What to do about the pension crisis
05 July 2004
In an address to Politeia, David Willetts MP highlights the extent of the crisis facing pensions over the years and decades ahead. In the course of the speech, he develops some radical new solutions to help combat this problem.

SPEECH TO POLITEIA BY DAVID WILLETTS MP
Monday 5th July 2004

THE PENSION CRISIS : WHAT IT MEANS AND WHAT TO DO ABOUT IT

Understanding the pensions crisis

Gordon Brown has now passed Lloyd George’s record length of service as Chancellor of the Exchequer. Many commentators took the opportunity to assess his macro-economic record, focussing above all on his historic decision to make the Bank of England independent. But there was surprisingly little comment on what future historians will surely judge to be the biggest single disaster of his chancellorship – our pension crisis. The scale and implications of the pensions crisis is still not understood. But I believe it is up there with terrorism or global warming as a threat to much of what we value. The Day After Tomorrow I can see companies bankrupt, taxes up, local government in crisis and our charities collapsing. Above all it is a threat to the living standards of generations of pensioners.


Implications of the crisis – for the public and private sectors

This crisis is going to change the shape of the British economy – and indeed society – for decades to come. Let me just briefly sketch some of the consequences first for companies, and then more widely. After that I want to turn to practical policy responses.

We used to believe that we in Britain were exempt from the pensions pressures facing Continental Europe. Now we can see that we too have a pension crisis, though in a rather different form from the rest of Europe. On the Continent
the pensions crisis takes the form of generous pension promises that have been made by governments. It is above all a long-term fiscal crisis. In Britain we have our generous pension promises too: but they have been made by companies. Our pensions crisis takes the form of a long term threat to the profitability of our businesses. And there is an extra twist. On the Continent governments are busy cutting back on those promises to try to rescue their public finances – there has been no cash increase in the state pension in Germany this year for example. In Britain the government is busy legislating in order to make the pension promise of companies even more onerous. This is one of the reasons why the British stock market has under-performed and may continue to do so for some time.


The size of the deficits in pensions is bringing a new uncertainty to company finances. Only the other day a potential takeover of WH Smith failed because of the size of the deficit in its pension scheme. The state of the pension is now one of the most important single issues in company takeovers. The government is going to force companies to honour the pension promises that have already been made. In pursuing that objective they have now added clauses to the Pensions Bill so that they can pursue shareholders and directors in a company personally for money to make up deficits in a pension scheme. They have abandoned the whole concept of a limited liability company in the cause of forcing companies to honour their deficits. It means that being a shareholder in a company or a director of it is much more like being a Lloyds Name than any traditional idea of a limited liability shareholder. This is going to have profound implications for company finance.

I also see much greater risks of company bankruptcies With the arrival of the Pension Protection Fund, trustees of the pension fund have a new interest in pushing the company into bankruptcy because they can then make a claim on the fund. They are going to have much less interest than in the past in negotiating a compromise deal with the management – so-called Bradstock Agreements – which rescues the company by accepting it will pay less than its full obligations to the company pension scheme. OPRA, the Occupational Pensions Regulatory Authority, and the new regulator, will be urging trustees to take companies on: indeed, they have already issued a guidance note expressing their unhappiness with pensions trustees reaching compromises with company managements when they should be extracting more from them for the pension scheme. The new battle ground in corporate Britain is the pension trustee versus the management. And it is going to push more companies into bankruptcy.


