schemes. Such people were then enticed into leaving those company schemes to take out personal pensions. The entire pension mis-selling debacle, which is used by some UK commentators as an argument against Social Security reform in the United States, arose as a result, not of privatization, but of government interference in private employment contracts.

Pensions: The Real Problems

The UK pension system is in a mess even if the diagnosis of those who are criticizing the U.S. reforms is wide of the mark. It could be argued that the state should not provide pensions at all. James Bartholomew in his recent book, The Welfare State We’re In, shows how state pensions undermined saving and alternative ways of looking after the aged, particularly in the case of the poor. The philanthropist Octavia Hill, speaking to a parliamentary committee in the nineteenth century, described proposals for state pensions as “the most gigantic scheme of inadequate human relief ever devised by any human being.” We see today that either pensions are inadequate (as in the UK) or tax burdens are rapidly rising up to and beyond 50 percent of GDP (as in continental Europe). The state has promised and not delivered. It has deceived the people. It has practiced “state pension mis-selling” on a huge scale. It has then worked systematically, though not deliberately, to destroy the private pension saving that remains. The real faults with UK pensions lie with government interference and not privatization.

Like Britain, the United States is an overtaxed and overregulated state. It might repeat the mistakes that Britain made. It rather should learn lessons from Britain.

It is impossible to detail the real problems of British pensions in a short article, so I will just refer to some key issues. (For a full discussion, see my and Deborah Cooper’s The Way Out of the Pensions Quagmire, Research Monograph 60, published by the Institute of Economic Affairs.) Since 1997 the level of means-tested (social security) benefits paid to pensioners has increased massively, and the chancellor of the exchequer, Gordon Brown, has stated that such benefits will continue to rise more quickly than state pensions. The result is that the benefits are no longer just paid to the very poor who have no other source of income. They are paid to half of all pensioners, a figure that is set to continue rising to 70 percent. These benefits are withdrawn as pensioners’ private sources of income rise—thus many people have little incentive to save.

The following table (reproduced from The Way Out of the Pensions Quagmire) shows, for different levels of return on investment funds (over and above inflation), the return to saving after allowing for the loss of means-tested benefits for a low earner.

Real investment returns are low in Britain at the moment. A guaranteed return of only 2 percent can be achieved from index-linked government bonds. Returns might be higher from other investment instruments, but if we take the 2 percent figure, we see that the saver actually receives a negative return from investing in private pensions after the loss of means-tested benefits. Small savings by poor people are penalized the most.

The government has also enmeshed the whole pension, social-security, and tax system with interfering regulation and complex benefit-withdrawal provisions. Pensioners face no fewer than 12 different tax and withdrawal rates before their income reaches £35,500 a year. Furthermore, one of Gordon Brown’s first acts was to increase the tax burden on pension funds, a move that sucks £5 billion a year out of private funds. This increased the cost of providing a given pension by 10 percent. Also, an individual receiving about £10,000 a year in retirement is likely to be receiving the income from eight different sources—seven from the state. People do not understand pensions anymore. The rational individual opts out and saves through other vehicles—for example, a house purchase.

Regulations surrounding the sale of financial products have increased to the point where advisers will not provide independent financial advice to individuals earning less than £55,000 per year (twice average earnings) because the cost of that advice will be greater than any conceivable benefit. And the opponents of privatization blame the private sector for high costs! (The government has tried to alleviate this problem by promoting low-cost, price-capped products sold without advice known as “stakeholder” pensions.)

One small personal example of regulatory costs illustrates this point. When I wished to invest a very small sum in my employer’s pension scheme, I first had to sign forms confirming that I did not want financial advice for the transaction. (These forms are required by the regulator and will have to be stored by the adviser for decades to come.) I then handed over the check. Two weeks later I received a letter asking me to send two forms of identification showing my name and address (for example, a passport and a driving license). This is a result of anti-money-laundering regulations. Apparently I might have made the money by selling drugs. The facts that I had the bank account for nearly 20 years, the pension scheme was set up by my employer and not by me, other regulations prohibit me from touching the money until I am 55, and the sum of money was tiny are all irrelevant. Three weeks later, the contribution was still not credited to the account. And this is all for a small contribution to an existing scheme.

Company pension schemes have the same problems. Ever since the late 1970s more and more regulatory burdens and financial risks have been imposed on such schemes by the government, particularly on the ones providing the best benefits—where the benefit is related to final salary. Forty percent of such schemes have been closed down in the last five years. The pursuit of the perfect has been the enemy of the good.

While all these problems have been developing, the government has consistently short-changed those opting out of the state pension system by reducing their rebates of social security contributions. Financial advisers now tell clients to opt back into the state system.

Privatization has been undermined by stealth. The problems that Norma Cohen, Paul Krugman, and others identify with British pensions have nothing to do with allowing individuals to contract out on a personal basis. The system of contracting out has arguably enabled Britain to build up private pension funds that were the envy of the world only a few years ago. The current problems with British pensions merely indicate that there is nothing so impressive and impregnable that government incompetence cannot destroy it.

If we cannot trust the government, it had better trust the people. It is important not to allow a pension system to become completely bound up in red tape, micro-meddling with people’s incomes to achieve social objectives and obsessively restricting people’s actions. If the state makes sure that welfare benefits in retirement are sufficiently low, by and large people will behave rationally and sensibly in making private pension provision. Privatizing social security gives people a better, more secure, and more just option than relying on the government. The United States should avoid the British mistakes; but it should copy the one thing we have got right—allowing individuals to opt out of the state social-security pension.