Pensions – an impossible dilemma for governments?

22nd August 2012

The trick for politicians is to find a way of doing this that does not immediately generate massive popular unrest. As one senior German politician put it recently

"We all know what needs to be done, we just don't know how to get re-elected after we've done it…"

In a paper which I blogged some two years ago, the Bank for International Settlements (BIS) showed just how unsustainable government debt was likely to become by 2040 if governments continued on their present path. The UK, for example, would be at over 400% debt to GDP ratio. Of course, things would go smash long before this point was reached, but the BIS point was clear: change course or you're doomed!

The UK's move to adopt auto enrollment into a pension fund for all employees earning over £5,664.00, is a clear attempt by the UK Coalition Government to scale back the State's promise on pensions and to shift the burden for funding retirement back to the individual – particularly, it seems, the low paid individual. The UK Coalition government recently estimated that auto enrollment would bring between 6 and 8 million people who are not currently saving for a pension, into the pensions net.

This immediately raises some interesting technical issues as far as investment and returns are concerned. We are in a world of negative returns for risk free cash (i.e. the best interest rate available for a risk free investment is below the level of inflation). This immediately leaves us with the problem that a low monthly pensions contribution from a low paid employee, compounded at a very low rate of interest, is not going to generate a pension that is capable of sustaining life, never mind a reasonable quality of life, on retirement.

Viewed from this perspective, all the apparatus of pensions enrollment, monthly contributions, the provision of a default fund and so on and so forth, looks like nothing more than a con game. The State is opting out of a real promise, that it will provide a sustainable pensions safety net for the low paid when they can no longer work, and instead is offering something of a hollow promise in its stead. Why hollow? Well, according to Sean McSweeney, Principal Consultant with independent financial advisors AWD Chase De Vere, the Government's default scheme, being operated by NEST, the National Employment Savings Trust, is targeting inflation plus 3%. NEST charges 1.8% plus a management charge of 0.3%, making a grand total of 2.1%. So after inflation, and after fees, an employee's pension pot in NEST is likely to grow at 0.9% per annum, compounded. Unhappily, the magic of compound arithmetic cannot conjure wondrous pension pots from a magician's silk hat. Compound arithmetic with very low figures generates very low pots, unless you have a few centuries at your disposal.

McSweeney points out that according to his firm's calculations, if a 20 year old was auto enrolled into NEST and stayed in the scheme for all his/her working life, saving at the designated rate, the pension scheme on retirement in 40 years time would return less than £500 a month by way of benefits. When large numbers of people do finally retire or are well on towards retirement and then discover that they can look forward to nothing but grinding penury in their old age, there is going to be trouble…

One of the answers to this dilemma that the UK government may well have up its sleeve is the idea of borrowing not just auto enrolment from the likes of Norway, New Zealand and Australia, which have had auto enrolment for years, but their very high rates of mandatory employer contributions as well. In the initial instance, with the employer contributing just 2% of salary (more if they want), the annual contributions are too low to do the job, as we have said. But clearly if this mandatory figure is ratcheted up, then you can reach a level where the pension delivered by auto enrolment would be substantial at the end of a working life.

Continue reading…


More on Mindful Money:

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The real cost of rising food prices

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