Pensions reform: adverse selection, our future selves, and intergenerational risk sharing

The Government has announced plans to drop the requirement that pension holders be forced to purchase annuities when their pension plans mature.  This will have the positive benefit of allowing people to have more control over their savings, to be valued in a society predicated on allowing people as much self-determination as possible.  However, there are some downsides.

1.  It will allow people more control over their savings!  Annuities insure us against the uncertainty we face in predicting how long we are going to live without being able to or wanting to work to feed ourselves.  Peversely, annuities help in the unfortunate event that we live longer than we guessed we might, paying us the savings someone else accrued who lived less than they thought they might.  It is an insurance against risk that our future selves face.  Unfortunately, there is abundant evidence from the experimental and other empirical literature in behavioural economics and finance that we are i) terrible at paying proper attention to the wants of our future selves [usually neglecting them] and ii) terrible at responding rationally to risk.  Allowing us to make decisions for ourselves is therefore likely to lead to suffering.  Our present selves may love it, driving to retirement coffee mornings, or our self-funded Physics PhD, or going on cruises.  But our decrepid far future self will regret that, cowering without the heating on.  To the extent that we differ in how we neglect our future selves, there will be a subsidy going to the most stupid, who run out of money and fall back on the state for assistance.

2.  There is a risk of inducing adverse selection in the annuities market.  Adverse selection occurs because in a voluntary annuities market, insurers guess that those who knock on their doors for an annuity are those who know from the history of their relatives that they have a fair chance of getting one of those Telegrams from the monarch when you reach 100.  So they charge more for the service, anticipating having to pay out for longer.  And this thins out the customer base further, to those expecting to get into the Guinness Book of Records for longevity, and so on, until the market disappears.  Is that why the share prices of annuity providers dropped as the 2014 Budget was read out?

It’s not all bad, of course.

Annuity providers may be lazy through lack of competition, or capricious and sell people more insurance than they need, confusing people with a proliferation of hard to price options. [Perhaps that’s why the share prices of annuity providers dropped as the 2014 Budget was read out!].  And we don’t all face the same amount of risk.  Single people face more of it than the married.  Spouses can agree to leave their money to the other, giving them a payout if they are unlucky enough to outlive them.  And some of us like risk.  Boris Johnson celebrated that people could become buy-to-letters.  Sure.  Provided we can pay someone to run it for us [remember we are thinking of a time when we can’t work here] that would generate an annuity, just more risky, since it would rise and fall with changes in the relative yield on houses.

Another reason that private sector annuities are not the perfect solution, is that their providers, though they can, in principle, pool longevity risk across their customers [adverse selection aside], they cannot do anything about aggregate longevity risk.  Mervyn King’s British Academy lecture in 2004 documented the extraordinary increases in life expectancy that mounted through the 1970s, 1980s and 1990s, much of which took the industry by surprise, leading to hardship given the defined benefit based promises they had made with their customers.

The only way to deal with that risk is for the state to pool it across generations.  A generation that lives longer than forecast gets a handout through the Government borrowing, and future generations that live less than forecast pay out.  Intergenerational risk sharing of this sort is not radical.  It goes on the time.  That’s what Krugman, Wren-Lewis and the others urging much looser fiscal policy during the crisis were advocating.  Borrow now, and future generations can pay back.  We are sharing in the generational risk that crystallised in the form of the second world war.  (Well, thankfully only some of it.)  The Government borrowed to finance defeating the axis powers, on the understanding that baby-boomers and their children would foot some of the bill.

The difficulty with intergenerational sharing, of course, is that today’s generation can change its mind and not keep the bargain made for it, perhaps even before it was born.  In fact, if it suspects that some future generation might vote down the state pension just as it comes to draw it, why would today’s generation agree to pay taxes to fund today’s old?  We have a state pension, you might say, isn’t that evidence that the system works?  No, because it might be much higher if we could somehow constitutionally guarantee that it would never be ditched, so we would all share in its benefits, without worrying about selfish youngsters abolishing it just as we had got too tired to work.  The shift from defined benefit to defined contribution pensions amounts to a reduction in intergenerational risk-sharing, and reflects the difficulty of designing systems by which society can, in a time-consistent and predictable fashion, substitute for the private sector’s inability to do it.

Simply giving people the choice not to buy these private annuities isn’t a solution, of course.  That would have to be solved by either i) the state providing more than it does, or ii) equivalently, the government issuing ‘longevity bonds’, which annuity providers would buy.  These would be bonds that paid out more to their holders if life expectancy turned out greater than forecast, so the annuity provider holders could pass these on to the wizzened-old, record breaking wrinklies.  [And thanks to Dan Davies for reminding me that i) and ii) are in principal the same].

One of the cheers for the new reform was from the savers lobby.  In particular, I picked up tweets from Ros Altman, who rails constantly against the long period of low nominal interest rates, which she and others think have harmed savers.  So now, the government is doing something to compensate savers for that.  That is a silly argument.  For a start, savers’ livelihoods depend on the real rate.  But of course real rates have also been extremely low in recent years.  However, in the medium to long run, there is nothing governments can do about that rate.  It’s determined by growth, demography, things outside government control.  All governments can do is pool the risk across time periods in the way I described above.  So generations experiencing low real yields could justifiably claim against those who might get higher real returns.  The authorities can do something about the very short run real rate.  But if that were to be increased, by the central bank raising the nominal rate it controls, that would likely cause a huge, further, long-lasting recession and a collapse in asset values;  ultimately, savings returns are paid out of the returns of economic activity which would be devastated by the use of the nominal rate for anything other than inducing inflation and output gap stability.

[Update:  see also Simon Wren Lewis’ post on this topic.  In particular, he fills in a gap I left by pointing out that it’s not just the stupid who would end up falling back on state annuities, failing to save enough for themselves, but the calculating, since they would calculate that the government would back down and help them out.]