Pension reform not just about raising age

By John Hutton

All over the world, people are living longer. That trend is set to continue. Indeed, life expectancy in OECD countries will increase more than three years between now and 2050. This is on top of large increases in life expectancy already seen: In the United Kingdom, public-service pensioners who stop working at 60 can expect to spend about 40 percent to 45 percent of their adult lives in retirement, compared with about one-third for such pensioners in the 1980s.

While these developments should no doubt be celebrated, governments, companies and individuals around the world are tackling the biggest problem that comes with increased life expectancy: growing costs.

Last year, I accepted the UK government's invitation to undertake a review of public-service pensions. From the beginning, I was mindful of the complexity, sensitivity and importance of this issue to our economy and society. More than 12 million people in the United Kingdom are dependent in some way on public-service pensions for their retirement income. These pensions are a vital part of Britain's national savings infrastructure.

My role was to find a way to sustain high-quality pensions that could set a high standard of fairness and adequacy, but that could also remain affordable to taxpayers - who, after all, pay the lion's share of the costs of public-service pensions. Balancing these objectives remains the key challenge: Public-service pensions must not become an unsustainable burden on public finances and the wider economy, but they must also deliver decent incomes that minimize the need for retired public-service workers to rely on state welfare benefits.

In an interim report, I highlighted recent reforms to public-service pensions, which, however, have not gone far enough in dealing with the issue of rising life expectancy and growing costs. In the early 1970s, when public-service pension schemes were first substantially reformed, the life expectancy of a 60-year-old had increased about 18 years. This has now risen to around 28 years, and the scheme's costs have grown about one-third since the 1950s.

The growing costs associated with rising life expectancy are not the only problem. Current public-service pensions are almost all defined-benefit schemes based on a worker's final salary. This means that most of the cost risks associated with longevity fall on government and the taxpayer.

Current final-salary schemes are not suitable for a modern work force for three reasons. First, they unfairly benefit high flyers, who can receive up to twice as much in pension payments per ?100 of contributions. Second, they expose taxpayers to the risk that salaries will rise more quickly than expected, which would increase pension cost. And, finally, they create a barrier to labor flows from the public to the private sector.

In my final report, my main recommendation was that current defined-benefit schemes be replaced by new career-average (CARE) schemes. CARE provides a fairer outcome than those produced by the current final-salary schemes. In an equal-value career-average scheme, the bottom 10 percent of pension benefits would be almost 90 percent higher than those from a final-salary scheme. The top 10 percent of pension benefits would be about 6 percent lower.

A CARE scheme is more suited to the new ways we need to start thinking about work and retirement. For example, a public-service worker moving to part-time hours or moving down a level toward the end of her career would not be penalized. I propose a switch to career-average schemes because they are easier to understand and simpler to implement.

But CARE schemes would still leave substantial risk with the government. Additional controls are needed to make sure that risks are shared more equitably than in current schemes. The first way to do this is to link pension ages in most of these schemes to the state pension age, thereby reflecting changes in life expectancies and controlling longevity risk.

According to current projections, this would bring the proportion of adult life in retirement back to around one-third; roughly where it was in the 1980s. The only exceptions would be members of the armed forces, police and firefighters, where the unique nature of the work suggests that a pension age of 60 would be more appropriate.

Second, a clear cost ceiling should be set for these schemes; I have suggested basing this limit on the percentage of pensionable pay financed by the taxpayer. And these caps would have an automatic stabilizer built into their design to ensure that future costs to taxpayers are more effectively controlled.

Taken as a whole, the reforms I propose should deliver a fair and sustainable public-service pensions system. My final report attempts to chart a course that addresses the concerns about sustainability and affordability, but that does not imply a downward spiral in pension provision for the millions of people who serve the United Kingdom well.

This is the most sensible and rational path to follow. I am pleased that the UK government has agreed with this view and has committed to full consultation with pension-scheme members and their representatives over the detailed shape of this reform package.

- The author was UK minister of state for health in 1999-2005; chancellor of the Duchy of Lancaster and minister for the Cabinet Office in 2005; secretary of state for work and pensions in 2005-07 and for business, enterprise and regulatory reform in 2007-08; and minister of defense in 2008-09. Copyright 2011 Project Syndicate