I said a moment ago that our fiscal crisis was not as bad on the Continent. But let me just qualify that. The reality is that we are converging on the Continent in our levels of public spending on pensions just as much as we are in our levels of health spending. But whereas the Government makes a virtue of the upward trend in health spending, it pretends that there is no upward trend in state spending on benefits for pensioners. It is pure fantasy to imagine that on current policy Britain will be able to hold its public spending or pensions to anything like 5% of GDP which is the official Treasury line. After all, the number of pensioners is set to rise by 50% over the next 30 years, during which time Gordon Brown expects no increase in the proportion of GDP spent on them. Moreover, his forecasts grossly underestimate the long-term cost of means-tested welfare for pensioners, especially as it interacts with low levels of savings. If future pensioners’ incomes from funded savings rise by prices not earnings then, the government revealed in an answer to a Parliamentary Question I tabled, this change alone increases public spending on the Pensions Credit by 2% of entire GDP by 2050. A nation that is saving as little as we are is heading for long-term welfare dependency. We are getting trapped in a vicious cycle in which low personal savings leads to more dependence on means-tested welfare which further destroys the incentive to save. It is one of the highest priorities for my Party to break out of this vicious cycle.

We are also heading for two nations in pensions with the traditional final salary pension only surviving in the public sector (including, it must be said, MPs) and very large private corporations. This is already a source of resentment by private sector employers who see their pension schemes closed whilst final salary schemes survive in the public sector. But we haven’t seen anything yet.

We can see these tensions in local government. Local authorities have funded pension arrangements. Actuaries are obliged to revalue their funded pension schemes every three years. I am already hearing reports that on the latest valuations not a single local government pension scheme will show a surplus: they could all be showing a deficit. Then local authorities have to work out what to do. As Tory Councillors take control of more and more local councils and open the books they are shocked by what they find. Local Authority pensions are in crisis. They are caught between a rock and a hard place. One option is to raise the retirement age for local government employees, which is very difficult to negotiate. So what have some councils done? They increase the Council Tax so as to extract more money from local residents, many of whom don’t have a final salary pension, in order to help employees of local government who do.

I have been amazed at the way nobody is talking about the implications of the pensions crisis for charities. We all talk about encouraging the voluntary sector, but very few people realise that many of our large charities have final salary pension schemes which are in deficit. They have often created these schemes because they want to be able to exchange of staff with the public sector and have found themselves under pressure to match the sort of pension arrangements which say a Social Services Department could offer. Any group of senior charity executives gathered together are likely to be talking about what the pensions crisis means for them. The Charity Finance Directors Group recently produced a very powerful report on this. It even included a foreword from Malcolm Wicks, the Pensions Minister, in which he said: ‘Recent changes in pension valuations have affected everyone, but there are particularly difficult issues for charities.” They don’t have shareholders to turn to boost their finances. They are going to need donors who give money not for the expansion of a service, but in order to prop up the pension scheme of a charity. That is not an easy fundraising proposition. In the words of the report, ‘Should it be using its money – whether endowed capital or donated income – to maintain its pension scheme? Can such payments be seen as part of its charitable purpose? What if the solvency of the whole charity is threatened by an FRS17 deficit in its accounts? These are pension scheme issues that may well involve the Charity Commission as well.’ We will hear much more of this in the months and years to come as some of our great national charities wrestle with this problem. Their income tends to be fixed. They can’t adjust their prices or increase their taxes.


What to do about the pension crisis

One could endlessly analyse the intricacies of the crisis and the degree of blame that attaches to the Government. But I want instead to look at how we can make things better. We in the Conservative Party have been at the forefront not just in revealing the scale of the pensions crisis but also putting forward constructive ideas for tackling it.

First, we have to reform state benefits so as to reverse the spread of means-testing. It is no good governments telling the private sector what to do when it has made such a comprehensive mess of the benefits system in its own back yard. We need a benefits system that reinforces peoples best instincts – to save and to provide for themselves and their families. Instead, we’ve now got half of all pensioners on means tested benefits and the Institute of Fiscal Studies predicts that within 20 years it could be up to 75%. That is a penalty for saving of at least 40% and for many pensioners once other benefits are included up to an incredible 90%. No wonder the savings industry is so afraid of being accused of mis-selling if it encourages people on middle incomes to save.

