IN addition to the banking crisis, the Government also faces a series of crises on pensions. There are at least three separate but related crises around the issue of pensions.
Firstly, we have a situation where the state is paying pensions, both for public servants and for others, but of current income. Secondly, the vast majority of defined benefit schemes in commercial organisations are underwater. The third is that the experience of the last number of years in relation to investments cannot but have had a chilling effect upon people’s willingness to engage with financial services, including pensions.
At present, Ireland is in the lucky position that we have a young population. Approximately 17% of the population is in the elderly category. CSO projections suggest this could rise to 25% by 2021 and to as high as 46% in 2041. All of these persons will be dependent, in theory, on a pension. For many of them, if the past is any guide to go by, this will primarily be the state-funded old-age pension.
A proportion of these will also be retirees from the civil and public service and, at least in the medium term, the majority of these will be on the “old-style” pension arrangements, where the pension is tied to the final retiring salary.
As of 2009, this liability, for public sector pensions alone, was €116 billion.
In other words, were the state to have to go out and purchase on the open market an annuity, the annual yield on which would be equivalent over the period to the pension to be paid to these public servants, this would cost €116bn.
It is inconceivable that this liability can be allowed to continue to grow. The recent changes announced by the Government in relation to pensions for public servants being based on a lifetime average will help to reduce the growth of this liability. It is entirely probable, however, that faced with the need to cut both immediate and future expenditure the state will have to move to reduce the actual amount of expenditure on public sector pensions in the near term. The proposed new arrangements would also, it appears, be applicable in certain circumstances, to existing pensions.
This might mean that public servants find that while their existing built-up pension entitlements stay as they are, future pension entitlements might be linked not to final pay but either to average pay or the consumer price index.
Another possibility might be the imposition of additional taxes on lump sums, or indeed full retrospection of the average lifetime provision. Public sector employees will need to be aware of the fact that pension provision, coming out as it does and will of current taxation, is going to be reduced.
Private sector pensions are not in much better shape.
Up to 80% of defined benefit schemes may well find themselves in actuarial deficit. Persons paying into defined contribution schemes have been very badly hammered, especially those coming up to the last number of years before retirement. All of this will serve to throw additional strain on the public purse.
Government does have a good plan in the automatic opting-in of new employees into a defined contribution scheme. However, this will, over time, result in the building up of very large defined contribution schemes, which will in itself pose problems. One could easily conceive of a situation whereby, faced with pension pots of tens of billions and a government fiscal position that becomes strained, there is a temptation for said government to either engage in financial repression, or to direct pension savings away from market towards government assets.
The experience of countries such as Chile and Poland is that firm controls need to be put in place to ensure that management fees of state-mandated pension pots are kept at the absolute lowest level possible.
We must also learn the lessons from behavioural finance, such as a general tendency to overconfidence, loss aversion, and the tendency of people to over diversify, which might result in individuals making significantly sub-optimal choices in how they allocate their pensions savings.
In an environment where there seems to be no such thing as a risk-free asset, where even sovereign bonds are exposed to the possibility of major losses, where equities may face a secular bear market, and where investors have been badly burned, the appetite for the risk required to grow defined contribution schemes to an adequately large amount of money is likely to be muted. That would be a pity, as taking risk is needed to ensure a decent return is obtained.
If we want to provide a decent level of income for ourselves when we retire, we have only two choices. Either we save it ourselves, or we pay for it through taxes. Either way there is a high probability that in the near term we are going to start to pay more. This will result in further withdrawals of money from an already fragile domestic economy.
There is no choice.
Brian M Lucey is professor of finance, School of Business Studies, Trinity College Dublin
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