Cicero Policy Briefer

Issue 4, September 2006

Pensions and the longevity bind

By Malcolm Small

Last year, just short of 570,000 people in the UK died. 66 per cent of these deaths were at age 75 or greater, compared with just 12 per cent at the beginning of the 20th century.

This rather morbid statistic encapsulates the nub of a rather serious problem for those trying to run Defined Benefit pension schemes or providing annuities which convert retirement funds into a regular and, usually, guaranteed, income. That problem is that we are all living longer.

Why is this a problem?

It is on several fronts.

First, it doesn’t take a genius to work out that if we are going to be around for longer, we’ll need more savings, or other capital, to support us in our old age. Assuming a net return of 7 per cent per annum, this means that, as a rule of thumb, you’ll need to be putting away half your age each year as a percentage of your gross income in that year if you want to cut your income by a mere 33 per cent when you stop working, at current levels of life expectancy. How many of us can honestly say we’re doing that?

Second, if you are trying to estimate how much funding you will need to support a pensioner population in a Defined Benefit scheme, you are looking at a moving target, and one moving against you. The problem is the same for annuity rates. Get it wrong, and you are looking at a very serious financial loss.

Third, an ageing population poses similar problems for state benefits. When the first state pensions were established in the early years of the 20th century, well over half of all deaths occurred under the age of 45. In some industries, it was rare for men to make age 65 at all – the old heavy industries were cases in point. As these industries have declined and as people become better nourished, and as they become more aware of health issues such as smoking, they are living longer.

This poses serious and potentially unpopular policy issues for the Government as well as insurance companies, scheme providers and the actuarial profession, among others. We can either work longer (assuming we can get work as ‘elders’), retire later, accept a lower pension or use other assets, if available, as a means of keeping going. The recent announcement of the intention to raise the state pension age is an example of such a policy choice.

But there’s another issue underlying all this. As people get healthier, they live longer. However, that life may not be a healthy one in its final years. Evidence is starting to emerge that today’s super-elderly generation can expect to spend an average of 18 months in some kind of residential care – and that figure is rising. Elderly care is extremely expensive, with a stay of that duration typically costing £30,000 before medical costs, which in themselves are characteristically high. Often, this bill falls to social funding of some kind – and that’s you and me as tax payers.

Interestingly, 120,000 (just over 20 per cent) of deaths last year were “smoking-related”, a number that has been in decline for some years. Mortality tables tell us that smokers die earlier, though they raise £10bn each year in taxes for the exchequer. They also, therefore, are less likely to need long residential care, though they may need sporadic hospital care.

As these trends continue, I wonder how many years it will be before we see a government-sponsored advertising campaign encouraging people to take up smoking?

Crazier things have happened.

Malcolm Small can be contacted on +44 (0)20 7665 9530 or click here to email.

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