Pensions World

Increases in state pension age need to reflect “healthy” life expectancy to be effective argues Steven Baxter, Club Vita

The UK state pension faces a challenge. The number of contributors is declining – driven by a combination of falling fertility rates and greater access to higher education leading to later entry to the workforce. This is happening at a time where the outgo is rising – we are living longer, more retirees are eligible for full state pensions and the baby boomer generation is now reaching state pension age. Furthermore, the restoration of the link to earnings via the “triple guarantee” (the greater of the increase in average earnings, inflation and 2.5%) is likely to increase the costs of state pensions.
The combination of these factors means that the state pension risks becoming unsustainable.

Maintaining the balance

Any approach to ensuring that the state pension remains affordable needs to consider both sides of the income–outgo balance. Controlling the amount of expenditure on state pensions is a benefit design problem. The options are broadly to:

1. transfer or share the risk to the member, eg via defined contribution (DC) arrangements
2. reduce the benefits to an affordable level
3. increase the age at which benefits can be taken unreduced.

All of these options have been used by other European countries to manage state pension costs. For example, Italy, Sweden and Poland have switched to notional defined contribution schemes for part of their state provision. However, the relatively low level of the UK state pension, combined with its safety net role, means that reducing benefits or having an uncertain level of benefits are not viable. This leaves us with the challenge of ensuring that state pension age responds appropriately to changing longevity.

One way to reflect changes in life expectancy is for state pension age to increase by one year for each extra year of life expectancy. This works well provided each extra year is healthy, ie an individual can reasonably be expected to work for another year. If not, there is a risk that state pension age will rise, but the reducing state pension outgo will be offset by increased pre-retirement welfare benefits. For example, one recent study suggested that around 20% of the savings made from raising state pension age will be spent on increased sickness and disability benefits1. Currently for every extra year of life, around nine months are healthy – so perhaps state pension age should increase with “healthy life expectancy”, ie the number of years spent in good health?

In a recent study2 written by the Oxford Institute of Ageing and Club Vita, we explored how state pension age might increase to reflect our longer lived, ageing society. Alongside a direct link to life expectancy and healthy life expectancy we also considered:

• sharing the benefits of extra longevity between working and receiving state pension, by maintaining the proportion of adult life currently spent in receipt of state pension
• targeting a stable proportion of potential contributors (the “economically active”) to those supported by these contributors (the “economically inactive” including those in retirement).

All four approaches suggest that state pension age needs to increase more rapidly than current plans – even after allowing for the increase to 66 by 2020 (see Figure). Indeed in the absence of other remedial measures, state pension age will need to increase to 68 during the 2030s.

Each of these approaches also has the merit that should life expectancy increase more rapidly than currently forecast then state pension age automatically changes to reflect this. Similarly if life expectancy stops increasing, then state pension age need not be increased.

We are all different

So far, I have ignored the diversity in life expectancy that we see across the UK. For example high income, healthy men aged 65 today can typically expect to receive state pension for 11 years longer than low income, unhealthy men. If state pension age is set by reference to the change in life expectancy of an “average person” then the poorest and least healthy – ie those who have the greatest need for the safety net of the state pension – are likely to be disproportionately affected.
Can state pension reforms avoid this problem and so provide more equitable outcomes? Yes, provided we are comfortable breaking with the idea that there is some universal age where we all should be contemplating retirement. One way to do this may be to return to the principle of accruing full state pension over a working lifetime. For example, if a working lifetime of 45 years were required then a school leaver entering employment at age 18 might be eligible for full state pension at age 63, while a university graduate may need to wait to age 66.

The university graduate – by virtue of higher earnings and differences in lifestyle, occupation etc – can expect to live longer. So, although the graduate waits longer for his or her full state pension, he or she contributes for the same period as the school leaver and receives a state pension for a similar length of time. Naturally a system of credits would need to be retained to ensure child-rearing and carers are not penalised. Crucially though, as life expectancy increases, so the number of years needed for a full state pension would increase.

Alternatively, a more explicit link can be forged with differences in life expectancy. An individual’s salary is a strong predictor of his or her life expectancy. The state pension age could reflect an individual’s career earnings – different broad groups would have a state pension age reflecting the life expectancies within that group. Using career earnings smoothes income histories and avoids difficult decisions later in life (eg accept a pay increase or maintain state pension age). Provided the government retains the contributory principle then an individual’s national insurance records could be used to determine career earnings. For those with low or no earnings history, a default state pension age could be applied.

Paying the cost

The measures discussed so far relate to controlling the outgo side of our balance. If income from national insurance contributions can be increased then greater outgo is affordable and state pension age need increase less rapidly. Increasing national insurance contribution rates is one option, albeit unpopular with voters. An alternative is to increase the number of contributors.

Fuller employment, greater participation of women in the labour market and immigration all have a part to play in increasing the contribution income. Crucially any state pension age rises need to be accompanied by longer working lifetimes. In the immediate future the retirement habits of many will continue to be driven by when they can take any defined benefit pensions without reduction.

For subsequent generations, though, working longer may become the norm as we strike a balance between living longer and working longer.

An ideal time

None of the reforms described here are without implementation challenges. Practical issues such as how much notice an individual needs of changes to state pension age, along with the timing of implementation of any change, will need to be addressed.

With reform on the political agenda, perhaps this is an ideal time to take a more fundamental look at the state pension system and ask ourselves “What do we want from our state pension system?” Over forthcoming months I would expect many ideas to be added to those described above and look forward to debating the government’s proposals to ensure that as we live longer we also prosper.