It is not an unfortunate accident that Gordon Brown has created such a complicated benefits systems it is a direct consequence of his belief that it’s for him as Chancellor to determine everyone’s income. He claims to have abandoned fine-tuning the macro-economy. But he is one of the most obsessive micro-economic fine tuners we’ve ever had. He believes it is for him as Chancellor to determine everyone’s income. That is why 4 million pensioners are supposed to reveal all the details of their personal financial circumstances to a government official so he can determine the total income they should have.

Sheila Lawlor has been at the forefront of making the case against means-testing. I salute her efforts. Means-testing has increased, is increasing, and ought to be diminished.

We propose a carefully costed programme to increase the value of the basic state pension and reverse the spread of means-tests. By 2006 the Government plans that over 4 million pensioners will be entitled to the main means-tested benefit, the Pensions Credit, alone. We believe that we can take a quarter of them, 1 million at least, off means-tested benefits.

We will achieve this by raising the basic state pension in line with earnings during the course of the next parliament. We estimate that with this policy the basic state pension should be £7 a week higher for a single person and £11 a week higher for a couple. This will enable us to make great progress in reversing the spread of means-testing.

We are confident that we will be able to identify the savings that will enable us to carry on with this process. Provided that these are achieved, successive Conservative Governments will raise the basic pension up to the value of the means-tested benefit.

This is a dramatic reversal of our decision nearly 25 years ago to break the link between earnings and the basic state pension. But we can now see two very significant long term consequences of that decision. First, the danger with such a low basic state pension is that you end up with a mass inundation of means tested benefits on top. Contributory social security becomes irrelevant as mass welfare takes over. No other advanced Western country has tried to hold down its contributory social security pension to such a low level, and no other has experienced such widespread dependence on means-tested welfare as a result. We should distinguish more clearly between contributory social security and means tested welfare. This is something which historically the Conservative Party has understood. Indeed, the contributory state pension was created by Churchill, Chamberlain and Baldwin in 1928. Why did they set it up? To help get pensioners off the means tested benefit which Lloyd George had introduced in 1908. Lloyd George had introduced the contributory principle to finance health care. It was Conservative who applied it to pensions.

There is a second long term consequence of holding down the basic state pension – the over-regulation of occupational pensions. Company pension schemes are used to provide the bread and butter income of millions of people. Other countries such as The Netherlands, America and Japan have funded pensions as well, but they use them as an extra on top of a decent contributory state social security system. In Britain we have been using company pensions to provide a very basic level of income with the alternative of dependence on means-tested welfare. Increasingly, governments have been using company pension schemes to deliver public policy objectives off the government’s balance sheet. (And they weren’t even on the company’s balance sheet either. No wonder things looked so rosy). Governments try to achieve a better deal for widows or price protection for future pensioners or better treatment for early leavers by putting new obligations on company pension schemes which go way beyond the logic of the employment contract. Company pensions are used as part of the welfare state and they are staggering under the burden.

So a very low basic state pension has exposed the British system to the twin perils of mass means testing and the over regulation of company pensions. Our vision is to increase the basic state pension so as to reverse the spread of means testing. We will also phase out the accrual of new rights under the State Second Pension, a further complication in the system. This adds up to a bold programme for reforming state benefits for pensioners. Instead of a complicated three part system with a basic pension submerged under means-tested welfare and the state second pension we will have a decent basic state pension which gradually displaces means-tested welfare and the state second pension. And above that for every pound you save you are a pound better off. We will keep the Pension Credit but fewer and fewer pensioners will need to claim it as the basic state pension rises in value and displaces it.

Once you allow for offsetting savings in means-tested benefits as the basic pension increases in value, and savings in the state second pension, our policy is over time no more expensive than continuing with the current trend to more and more means-testing.

