The first step towards an understanding of the pensions crisis

In the first of a three-part series on the sustainability of pensions in the UK, Con Keating, head of research at Brighton Rock Group, looks at the numbers behind the assumption that DB is no longer affordable

It is usual in the economics literature to motivate pension arrangements for individuals by reference to consumption smoothing and insurance. The problem for the (average) individual may be illustrated with a simple comparison of the age profiles of individual labour income and consumption, as in Chart 1:

Chart 1: Per Capita Consumption and Labour Income

The problem for the individual is the replacement of labour income in retirement to enable continuing consumption. The chart above shows, at a single point in time (2007), the average labour income (including self-employment) of individuals of different ages and their consumption profile. Of direct relevance for pensions, an income in retirement is that no individual knows their own longevity, the point at which their consumption will cease, which introduces the concept of a pension as insurance.

The individual may provide for their own retirement by saving through their working lifetime and then realising and consuming these savings in retirement. Economically, the individual saves in order to acquire claims on future production, and the claims in positive net supply are private sector equity and government obligations. The individual must buy these assets in financial markets.

There are many advocates of this simple form of self-provision. However, the individual faces the problem that he does not know his own longevity and to provide for this uncertainty needs to over-provide or face penury at some point in old age. In retirement, consumption cannot be financed by an individual from borrowing as he lacks the income from which to service and repay this debt. Over-provision is not efficient.

Of course, an individual may purchase a life annuity to resolve this longevity uncertainty, but that introduces explicit dependency upon a financial institution, the life assurer. This contract, of course, is costly to the individual. It is also problematic from the stand-point of individual planning. Unless the annuity is bought directly with savings at the points in time when the individual has surplus income, both the value of these savings at and after retirement and the cost of an annuity at those future times is unknown to the individual. This represents a significant problem for the form of saving known as (individual) defined contribution ‘pensions’.