Entitlement reformNovember 2012
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The seventieth anniversary of William Beveridge’s famous report (Social Insurance and Allied Services) provides an opportunity for debate on the future direction for the welfare state. Clearly the world is now a very different place to that of 70 years ago. But just as the Beveridge report encouraged a radical departure from the past in response to major challenges (the “five giants” of want, ignorance, disease, squalor and idleness), structural changes (including population ageing) mean modern welfare states require reform. To illustrate, this report considers the prospects for the welfare states in Australia, New Zealand and the United Kingdom. These countries provide an interesting comparison given their similar social policy traditions and similarities and differences in their approaches to reform. There are also important lessons – on what to do and on what not to do – that the countries can learn from each other.
Old and broke
No-one should be surprised that populations are getting older. This topic has been filling academic journals for years. In schools demographic charts are standard fare. Some politicians have even written books on the matter. Population is ageing is taking place as not only are the baby boomers (people born between 1946 and 1964) starting to retire in large numbers but fertility rates are falling and people are living longer. As a result “dependency ratios,” the number of workers per dependent member of the population, will worsen in years to come.
There should also be little surprise that population ageing will present fiscal challenges. Spending in areas like health, pensions and long term care is accelerating as the share of the population of working age (who fund this spending) is falling. These changes will impact on governments’ spending plans, tax bases and fiscal headroom; limit the degree to which future fiscal policy could respond to major shocks; force reform of the funding of the welfare state (both transfers and services); and force changes to the delivery of public services (e.g., with health systems needing to focus more on long-term conditions).
The private pillar
A complete picture of the likely effects of demographic change also requires looking at the range of sources pensioners receive income from, not just government ones. This is a key area of difference between the three countries. Australia has done the most to encourage a nation of savers and private contributions to services like healthcare. In the United Kingdom and New Zealand pensioners rely to a greater degree on the government for their incomes, although the situation has changed in New Zealand in recent years. A similar bias is present in their health systems, with both countries having relatively low levels of private health funding.
This is significant as the best welfare states have strong private pillars as well as a public one. Mixed model systems provide a number of benefits. By reducing pressure on the public system they can mean programmes are more affordable for governments in the long-run (although this may be undermined by policies like poorly designed tax-breaks). Increasing private saving, for example, can mean more pensioners are able to provide for themselves in retirement and so public programmes can be targeted to more clearly focus on supporting pensioners in need. From a national-economy perspective a stronger private pillar can also make the welfare state more efficient by increasing the range of tools available for smoothing income and spreading risk. And a mixed model has important political effects, with a stronger private pillar helping build consensus that funding the welfare state is not just the job of the government. As a result, with population ageing countries with small private pillars will face pressure to further expand their welfare states, while the broader funding base in other countries will mean greater flexibility to introduce pro-growth policies, such as more competitive tax systems.
Time for an honest conversation
While there is growing recognition of the challenges that population ageing presents, developing workable solutions and identifying the role that government should play in these solutions has proven much harder. Policymakers in the three countries still need to get a grip on key areas of age-related spending.
Costs of delay
Reform should no longer be put off. The political challenges of reform are high (powerful vested interests) and many members of the public are anxious about change. Yet undertaking reform quickly would provide real benefits. Even just in fiscal terms putting the welfare state on a more affordable footing sooner rather than later would be beneficial. Yet the argument for early reform is much more than a fiscal one. The temptation for governments will be to put off dealing with these challenges but this will limit future governments’ options. This is not just a challenge for the distant future but will be felt as political parties in all three countries start to develop manifestos for their next general elections (baby boomers are retiring now). Looking forward this is going to intensify, so that by 2050 the share of the voting population over 65 in the United Kingdom, for example, will have increased from 1 in 4 now to 1 in 3.
There is also a potential personal cost to delaying change. In any change there will be a group of people who are likely to “lose out” or be relatively disadvantaged by the transition from one system to another. Governments are likely to want to protect current recipients and younger people should have sufficient time to change their plans to adjust for any loss of government support. But there is a group of people closer to retirement who will face losing their support and who may not have enough time to, say, significantly build up their private savings. Over the next 10 years this group of people is going to make up an increasing share of the population, and so the potential disruption from reform (and the costs of the transition) will rise.
Getting a grip
Principles for reform
Reform must be free from political whim. This requires an open process of consultation and robust scrutiny of policies. The more uncertain the decision making environment, the harder it will be for families to make the decisions that are in their longer term interests and for private providers to complement State programmes. Yet this need for consultation should not be seen as excuse for delay. Indeed, given the need for long lead times (to allow people to adjust their plans) certainty over the direction of reform must be provided as soon as possible.
Reform should also be based on a clear set of principles. These principles could include the following:
- Reforms must start quickly. Early action reduces the overall costs of change and minimises disruption.
- Changes must not only restrict the long-run growth of the size of the state but also reform what the state does.
- No area of government should go untouched. Nothing should be off limits and one change (e.g., increasing the retirement age or auto-enrolment for defined contribution pensions) cannot do all the heavy lifting.
- People must put aside more money for their own needs and contribute more to public services, including health and care.
- Market based solutions are required to support greater individual contributions, e.g., through income smoothing and risk pooling (e.g., private insurance) and releasing the equity built up in assets (e.g., equity release).
Key directions for reform
The state pension system should focus on poverty reduction. This means that the ways in which the pension automatically increases (indexation) over time requires review, particularly in the United Kingdom. This also means that supplementary pension benefits should restricted to cases where there is a clear policy rationale for them. Again, this is particularly an issue for the United Kingdom, with programmes like the Winter Fuel Allowance, free bus passes and free TV Licenses being particularly poor value for money. As a simplification measure entitlement in the United Kingdom should also be based on residence rules not contribution histories.
A more focussed state pension system means that many people will need to make a greater contribution to their own living standards during retirement through accumulating greater assets during their working lives and more effectively converting these assets to income at or during retirement (decumulation). This means that governments will be under pressure to:
- Lower the fiscal costs of the accumulation phase. There is a need to reform poorly designed subsidies and tax breaks for savings and insurance.
- Strengthen the decumulation phase. As baby boomers begin to retire in larger numbers the products that could help them convert financial and housing assets into income streams will become more important.
Reflecting both policy changes (such as the increase in statutory retirement ages) and the demise of yield there is a longer term trend for people to work for longer. This trend for working later is likely to continue, particularly given the impact of the global financial crisis on superannuation balances and wealth, and raises a number of policy challenges. As working lives increase the state pension age should increase also. Australia and the United Kingdom have already introduced plans to increase their ages to 67 by 2013 and 68 by 2046, respectively. There are no plans to increase the age from 65 in New Zealand, which is a major omission.
None of the options above are easy and they may be resisted by powerful vested interests. Families are likely to be anxious about changes of this nature. Yet delaying reform will increase the costs of change and mean future reforms must be more disruptive. There is a need for an honest conservation over the real costs of population ageing and how to address them, no matter how difficult this may be.