This is part of a mainstream consensus about how to reform the British system. People may disagree about the precise details, but just about every serious reformer from the National Association of Pension Funds through to the Adam Smith Institute now agrees that the way forward is a decent non means tested state pension as a foundation for funded pensions savings on top. The Pensions Policy Institute estimated that of the 26 major organisations responding to the government’s Green Paper on pensions, 24 called for reform of state benefits. I am proud that the Conservative Party has played its part in forging this new consensus. In fact, just about the only people who don’t share in it this are Gordon Brown and his Treasury advisers.

Increasing the value of the basic state pension in itself improves incentives to save. But it won’t do on its own. That is why we are also proposing to introduce new incentives to save.

We are looking at ways of encouraging people to save that don’t involve an absolute requirement that the money be tied up until they reach pension age. We think this is a powerful way of getting people to save more. And paradoxically, it might even mean they have more money when they do retire. This is the thinking behind our Lifetime Savings Account about which I hope you will be hearing more in the months ahead. It is a new more flexible form of saving that matches peoples behaviour through the life cycle. It rests on the paradox that we drive our car faster because we know the brakes work. So the ability to get at your money may make it a greater encouragement to put more money in in the first place.

So these are two radical policies to remove our dependence on means-tested welfare and restore our incentives to save. This evening I want to add a third item to that list – the reform of annuities. Annuities are one of the oldest savings devices of the lot. They are a classic product to enable people to convert a pot of money into a guaranteed income for the rest of their lives. Adam Smith discusses them in Book V of the Wealth of Nations. Indeed one of the main forms of government borrowing in the 18th century was to accept a capital sum in return for paying an annuity for life. You could also get a different interest rate if you added a second life to the annuity and the second annuitant’s income might rise after the death of the first annuitant, hence Voltaire’s remark ‘if you see a Geneva banker jumping from a window, jump after him: there must be 2% in it.’

Annuities

At the moment you are obliged to convert the money in your personal pension into an annuity at the age of 75. This is a very unpopular requirement – one poll from Watson Wyatt showed that more than half the people are deeply opposed to being compelled to buy an annuity. I can confirm today that my Party is committed to removing the obligation to buy an annuity. The only condition is that people have enough income to ensure they don’t end up on means-tested welfare. And as we increase the value of the state pension and get pensioners off means-tested benefits, so fewer and fewer will be affected by this condition. So far so good. But I have been trying to pin down about what lies behind this aversion to annuities. They ought to be a successful savings product, not a widely disliked government requirement.

Some of the reasons why people might object to an annuity are clear. First of all, the very fact that it is a compulsory product might cause people’s hackles to rise. We Conservatives believe in treating people as adults. So it is not for the state to tell people to buy annuities. And if you are obliged to buy an annuity you might suspect that this reduces the pressure on the providers to make them a good deal though you can shop around for better terms. But there are other problems too. You can’t pass on your personal savings to the next generation through inheritance if they have all been converted into an annuity. It is more difficult to use your capital flexibly to make lumpy payments. The financial services industry is working hard to re-design annuities to tackle some of these problems by much more flexible draw-down models.

But that is not the whole story. People’s views of annuities depend on their expectations about two fundamentals - how long they are going to live and how much money is going to be worth in the future. There are deep questions here about how people’s expectations for the future are shaped. It looks as if people under-estimate how long they will live for - perhaps because they think they might live roughly as long as their parents did. They might not recognise how rapidly life expectancy is now improving. If they do under-estimate their life expectancy then annuities will seem a worse deal than they are. Secondly, there are expectations about inflation. It looks as if people never fully appreciated how much damage inflation was doing to their saving. In the old days of high inflation annuities appeared much higher but in practice it was all front end loaded and after a few years your annuity was worth much less. People may have thought annuities a better deal than they really were. Now with inflation low and the real value of your annuity better protected people may not realise how much this future flow of income is worth.

One of the most interesting areas where psychology and economics meet is expectations such as how long we will live for and how much money will be worth: how they shape our behaviour really matters. Anyone who thought he or she would live as long as their parents, and would experience inflation as it used to be, would be making major mistakes in forecasting the future.

