Changing demographics present stark choices over pensions

London Briefing: Anyone reading the "Millions facing pensions misery" headlines of the past couple of days might think that we have suddenly discovered a new problem. In fact, the so-called pensions time-bomb was identified at least twenty years ago by the then Thatcher administration.

In a move which pushed a potential crisis far into the future - and to an extent averted one altogether - the government abolished the link between pensions and earnings.

It seemed a relatively innocuous move at the time, but the decision to index pensions to retail prices rather than earnings was a financial masterstroke. Gradually, people became aware of its implications and the calls for the restoration of the link to earnings - which typically rise much faster than prices - have grown to a crescendo.

If you want to hear a British politician telling an outright lie, listen to the ones telling us that the earnings link is to be restored. They are playing to the crowd but once someone quietly explains the financial arithmetic of such a move it will be quietly buried. Or be accompanied by a hike in the retirement age to 75.

Thankfully, arithmetic is beginning to impinge upon the debate, with the latest report of the Pensions Commission laying out the stark choices facing the country. That report makes the simple point that the pension crisis arises from demographic change: longer lives and fewer babies.

The existing system was explicitly designed for a very different world, one where there were relatively few pensioners who didn't live very long beyond retirement age. We all know how things have changed, how the birth rate has collapsed and how much longer everyone lives. Incidentally, demographers seem to be startled by how fast life expectancy is still accelerating.

The Pensions Commission suggests four possible policy choices, or, more likely perhaps, some combination of all of them. Three things will have to go up - taxes, savings and the retirement age - and we will have to accept that the number of poor pensioners will grow.

I think that the choice is even starker than this: policies to promote voluntary saving have failed and it is possible that tax rises can be self-defeating. In the end, the only real choice is a hike in the retirement age.

Adair Turner, the commission chairman, makes the interesting point that the need to raise the retirement age would be lessened if only everyone actually worked until their 65th birthday. If we could find some way to stop the flood of 50 something retirees the economy would reap huge benefits, not least a bigger tax base to fund pensions.

But the desire to retire early has become culturally ingrained: as our life expectancy has lengthened we have become more and more determined to cease working earlier than did our parents. Government sources suggest that half the UK population will retire before reaching 65. We have to find ways to encourage people to work longer.

We cannot afford the current system, which pays a meagre £127.25 (€185) a week to a married couple. And to get that you need to have paid 44 full years of National Insurance contributions (five years less if you are woman). Other benefits are available, but most of them are means-tested, always a miserable experience.

Given the sheer number of likely retirees, any suggestion that state pensions can be increased without serious tax rises should be greeted with derision.

The minister in charge of pensions, Alan Johnson, has recently suggested that up to 13 million people are not saving enough for their retirement. The reasons for this are abundantly clear - few people are in a position to save enough. Average earnings in the UK are currently around £25,000 (€36,000).

To maintain that income via an annuity purchase would require our average worker to have accumulated a savings pot of roughly £500,000 by the age of 65 (and much more if he wants to retire early on the same income). It is possible - just about - to save that much if you start at 20 to invest wisely and put away at least 10 per cent (and probably more) of your gross income. In the real world, most people are in debt until well into their 30s or longer and are in no position to save these amounts.