Pension reform and growth. Cui bono?

The UK government's decision to re-base pensions won't work, and even if it does, will be counter-productive. It's evidence of the inability of governments to think beyond the corporate view of economics and consider the economy as a whole.
Peter Johnson
12 July 2010

Last week the British Government announced that the basis for so-called Statutory Indexation of private sector final salary pension schemes would be changed from the Retail Prices Index (RPI) to the Consumer Prices Index (CPI). UK readers may already understand this terminology, but I’ll summarise it briefly, since although the story is really about how we understand the economy, we need to grasp what is being done here.

Pension plans in the UK are of two basic types. One is the defined contribution scheme, in which fixed proportions of the employee’s salary are paid into an investment fund that can be drawn down once the employee retires. This kind of scheme fixes the cost; the benefits are uncertain. The other type – the subject of the Government’s announcement – is the defined benefit or final salary scheme, in which the employer (maybe with the employee sharing costs) commits to funding a pension determined as a proportion of the employee’s salary at retirement. The amount to be funded is clearly uncertain and potentially volatile as well as subject to longer term trends in longevity, retirement age, and so on. State and many large private sector employers run final salary plans. A good number of private sector plans are badly under-funded (of course, state plans cannot become insolvent).

UK law prescribes that private sector final salary scheme pension payments should be increased each year by the rise in RPI. The proposal is to switch the measure to CPI, the same as already used to index the pensions of state employees. So what’s the difference? Both indices track the prices of baskets of goods and services, but only RPI takes account of mortgage interest payments. Usually RPI rises faster than CPI, although interest rate cuts in 2009 led RPI to fall whilst CPI continued to rise modestly.

This indexation change is likely to reduce what some UK pensioners receive. Estimates put the reduction at around 15%. And where does this money go – cui bono? Well, employers will have to pay less to fund their defined benefit pension schemes. KPMG have said that aggregate employer pension liabilities might be cut by £100 million. As the Confederation of British Industry said, “Statutory indexation is the biggest single regulatory cost borne by final salary schemes. That makes getting it right important. As CPI is a more accurate reflector of inflation for pensioners than RPI, we welcome this announcement.”

The CBI is saying that pensioners who don’t pay mortgage interest shouldn’t get more annual uplift than CPI offers. Shouldn’t? As if this were just about technical accuracy? What about the probably increasing proportion of pensioners still paying off mortgages? Why does the minister think it’s remotely important that the Bank of England’s inflation target and pensions should both be based on CPI? The business lobby wants to reduce the pension costs of its members. And with interest rates as low as they can practically get, switching now means they can lock in the indexation effects of a flagging RPI and jump to the slower CPI horse before RPI speeds up again. So the winners are – surprise, surprise – corporate shareholders and management.

Aside from such self-interested pseudo-technical nonsense, it’s difficult to find a clear explanation of why this measure is being pushed through now, not long after the government trailed an increase in the retirement age. The nearest I found was a radio interview with David Willetts, Minister of State for Universities and Science. He said the objective was to encourage saving. Let’s think about this for a moment.

First, we encourage saving by reducing the value of saving. That seems counterintuitive if comprehensible. In fact, it’s inane. A given benefit needs to be funded by someone. All this proposal does is pass the burden of funding from employer to employee. So if every employee coughs up extra cash to replace the payments his or her employer will not now make and so fund the same pension, aggregate retirement saving will be exactly unchanged. But of course that won’t happen, so not only will retirement saving fall, not rise, but employees, particularly those on lower salaries, who can't increase savings will end up with lower pensions. This ‘pro-savings’ measure will end up distributing retirement funds from poorer employees to companies.

Secondly, we should remember that saving is not in itself remotely useful. What is actually useful – what encourages companies to invest in productive capacity – is demand for consumption. Without real income growth, more saving reduces consumption and therefore reduces the profitability of investment, so as Joseph Schumpeter perceived 60 years ago, higher saving may sometimes discourage investment. Unproductive saving will generate ever lower returns and be entirely self-defeating.

And this is connected with a broader point. On the one hand, aggregate demand will fall to the extent the money that is transferred from pensioners to shareholders is not applied to consumption – and that will be a large proportion. On the other, the prospect of lower retirement payments makes the future less attractive, more uncertain. Employees who can will want to save more while in work to add to their retirement funds. This will further lower demand for consumption. Whichever way you look at it, the proposal will slow any economic recovery and perhaps permanently lower growth prospects.

Although the sums we are talking about are small compared with GDP, this highlights the deficit cutters’ supply-side view of economics. We tighten the belt, put some money in the bank (which will charge us handsomely for the service), and lo and behold, all will be well because companies will invest irrespective of what their customers want to buy, or even whether they have any customers. Is this a credible story of the economy? Might we just carry on tightening the belt until there’s nothing left? Or does the prevailing view – continuing the orthodoxy of the last 30 years – reflect a narrow technical corporatism that lacks perspective on the economy as a whole? Would it not be better to think about funding pensions through productive, employment-producing growth rather than by financial tinkering?

The absence of joined-up economic thinking or even half-credible explanation is startling, and the UK should worry that neither of the two most economically literate people in the new government – former Chancellor of the Exchequer Kenneth Clarke and the Lib Dems’ former shadow Chancellor Vince Cable – has a role in forming macro-economic policy. Here as in many countries we shall have to wait and see whether the new boys with the old ideas have got it right after all.


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