But even what the critics call ‘myopia’ of customers is not the full explanation. If you look at the stark financial figures they show that there is still a problem. If you are a 65-year-old man with £100,000 of savings then you can buy an annuity for you alone that might perhaps be worth £7,000 per year. If instead you put that money in a bank and earn some interest and gradually draw down that same amount of money per year then that money will finally run out after perhaps 18 years. That is why many people think that it is more attractive to keep hold of their own money and hope there is still some left over for their children. Especially if you allow for people who under-estimate their life expectancy you can see why they don’t wish to buy an annuity.

We are getting to the heart of the reason why annuities look expensive compared with just holding the money in the bank. If you hold the money in the bank and draw it down yourself you are taking a gamble on your own life expectancy. But an annuity takes that risk away. It insures you for the gamble that you may live too long. This was classically the policy taken out by Madame Calmet the world’s longest lived person, who died at the age of 122. When she was in her 70’s she reached an agreement with her lawyer in which he would pay her an annual income in return for inheriting her property when she died. In the end he died long before she did.

When we buy an annuity we are turning to an insurance company to insure us for the risk of living as long as she did. These risks are increasing. It’s not just that longevity is improving, though it is. It’s not even that the rate of longevity appears to be improving, though there is some evidence for this. It is that there is a greater and greater range of uncertainty about how long life expectancy might reach for the future.

In the old days life expectancy improved as we eliminated the hazards of disease and accidents that killed people in their 20s and 30s. Once you had got to the age of 65 there was not much further improvement in life expectancy. In America, for example, through the 20th century, life expectancy at birth increased by 26 years but life expectancy at the age of 75 increased by only 3 years. That is now changing. We are at last succeeding in raising life expectancy among older people. Indeed, now the major improvements in life expectancy in Britain are not occurring amongst people in their 20s and 30s but people in their 50s and 60s. The most extreme form of this is in Japan, where we can all see our demographic future. Life expectancy for a woman aged 85 in Japan is now rising by an extraordinary 4% per year. A recent report to the Institute and Faculty of Actuaries stated that “it is highly probable that in the first few decades of the 21st century mortality rates for elderly people in the UK will improve at a faster rate than ever before …life expectancy at retirement will surge upwards.” As Gradgrind says in Charles Dickens’ Hard Times: “the average duration of human life is proved to have increased of late years The calculations of various life insurance and annuity offices and other figures which cannot go wrong, have established the fact.”

This has an obvious financial impact, though not through the widespread and false belief that these are extra years of ill health and disability. We are also dying fitter. My near namesake, Richard Willets, who studies these matters carefully, estimates that improvement in mortality has already added 21% to the funding level required by an occupational pension scheme compared with the assumptions underlining the minimum funding requirement. If life expectancy continues improving at the current rate this becomes an extra 49% added to the funding requirement.

As a final twist in this, there are now greater uncertainties than ever before about how much mortality is going to improve. Imagine a widening funnel of options on a graph showing the range of projected male mortality rates at the age of 80 within 75% confidence limits. One leading life insurance company has calculated within this range there is a 10% chance that their profit margin on annuities is eliminated entirely and a 10% chance it is doubled.


Companies that sell annuities are covering us for these risks and they are getting greater all the time. The FSA is already requiring life insurance companies to hold 6% of the cost of their annuities as a capital reserve simply to cover mortality risk. This is a big extra cost to bear; in fact it is higher than the 5% you are required to hold for credit risk. That in turn increases the cost of an annuity. In fact longevity risk is now one of the biggest single factors pushing up the cost of long-term savings products.

Longevity risk does not just affect annuities, though it is here that we can see the mechanisms most clearly. It also affects conventional company pension schemes which promise to pay people a company pension for the rest of their lives. Many company schemes are now closing to new members and thereby removing one of the obvious ways of ensuring that there is a continuing transfer from working generations to retired generations so as to keep the pensions contract viable. As their members get older and more and more of them retire, so they will also increasingly become insurance style vehicles bearing promises that look more and more like annuities. They will need to be confident that they can pay out the pensions however long people live.

