Working longer will remedy pension deficit

London Briefing: The idea that many countries are facing a demographic "time bomb" has become familiar.

Population projections for countries like Japan and Italy are truly startling: there are going to be astonishing falls in the number of people living in these countries.

Many developed countries are having too few babies and those who are born are living longer. This is less true for many developing countries.

Indeed, in some of the poorest parts of the world, the birth rate is very high and life expectancy is actually falling.

One aspect of all of this that attracts almost daily political and media attention is the growing "pension deficit". The modern western retirement system was more or less invented by Bismarck, who instituted the idea of retirement on a decent income at the age of 65.

This pension scheme was an actuary's dream as it came into being when the average life expectancy was 48 - the fiscal implications of this set of arrangements were not terribly severe.

The idea that we are living longer is hardly new, but what is less well appreciated is the accelerating rate at which we are stretching out our lives: demographers are continuously surprised by the lengthening of the average life span. Simple extrapolation of past trends is not capturing the full extent of increases in life expectancy.

Stung by this, some actuaries in the UK have stopped making projections about how long they expect us to live.

The authors of something called the Continuous Mortality Investigation - I can't imagine these fun people relishing their own lives stretching ever farther into the distance - have just said that if we continue to extrapolate from recent trends, anyone retiring in 10 years' time at 65 can expect to live, and therefore needs a pension, for another 25 years.

But each similar extrapolation in the past has underestimated the actual increase in life expectancy.

So, the basic pension scheme that exists throughout much of the developed world - retire on a pension at 65, or earlier in many cases - is going to have to have enough money behind it to last each pensioner, on average, 25 years.

Of course, the number of such schemes so well funded can probably be counted on one hand. Hence the inevitable talk of a pension deficit.

The solution to this is as obvious as it is inevitable: identify what has caused the problem, and do something about it. In this case, the cause is not in dispute: we are living longer. The solution, and there really is only one solution, that we have to work longer.

Politicians, by contrast, pretend that we can all save enough money to finance 25 years' of retirement. The government's pension commission is due to issue its major report in November and is widely expected to witter on about increased saving incentives and to tentatively suggest further study into the merest possibility that we will have to work a bit longer.

Actually, that's probably a bit unfair. The commission's head, Adair Turner, will be more honest than that and will explicitly call for longer working lives, but politicians will suggest further study.

The arithmetic is relentless. Based on today's mortality rates, a 65 year old man will need a savings pot of close to £300,000 (€437,000) if he wants to buy, via an annuity, a £20,000 yearly pension. If life expectancy rises further, it becomes more costly to purchase the same pension: today's savers are chasing a moving target. In any event, the chances of large numbers of people accumulating this amount of pension capital appear to be about nil. Most people have bet their old age on the family home.

A big change in UK pension saving legislation is on the way, in a desperate attempt to persuade people to salt more away for retirement. There is lots of ridiculous talk about the likelihood of everyone acquiring second homes, vintage wine cellars and fine art collections, all in the name of our pension funds.

And, surprise surprise, we are hearing the first mutterings about a rise in the retirement age. Gordon Brown, no less, has a suggested a "national debate" about the age at which we can all expect to quit work. Gordon, better than anyone, knows the arithmetic and how truly awful it looks.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.