Over my working lifetime, the individualised savings (known as defined contribution (DC) or money purchase, more accurately, contribution-based) model where risk is passed to the individual, has become the main means of providing for later life. However, even if consumers understood the risks – which generally they don’t – it would still be an extremely inefficient means of organising retirement income.
A pension removes the risk of exhausting savings during retirement. It is a form of collective risk management and a brilliant financial innovation. Most people need pensions. Only having millions in the bank (because exhausting savings in your lifetime is unlikely) makes pensions become irrelevant. The power of pensions to transform lives cannot be overstated. Defined contribution (DC) equates to every household setting aside enough cash in the bank to meet rebuilding costs and replacing all contents. Since such a catastrophic loss is rare, insurance is more efficient.
A pension has elements of both insurance (by managing the risk of running out of savings during a lifetime) and savings (deferred income). The state pension is the most efficient means of organising retirement income because its compulsory nature ensures the widest possible coverage. There is no need for expensive marketing, for example. Funding is unnecessary because of the credit and good faith of the UK Government, saving on investment costs and taken with economies of scale, administration costs are low. Security is high because a sovereign Government with control of its currency and taxation can never go out of business. State pension rights can be protected against periods of absence for sickness, caring or unemployment. Having the widest possible range of life expectancies means that there is no problem of ‘selection against the provider’ where those with good prospects of longevity buy insurance.
Unfortunately, the UK state pension which should be the foundation of retirement income is the lowest among developed economies, following successive raids on the national insurance funding.
The inefficiencies of self-insuring retirement income are cogently set out by Tom Sgouras of the US Haas Institute (my emphasis):
“Isolated from a group, an individual employee must save for his or her maximum expected life expectancy, not merely for the average, as with a Defined Benefit (DB) plan… It is harder to reach the appropriate target, so fewer people will succeed, and the appropriate target is too high, so only the luckiest of the successful—the ones who both save enough and live their maximum life expectancy—will not be wasting money. It’s a problem, but from the perspective of efficiency, it is a very real waste of resources.”
Funding Public Pensions – Tom Sgouras Haas Institute
The views shared in this article are personal views and not
those of the Money and Pensions Service.
By Ken MacIntyre, PMI Fellow, Money and Pensions Service Helpline Adviser