The Government’s new regulation on winding up a company’s pension show how expensive this risk can be. When a company winds up its pension scheme it has to buy a deferred annuity for all the members of the scheme. Trying to buy an annuity for someone aged 45 who has been with the company for 20 years and who has been expected to retire in 20 years’ time with potentially another 30 years of life after that is not an easy matter. In fact there are only two companies left in the UK – Legal & General and Prudential - that will provide bulk annuities and they both set a limit to their annual sales. The current annual supply in capacity in this market is between £1 bn and £2 bn a year. As Law Debenture explain, being unable to match inflation, deflation, duration or longevity they must limit they risks the take on. A paper for the ABI estimates the demand for the total bulk buyout of annuities in 2012 ranging from a low of £1.5bn to a high of £128bn. It is difficult to see how the market would have the capacity to deliver this. These products are difficult and expensive, not just because of growing longevity risk but because of reinvestment risk as well. That is to say that it is virtually impossible to hold an asset continuously that will meet all these obligations so they have to allow for the fact that they will be buying and selling equities and bonds over the next 50 years.

So these are substantial long-term risks that we are expecting our savings products to carry - the risk of people living a lot longer and the risk of re-investing into new assets. At the same time we have removed one of the safety valves that post-war Britain developed to protect itself from some of these risks - that safety valve was inflation. Historically I would have predicted that the financial system now faces such high costs from the promises that have been made to future pensioners that the temptation to solve them by inflation would be irresistible. In fact I sometimes think the Chancellor’s biggest single success – entrenching low inflation with an independent Bank of England – has hit our pension funds almost as hard as his biggest single mistake – the £5 billion pensions tax. In the past our pension funds have experienced times when a low stock market has hit their assets or low inflation has increased their liabilities. Today’s crisis arises from the unique combination of low assets and expensive liabilities at the same time.

One of the biggest obstacles to increasing the supply of savings in this country is the significant longevity risk that companies selling insurance or companies offering occupational pensions now have to bear. Can the government to try to reduce the cost of this longevity risk so as to lower the cost of savings products? The obvious way in which the government could do this is by issuing bonds that help to cover some of these risks. There is a learned debate about this amongst the experts. The time has now come to bring it out into the open. That is why today I can announce that I am inviting the financial services industry to comment on possible changes to the structure of government bonds. I should emphasise that we are not talking about issuing more government debt in total – Oliver Letwin has already set out rigorous plans for controlling public spending. The question is whether the pattern of debt should be changed. At the moment the average maturity of all government bonds is under 12 years. The average duration of conventional dated gilts is just 7 ½ years. There are only five conventional gilts in the UK with maturity dates over 15 years, the longest having a redemption date of 2036. There has been no significant innovation since the introduction of indexed gilts over 20 years ago. Indexed gilts covered the big risk of the day – inflation. If the big risk of today is longevity perhaps we could issue gilts that cover that instead. There are various ways in which government bonds could be structured so as to do this. Let me briefly set out four possible options.

First, the government could simply issue gilts with a much later maturity date than at present. That would enable the insurance companies and pension funds to hold assets that yielded an income that lasted as long as their liabilities. The ultimate option would be to go back to the irredeemables that were issued in the 19th and 20th century. Should government debt issues just be much longer?

The second option would be to issue gilts that more accurately reflected the inflation risks that companies have to bear. The Pensions Bill going through the House of Commons requires company pension scheme - to cover inflation up to 2½%. Moreover, in times of deflation the coupon on an indexed gilt is cut whereas there is no provision for companies to cut their pension payments. Indexed gilts do not therefore match accurately the inflation liability that company pension schemes face. So a second possibility would be to issue indexed gilts which more exactly reflect the limited price indexation which the government imposes as a legal obligation on company pension schemes.

