Reforming Public Pensions In The United States And The UK

Writing in the February 2006 issue of the Economic Journal, leading US pensions expert Professor Peter Diamond describes the current debate about social security reform in the United States and draws inferences for the UK. Much of what he says is relevant to the proposals from the Pensions Commission.

Providing adequate public pensions
Government pension policy should address both poverty among the elderly and pension adequacy over a much wider swath of the population. Poverty levels depend on benefit levels relative to average earnings, while pension adequacy depends on a person''s benefit relative to his or her past earnings. Both ratios are referred to as replacement rates. Lowering replacement rates may be appropriate to reduce benefit costs. But doing so by linking pensions to price changes, as currently in the UK, rather than to wage changes, as formerly, is a poor method, because it cuts replacement rates arbitrarily – the faster the growth of real wages, the larger the benefit cut and the less the financial need for cuts. A better approach is to lower pensions as life expectancy increases, which ties benefit cuts to changes that do increase costs relative to revenues. The Pensions Commission favours an eventual return to wage indexing and an adjustment based on life expectancy.

Raising the state pension age
The State Pension Age (SPA) of 65 has two roles. It is the earliest age at which a person can claim a retirement pension and it affects a person''s pension benefit level – benefits are 10.4% higher for each year of delayed start beyond the SPA.

A one-year increase in the SPA would (a) require workers to wait to 66 to claim benefits and (b) remove a 10.4% benefit increase for starting benefits at 66 rather than 65. Increasing the SPA is not an alternative to benefit cuts, but a particular way to cut benefits, combined with a delay in the age when benefits can first be claimed. Setting benefit levels and setting the earliest age for claiming benefits should be unbundled rather than tying both to a growing SPA as the Pensions Commission proposes.

A 10.4% decrease applied to all benefits would lower costs. If, in addition, the earliest age for claiming benefits were increased, that increase would not help with long-run pension financing since the 10.4% increase in benefits from a one-year delayed start would more than offset the savings from not paying benefits for one year.

Preventing benefit claims at 65 should be examined by considering the people who are helped or hurt by needing to work an additional year and thereby receiving higher benefits, as well as examining the situation of people who would like to find suitable work but can't.

While average life expectancy is informative about system costs, it is not likely to be a good proxy for the net balance from requiring a delay in the start of benefits. Thus, benefit cuts and benefit eligibility should not both be linked to average life expectancy as favoured by the Pensions Commission.

Moreover, with future increases in both life expectancy and earnings levels, some increase in working life is sensible, but full proportionality to life expectancy is not likely to be best for workers. Yet the Pensions Commission favours proportionality for the SPA.

Voluntary savings schemes
The management costs of funded individual accounts can be lower than those currently available in the UK. The paper contrasts the alternative methods of organising individual accounts in Chile, Sweden and the UK and concludes that an approach similar to that of the Thrift Savings Plan in the United States is better than any of these three, and is favoured by the Pensions Commission for a new voluntary savings scheme.

''Reforming Public Pensions in the US and the UK'' by Peter Diamond is published in the February 2006 issue of the Economic Journal. Peter Diamond is an Institute Professor and Professor of Economics at MIT, where he has taught since 1966. He has been President of the American Economic Association, of the Econometric Society and of the National Academy of Social Insurance. He is a Fellow of the American Academy of Arts and Sciences and a Member of the National Academy of Sciences. He first consulted to the US Congress about social security reform in 1974. He has consulted about social security to the World Bank and has written about social security in Chile, China, Germany, Italy, the Netherlands, Spain, Sweden and the UK as well as the United States.