Privatize pensions for the unorganized world

Pensions are a major issue across Europe and the rest of the world. How pensions should best be provided is one of the questions which dominates election campaigns. Today’s typical pension is a basic state one- financed by tax contributions to government and paid out by the government.

This method of state provision is now outmoded and causing problems in the unorganized world. More and more countries around the world have more old people as a proportion of their total population. This means fewer working people paying enough taxes to finance state pensions. Reform of existing pension arrangements is therefore urgently required if the so-called "pensions time-bomb" of pension pay-outs exceeding tax contributions is to be avoided.

When people retire, they need an income to live on. This is just as much the case in the unorganized world as it was in the old organized one. The fact is that saving when your income is high so that you can spend when your income is low is a sensible idea. It is especially sensible given the increased uncertainty in the unorganized world, which means that when times are good, and income high, people should save to be prepared for times when income is not so high. This is part of economizing- living within your current and future means.

Unlike many of its European neighbors, Britain defused its pensions time-bomb in 1979. Even so, pensions were still in mid-1997 the largest single item of government expenditure. Since the 1979 reform, the basic state pension has been raised in line with increases in the rate of inflation rather than the (usually higher) rate of increase in average earnings used previously.

This has meant that the basic state pension in Britain will be worth under 10% of average male earnings, compared to 20% when the reform was carried out. As such, people in retirement in the future will receive a lower income from the state than today’s pensioners. This in turn necessitates that people take out something in addition to the basic state pension. This reform rightly reduced the role of government in pension provision and the increased that of the private sector.

There were two principle types of private pension available in Britain to top-up the basic, low state pension. These were corporate pensions linked to an employer and personal pensions independent of employer.

Corporate pension schemes run by employers are a relic of the old organized world. They confer the most benefit and the highest rewards on those employees who stay in a single organization for many years. Those people who change employers every few years, as many people now do, are penalized. Corporate pensions often provide a low transfer value to members who leave the company before reaching retirement. Company-based pension schemes lock employees in by providing a reward for staying with the company. Hence, employer-independent private personal pensions are a good idea. Such personal pensions do exist already, but are configured in a sub-optimal way.

Such private pension plans should NOT be set to last for a fixed term, estimated to run out at about the same time as people "typically" retire. Anything of a fixed term, such as mort-gages as well as pensions, is inherently problematic in today’s unorganized world. Fixed term private pensions start off with high charges at the start and thereby penalize those people who discontinue the pension because of (more likely) changes in personal circumstances which mean that they no longer have sufficient income to continue to defer current consumption in return for income upon retirement.

In other existing private pension plans, the companies running them tend to waste a lot of the money paid in by individuals on active fund management (buying and selling the constituent stocks and shares). It is always cheaper and seldom less beneficial to pay into pension funds which consist primarily of low transaction cost stock index-tracking funds which simply aim to closely mirror the general performance of the stock market. The high fees charged for actively managed pension funds are either hidden or justified by unproven claims of higher than average long run returns.

Just because we live in a complex world, does not mean we need more complex policies or instruments. In fact, the secret to making decisions in general, and managing and investing in particular in the unorganized world is to be smart enough to know when you are not smart enough. Each of us needs to recognize when attempts to achieve better than average performance have the unintended consequence of worst than average performance (especially when costs are taken into account) in practice.

Hence, whilst private pensions are better than state or corporate pension schemes in the unorganized world, such private pensions should be configured in a way which maximizes revenue for private pension holders.

In fact, in early 1997, the right-wing Conservative Party in Britain built on its earlier reforms which necessitated a private supplement to the state pension. A further increase in the responsibility of the individual to provide for his or her retirement was proposed (but not (yet) implemented), with the state role not just reduced, but minimized.

Under such a privatized pension system, it would be made COMPULSORY for everyone entering the workforce after any such policy is introduced to take out a private pension. Such pensions would be "fully-funded", which means that working people’s contributions would be paid into and would subsequently pay for their own pension. The government would act only as a safety net for genuinely needy people whose actual private pension turns out to provide only a very low real value. As such, most people would receive no state pension at all.

This would be a true privatization of state pensions, but with a safety net. Such a system would provide each AND EVERY individual with advantage of personal choice and responsibility, and bring about a sizable reduction in government spending (and therefore tax requirements) whilst providing a fair and certain pension for every citizen upon their retirement. Realization of such pension policy objectives is the holy grail for all governments to pursue in the unorganized world of the future.

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