A third option would be survivor bonds. These have been put forward by Professor David Blake of the Pensions Institute, of which I am honoured to be a Visiting Fellow. He has proposed that the Government should issue bonds where the size of the payments matched the number of surviving pensioners from a cohort. He proposed that the bond payments would diminish as the cohort of people who were pensioners when the bond was issued diminished. It is a modest version of the schemes of the 18th century for the government to borrow upon annuities for lives which so fascinated Adam Smith. In fact Professor Blake’s proposal appears to be a mid-point between two options described by Adam Smith in The Wealth of Nations’:

Annuities for lives have occasionally been granted in two different ways; either upon separate lives, or upon lots of lives, which in French are called Tontines, from the name of their inventor. When annuities are granted upon separate lives, the death of every individual annuitant disburthens the public revenue so far as it was affected by his annuity. When annuities are granted upon tontines the liberation of the public revenue does not commence till the death of all the annuitants comprehended in one lot, which may sometimes consist of twenty or thirty persons, of whom the survivors succeed to the annuities of all those who die before them; the last survivor succeeding to the annuities of the whole lot. Upon the same revenue more money can always be raised by tontines than by annuities for separate lives.’

The fourth option, and in some ways the most attractive of the lot, is to issue bonds that are indexed to changes in longevity. They would have a normal interest rate coupon based on the Government Actuary’s central forecast for life expectancy in the future. But if life expectancy moved by say more than 5% or 10% outside that central forecast then the interest payments would go up or go down. This would mean that if, for example, dramatic advances in genetic medicine meant that we all live much longer, then long-term savings institutions holding Government bonds would find that they had a greater income and so were able to discharge the promises they had made to their annuitants or members of the company pension scheme.

We are certainly not committing a future Conservative Government to issuing such bonds. But I do think that as the Party that believes above all in saving, we need to think boldly and radically about the measures that are needed to tackle Britain’s savings crisis.

The purpose of all this of course is to offer a better return to savers. Let me give you some figures which illustrate what the benefit could be. One leading insurance company holds at the moment some 4%-5% capital for mortality risk on an annuity for a retired person where the payments have commenced immediately. They estimate that a Longevity Bond might enable them to halve the capital they need to hold for mortality risk and that would enable them to increase annuity income by some 2-2 ½%. For a deferred annuity where the payments may not start for a decade or more the gains are even greater. One estimate was that they could increase deferred annuity income or reduce the cost for a company of buying a deferred annuity by at least 10%. This would be of direct assistance to, for example, the victims of pension wind-ups. At the moment pension schemes are legally obliged to buy deferred annuities as they wind up often on very unattractive terms. Issuing survivor bonds like these could improve the terms that companies could get for their deferred annuities by 10%. Given the scale of the wind-up problem this could be worth more to the victims of pension wind-ups than the entire £400m package which the Government has recently announced.

Before we could commit a Conservative Government to issuing gilts like this we would need the views of industry and economists about whether it is the right thing to do. There are three important questions that we need to tackle.

First, is it a legitimate role of government to lift from the private sector some of the burdens of longevity risk? After all, the public sector has a significant amount of longevity risk already through, for example, the cost of state benefits and public sector pension schemes. Should not the private sector also bear its share of the cost? I recognise the force of this. We would need to look very carefully at the amount of risk that the government was taking on. However, it does look like a classic example of a social risk, which is best borne by the country as a whole. Moreover, it is the government itself which obliges the private sector at the moment to take these risks. It is regulatory requirements from the Financial Services Authority which are pushing up the cost of annuities because the FSA is concerned that these risks should be fully accounted for. It is the obligation to buy an annuity at the age of 75 which forces people to bear the cost of these risks. It is the rule that a defined benefit pension has to be increased at least by inflation up to 2½% which adds to the long-term cost of providing for people until they die. So the government is, if you like, forcing them to be prudent in recognizing the costs of these risks and therefore may have to accept its share of responsibility of meeting the cost of this prudence.

