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Tuesday, Oct. 26, 2004

British pension crisis looms

LONDON -- An important report on the pension crisis facing Britain was published Oct. 12. The report by the Pensions Commission, chaired by Adair Turner, a former director of the Confederation of British Industry, warned that, because of increased longevity and a shortfall in pension funds, British pensioners face penury unless taxes are raised substantially, savings rise significantly, or the age of retirement is extended.

Indeed, measures to effect all three conditions may be necessary in the long run. The government has decided to await a further report from the Commission on the ways of tackling the issues involved. That report, fortuitously for the government, is not expected until after the next election (probably in 2005 but not due until 2006).

The British have been living in a fool's paradise, believing that their system of low state pensions, combined with private pensions funded by companies and individual contributions, would ensure that the cost of providing pensions for an aging population would be much less than in countries where pensions are largely covered by taxes and contributions from workers.

In fact, whichever way pensions are funded, the burden inevitably falls directly or indirectly on the working population, except where income is derived from investments abroad.

The British state pension provides a minimum income and rises only in line with inflation. Funded through national insurance contributions deducted from pay packages, it is inadequate for providing an acceptable level of income for pensioners who don't have private pensions or other means of support.

Therefore, it has been supplemented in recent years with means-tested pension credits. These have been sufficient to prevent serious poverty among pensioners, but many eligible pensioners have been deterred from applying because means testing, which requires declaring all sources of income, is considered degrading. The pension-credit system also acts as a serious disincentive to save since all savings must be declared.

The system of privately funded pensions in Britain is complex. The most generous pensions have been paid by companies operating so-called final salary (defined-benefit) plans in which pensions are paid from retirement age (usually 60 to 65) at a level based on the number of years the worker was in the plan and on the final salary earned (or the average salary of the last three years). Such pensions have in recent years generally risen in line with inflation.

Similar plans have operated in the public sector, but many companies have either closed them or limited them to existing employees, blaming a volatile stock-market performance and an inadequate supply of index-linked government stock in which companies can invest funds.

Company plans were also hit by the decision of Finance Minister Gordon Brown, on coming into office in 1997, to tax pension-fund dividends.

The best companies have gritted their teeth and injected funds into their plans to meet developing shortfalls. Other companies have not been as prudent or honest, leaving a significant number of plans underfunded. A few, including those operated by foreign companies, have either reneged on their responsibilities or taken refuge in bankruptcy. The government has had to consider ways to rescue the employees of such companies, but the necessary legislation has yet to pass.

One foreign company, Maersk, which decided to wind up its plan and let pensioners meet the shortfall on their own, eventually decided to settle to protect its good name. Another plan that has attracted attention has been that of Turner and Newall, which had been taken over by the U.S. corporation Federal-Mogul. The latter, facing claims from asbestos-related disease sufferers, has tried to dilute pension claims through bankruptcy proceedings.

One Japanese company, Nikko Securities, has so far refused to honor all of its pension commitments to its former British staff. If it fails to do so, its reputation is likely to suffer.

Instead of defined-benefit plans, many companies have adopted defined-contribution plans. In these, the investment risk is transferred from the company to the individual, who together with the company makes annual contributions to the scheme. What he or she eventually receives in pension payouts depends on the performance of selected investment funds. Companies generally pay less than they do in defined-benefit plans.

Not surprisingly, the participation rate by employees in defined-contribution plans tends to be lower. Moreover, as the report makes clear, these plans are generally inadequate to ensure adequate pensions.

Against this background there is pressure for the state pension to be increased and, in the future, for it to correspond not only with rising inflation but also with average earnings. But the cost of a significant increase would be huge and, assuming that higher income taxes to cover the cost would be generally unacceptable, it could probably be covered only by having British people work longer. This will not be easy to arrange.

Many companies do not like employing older workers on the grounds that their productivity declines, that they cost more and that they block promotions of younger people. Accordingly, they are opposed to a ban on mandatory retirement ages, which is in place in the United States, and they do not welcome legislation that would prohibit age-discrimination in the workplace. Yet opinion is moving in favor of such legislation.

Meanwhile, Brown favors means-tested benefits because he says merely increasing the state pension would benefit wealthier pensioners more than the aged poor who need them most. Still, the disincentive to savings with means testing is becoming increasingly apparent.

So what can be done to increase savings? Tax advantages could and should be increased. There are arguments both for and against making pension savings compulsory as in Australia, but the issue has yet to be confronted.

Although the British pension crisis is serious, it is worse in many other European countries and in Japan, where increasing longevity combined with a birthrate that's even lower than in Britain means that an ever-increasing proportion of gross domestic product will go toward looking after the aged. This will result in increased friction between the generations. We are all likely have to go on working until we are considerably older.

Hugh Cortazzi, a former British career diplomat, served as ambassador to Japan from 1980 to 1984.

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