Rebuilding pensions on a sustainable foundation
The current €2 billion taxpayer subvention to the social insurance fund will almost treble by 2030 and increase by a factor of six by 2040.
Over the past five years in pensions, as in many other areas, tough decisions have been made and unpalatable realities have been faced. Sadly many people now know that their pension expectations are out of reach and they will have to work longer or save more to achieve a financially-secure retirement.
This is not an outcome that any of us are happy about, but the challenge now, assuming the worst of the immediate crisis has passed, is to ensure that similar disappointments don’t happen in the future. To start we need a solid and realistic foundation.
For the majority of the 2.2 million people of working age who expect to retire over the next 10 to 40 years the financial foundation upon which their retirement security will be built is the State contributory pension. At its current level of €230 a week (or about 34 per cent of average earnings) it has helped, as an OECD review has recently confirmed, reduce significantly the risk of poverty in old age.
In fact, unless something changes, such as the introduction of mandatory retirement savings, more than half the working population will have to depend solely on the State pension.
For the rest, who are already saving towards retirement, it will still be a core part of their retirement income.
So the key question is: can people rely on the State to continue to deliver pensions at current levels in the future? The answer is not straightforward.
State pensions face two major demographic challenges. First, people are living longer. The life expectancy of a 45-year-old male in 1994 was 75 while today a man of that age can reasonably expect to celebrate his 81st birthday. That’s a six-year improvement in just 20 years. This is a great gift but it does have obvious cost implications.
Second, the State pension operates on a pay-as-you-go premise: that the current generation of workers pays the pensions of the retired generation in the expectation that the same will happen for them when their time comes. That’s fine if the population profile is reasonably stable but ours isn’t. Generally as a nation we are ageing rapidly.
Today for every 100 people of working age there are 21 over 65s. This number will grow steadily and will be not far off 50 by the time it starts to stabilise in 35 years’ time. That will be one pensioner for every two workers.
The €230 weekly payment has been protected through the crisis but nonetheless some major reforms, prompted by the Troika, have been announced. These include most visibly raising the age from which the pension starts in stages to 68 by 2028 – starting this year with a move to age 66. As an aside, a similar proposal in France in 2010 was shelved when more than a million protesters took to the boulevards.
Even after taking into account these reforms, State pensions still face a very serious funding crisis. An actuarial review by KPMG has projected that the current €2 billion taxpayer subvention to the social insurance fund – the pension funding vehicle – will almost treble by 2030 and increase by a factor of six by 2040.
The situation is not helped by the fact that the National Pension Reserve Fund, which was established as a buffer against these rising pension costs, has been sadly depleted by becoming an emergency source of capital for our banking system.
So the dilemma we now face is: how do we make sure the State pension continues to deliver on its objective of providing a minimum adequate standard of living in retirement and is affordable in the long, and indeed in the medium, term?
Some of the levers available to us are:
1. Further increases in the State retirement age. This is arguably a reasonable policy response to continuing improvements in life expectancy.
2. Increasing PRSI contribution rates. It seems inevitable that this will form part of a solution but increases of more than 30 per cent in current rates would be required by 2030 assuming the taxpayer subvention is maintained at its current level.
3. Linking future increases in the State pension to price inflation instead of earnings: This is a subtle but ultimately very material change. In the UK in the 1980s a similar move eroded the core State pension from 26 per cent to 18 per cent of average earnings.
4. Widening the PRSI contribution base: We have a pay-as-you-go system under which only active workers and their employers make contributions. Should we think about spreading this burden to include those better-off pensioners who can afford to pay something?
5. Introducing means-testing: The theory of social insurance is that an entitlement, in this case to a retirement income, is secured by paying contributions. The reality though in a pay-as-you-go system is that the benefit is highly dependent on its affordability at the time it comes to be paid. So would it be better to accept that a universal pension at the current level is not affordable and introduce an element of means-testing for the top slice of the pension? This was a suggestion made in the OECD review.
I’ll leave to others to expand and improve on this list but there is no single solution nor are there any easy solutions.
Many of our recent financial and economic problems can be traced to us ignoring clear signals, trends and risks until the inevitable happened and painful and radical action was forced upon us. Let’s not make the same mistake twice in pensions. Reform takes a long time to implement so it is vital the debate begins now. As the OECD has said, “The time is ripe now to take some fundamental decisions on the future of Irish pensions”.
Paul O’Faherty is an actuary and a non-executive director; he is immediate past president of the Society of Actuaries in Ireland and a former chief executive of Mercer in Ireland