Managing social security pensions costs

Woman checking her pension statment

In their latest blog, the IFoA’s COVID-19 Action Taskforce Social Security Group look at the impact the pandemic has had on public expenditure and social benefit finances.

One of the consequences of high COVID-19 related Government expenditures, particularly in more developed countries, is the need to balance future Government finances, with the likelihood of significant increases to taxation or reductions in spending.  

Social security benefit spending is a high part of many countries’ public expenditure and there may therefore be some attention paid to how this might be controlled, especially if this is coupled with an ageing population.  Some commentators argue that the brunt of the cost of the pandemic has fallen on the young, with school and study disrupted, and the working population, with significant increases in unemployment as the result of the closure of certain parts of the economy.  They therefore suggest that there may be more attention paid to future controls on the expenditure on pensions and benefits for older citizens.

Policy Tools

It is normally difficult to reduce benefits that are in payment ‑ or shortly due to become paid ‑ because the people affected have little or no time to adjust their own expenditures or plans.  However, there are some ways in which the tighter limits to expenditure may affect the outlook for pensions.

One of these is a focus on the pension age, where spending challenges may make it more likely that the pension age is increased. 

A more immediate issue is the level of increases applied to pensions.  Some governments have automatic rules for increases linked to consumer price inflation or similar measures, but many have no explicit rule and make increases from time to time as they can be afforded.  It is more likely that such increases may be deferred or reduced when they are not part of the pensioner’s entitlement. 

However, inflation is generally low in much of the world, compared with inflation experienced in the previous half-century.  Looking at the impact of inflation of 2% a year on the value of the pension benefits to someone retired today, a flat rate pension would have significantly lower value compared with one indexed to inflation over their future lifetime. 

Age

Value of level pension compared with one increased in line with inflation

60

75%

65

79%

70

82%

75

85%

80

89%

85

91%

 

A singular issue arises in the UK, where a “triple lock” policy introduced for the state pension in 2010 has been to raise pensions in line with the best of

  • Consumer Price Inflation (CPI)
  • Earnings Inflation
  • 2.5% minimum

This policy was put in place when inflation was more of a concern than has recently been the case and since then increases have been made in line with CPI three times, in line with earnings three times and in line with the minimum four times.  Over that period, total increases were 35% compared with a rise in earnings of 23% and a rise in prices of 22%. 

COVID-19 Issues

The pandemic has led to a depression in earnings, which only rose 1.0% in 2020. Prices rose by a similar amount.  The payment of the minimum increase to pensions therefore results in an improvement of 1.5% for pensioners compared with levels of earnings or prices. 

In 2021, it is likely that recorded average earnings as the effects of the pandemic work through may alter significantly.  A fall, followed by a recovery over future years, or a rise in average earnings followed by a fall as more lower paid employees enter a recovered economy, could mean pensions are protected by a 2.5% rise at the time of falling earnings but benefit in full from the earnings rise. 

One difficulty in making predictions is that there is a furlough scheme in place which defers many employment decisions.  The resulting pension calculation is thus critically dependent on the timing of the end of the furlough scheme, which has effectively displaced the policy consequences. 

A fall of 5% followed by a rise of 5% would result in a pension increase of 2.5% minimum in 2021 and then 5% in line with earnings in 2022, an overall increase of 7.6% compared with earnings unchanged over 2 years and CPI increases of around half that.  The same would apply in reverse if average earnings rise because of the loss of lower-paid work and then fall as the lower-paid gain new jobs in a recovery. 

The higher the temporary fall in earnings, the more the impact on higher pension payments.  If earnings were to recover to close to their pre-pandemic levels, pensions could well have been increased 10% faster than earnings, leaving questions as to whether it is appropriate for the pandemic to have caused a significant economic shift from the young and the employed to the elderly. 

It is a political matter to decide on the rules and methods of making increases.  We note here that the experience of the economic shock caused by the pandemic shows the formula adopted in a very different light from that which would have been expected in normal economic conditions.

Modelling

The impact of the pandemic on formulaic pension increases calls in to question the way in which extreme uncertainties are modelled.  Anyone in 2019 modelling the likely progress of the triple lock would have looked to the past variations in prices and earnings, projected these and their variability into the future and estimated the small impact of the 2.5% minimum from time to time.  A single economic shock of one year's heavy fall in average earnings followed by a bounce back would have been unlikely to have been part of any modelling.

The same will be true of many other areas of modelling, such as the guarantees which might be embedded in life or general insurance policies or banking and other products.  Actuaries involved in those may need to revise their modelling and stress testing in the context of unforeseen crisis events unlikely to be part of models built from past experience.

Looking ahead, how often should shocks be modelled in to the future, given how irregularly wars or pandemics have occurred in the past?  Maybe the lesson is to test the system against such shocks and to design a better system which is protected through a different formula against such shocks?