Then there is the question: why embark on all this now? Why not just leave it to markets to tackle as presumably they have so far? These risks matter more because of something else that has changed – the shift to low inflation. In the past the way in which the state reduced longevity risk for savings institutions was by the dirty trick on savers of high inflation. That is why life expectancy was not such an issue in the past. Even if someone did survive to be 80 or 90 inflation would have meant that any cash promises to them would sadly become worth very little. In a world of low inflation and indexed liabilities longevity starts to matter a lot more.

There is a third question as well. Would the government’s own incentives for good behaviour would be changed by such a new sort of bond? I worked in the Treasury on the last great innovation in bond issues – index linked gilts. One of the many arguments in favour of them was that they were a kind of sleeping policeman which meant that the government would face higher costs if it failed to achieve its policy objective of low inflation. It acted as a further incentive for the government to be virtuous. But sadly the pattern of incentives would not be quite the same with a longevity bond. The government understandably has public health objectives of trying to make us all fitter and healthier so we live longer but it might entail higher costs through longevity bonds if its public health objective succeeded. Might the government’s incentives change if it faced a higher cost on its borrowings as a result? I believe that understandable fear can be set aside. The government is already exposed to these risks through state benefits for pensioners and this has not undermined its public health policy. The democratic pressures for good public policy that raise public health are so strong that I don’t believe the Treasury could resist it in the interests of savings on the possible cost of longevity bonds. Indeed very fact that there is a connection between a public health policy and longevity risk explains why it is right for government to take some of the risk off the private sector. It is government policies aimed at making us all live longer which have the effect of putting significant extra cost on our long-term savings institutions.

In the days of the monetarist debate we tried to think through the way in which the money supply would increase the rate of inflation by imagining what would happen if a helicopter showered £10 notes over the population. But now imagine a helicopter that didn’t drop £10 notes but dropped pills that raised everyone’s life expectancy by ten years. The economics profession is still in the early stages of thinking through rigorously what effect that might have on the economy and how a government should respond. One response, the pure free market response if you like, is to say that the government does not need to get in the way of the sort of flexible adjustment that should happen in everything from pension contributions to the age of retirement. This is the equivalent of the argument that it doesn’t matter if you drop large numbers of £10 notes on people because nominal prices just adjust and the real economy is unaffected. But there are a lot of rules and regulations in the economy with an explicit link to age, just as there were ways in which nominal prices were fixed. It is very difficult for these adjustments to take place. Helping to meet the cost of adjustment could be a useful and creative role for government.

Conclusion

This is, I hope, the start of a debate about whether and how governments can do more to lift the burden of longevity risk from our savings industry.

You have to tackle not just the demand side - encouraging people save to choose what they do with their money. You also have to look at the supply side - making it easier for the suppliers of long-term saving. If we can cut the cost of supplying long-term savings, that can make as much of a contribution as changing the incentives facing individuals by rolling back means-testing. We want to encourage people to save more. We don’t want more and more people to be retiring with pensions worth so little that they are driven on to means-tested welfare instead. That is Gordon Brown’s agenda of bigger government and smaller citizens. We want the citizens to be bigger. And what better way to achieve that than by making it possible for them to build up bigger, funded savings

We need to make savings more attractive. That is why we have to reverse the spread of means-testing. It also means increasing the returns that pensioners get on their savings. If companies don’t have to set so much money aside to cover greater life expectancy then they can offer a better deal to their savers. That’s why we will be exploring with the savings industry the radical proposal that the Government should issue bonds that pay more if longevity rises.

The coherent and wide-ranging Conservative approach to saving involves reforming state benefits, reversing means-testing and also making long-term saving more attractive and more effective. The ideas set out this evening are aimed at achieving precisely that.