Broken Pension Promise: How Soaring Costs Will Leave Many Paying For A Retirement They May Never Receive

The UK’s once-solid state pension relies on a system where today’s workers fund yesterday’s retirees, yet soaring costs have meant that many are paying for a pension they may never receive.

The UK state pension began as a very modest safety net, introduced over 100 years ago as a means-tested benefit payable from age 70, and funded entirely out of general taxation. No one paid into it while working, and it was designed only to relieve destitution in the few who lived to 70 and earned very little. In the 1920s this changed with the Widows, Orphans and Old Age Contributory Pensions Act that imposed compulsory contributions from workers and employers, in return for a more generous pension at 65. This familiarised the idea of earning a pension tied to your lifetime contributions, however in reality each generation’s contributions were paid straight to current pensioners, not put aside for the individual’s own retirement.

By the mid-1900s, a universal Basic State Pension was developed, funded by compulsory National Insurance payments from all workers, creating a flat-rate scheme available to all those who paid in. Importantly, this was a pay-as-you-go system whereby each pound of National Insurance received would immediately flow out to pay current pensioners. This proved to be very effective initially, thanks to a young, rapidly growing workforce that supported a much smaller group of retirees. However, over time living standards for the elderly fell behind those of the working population, with the government implementing a radical change to the system in order to try to keep pension income in line with the labour market. This culminated in the ‘triple lock’ being introduced in 2010, which guaranteed that the state pension would rise by the highest of inflation, average earnings growth or 2.5%. The benefit of this annual uplift was that it protected the income of existing pensioners, however it also committed the Treasury to much steeper increases in future payouts. For each percentage point by which the pension uplift exceeds wage growth, the additional annual cost is estimated at around £6 billion, making the model far less financially sustainable than the previous system.

A critical issue with this system is that the modern day pension framework operates with the same funding model as in the early 1900s. Pensioner payouts are entirely financed by the pay-as-you-go approach where every worker’s National Insurance payments are continually spent on the preceding generation. This has formed an unwritten intergenerational contract that tomorrow’s workers will do the same for the current workforce. However, times are changing, and although this arrangement may have been feasible when the population was younger and growing, it now faces a deep strain as the demographic tide has started to shift.

Given that there is no substantial sovereign pension fund or pool of investments to fund future retirees, the government account often runs into deficits, requiring top-ups from general taxation to meet short-term pension obligations. When top-ups are required, this is currently reasonably achievable, with the total state pension representing a few percent of GDP. However, forecasts see this rising sharply in the years ahead, climbing to over 7.5% by 2050, equating to an extra £45 billion in required annual funding. In total, the amount of future payouts to retirees is estimated at around £8.9 trillion, or more than three times Britain’s GDP. Yet this is not an isolated cost, and when combined with long-term care provisions for an ageing population, the total future fiscal burden becomes enormous. In fact, warning signs are increasingly visible, with estimates that by the mid-2030s the state pension could be effectively insolvent unless National Insurance contributions are drastically increased or pension payouts significantly reduced.

First and foremost, this looming pension crisis is driven by rapidly changing demographics, as the population is now living longer and birth rates have fallen. As a consequence, the ratio of workers to retirees has plunged, so instead of four or more workers supporting each retiree as was the case in the mid-20th century, in a few decades, there are likely to be only two adults of working age per pensioner. Even with plans to raise the pension age from 65 to 68, the number of people drawing pensions is still set to grow 25% by 2050, which means that without a much larger workforce the tax receipt per worker must rise considerably.

Another contributing factor is the unfortunate reality that Britain has chosen not to prepare for this population ageing through building a national pension reserve during years of demographic surplus. When National Insurance contributions exceed annual payouts, these funds are absorbed into the general budget or used for other welfare spending, rather than hypothecated in a pool for future payments. In fact, the National Insurance Fund briefly reached £53 billion in surplus between 2008 and 2009, but after the financial crisis those funds were quickly deployed to cover shortfalls elsewhere. This short-sighted approach of treating the pay-as-you-go pension budget as flexible spending rather than sequestering it for future use, has been a primary driver of the financial strain that will be inevitably faced by the next generation.

For younger Britons, the outlook is uncomfortable, with an expectation of higher National Insurance during their working lives to fund a bulging pension bill, despite the likelihood of receiving far less in return. It was estimated that someone born in the 1950s will collect hundreds of thousands of pounds more in state pension in present value than they paid in contributions, with this net gain being underwritten by younger taxpayers. Furthermore, the next generation of workers is likely to see further delays to the pension entitlement age, with 70 expected to become the new norm. This may also be combined with policymakers dropping or weakening the triple lock, resulting in pension payments being unable to keep up with wages, eroding living standards. Worse still, private pensions are unlikely to fill the gap, as despite auto-enrolment forcing many to save, the minimum 8% total contribution yields relatively small pots, and millions of young people are still outside the auto-enrolment net. Not to mention that for those who do manage to save in their pension, the absence of final-salary schemes has meant that individuals will face all of the investment risk themselves, with the value liable to swing considerably.

For the next generation, the social contract that promised retirement security to those who paid in is fraying, and the ultimate guarantee that hard work will not end in destitution has started to be questioned. As with many other areas of the economy, a generational divide is forming, with the year of your birth now playing an increasingly important role in your economic destiny. The emerging picture is one of a two-tier retirement landscape where those with assets and savings will manage, but the rest will face financial insecurity without a safety net. Unless direct action is taken, state pension affordability will continue to pose a problem, however almost all potential solutions will involve taking with one hand, to facilitate the continued giving with another. There is likely to be a renewed pressure for a responsibility shift from the state to the individual, reinforcing the importance of independence and self-preservation, rather than a reliance upon state support. Yet for many this will be seen as another instance of the social contract being broken for the younger generation, leading to a growing cohort of disenfranchised and demoralised youth who have understandably lost faith in a system that is no longer fit for purpose, and endlessly puts the interests of others first.