Who will pay our £7 trillion pensions bill?

By John Hawksworth, Chief Economist

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At the end of April the Office for National Statistics (ONS) published, for the first time ever, official statistics on the total obligations of all UK pension providers, including the government. At the end of 2010, these obligations – which also represent the total pension entitlements that UK households had built up by that date - are estimated at over £7 trillion in total, or around 4.8 times annual UK GDP.

That estimate is subject to all sorts of uncertainties since it relates to the discounted present value of potential pension payouts stretching up to 100 years in the future. But more interesting than the headline number is how it breaks down: who is liable to pay these pensions and how much of this £7 trillion is backed by actual assets as opposed to unfunded promises to pay by future governments? There is a lot of detailed data in the ONS report, but I have boiled this down to a single table of key numbers for ease of reference.

Breakdown of total UK pension obligations (at end of 2010)

The first striking fact is that more than half of total UK pension obligations (£3.8 trillion) relate to state pension entitlements based on past work and national insurance contribution records. This includes the basic state pension and additional state pensions such as SERPS and S2P, but excludes other potential means-tested state benefit payments to pensioners since these are not entitlements that have already been earned.

There is no ring-fenced pot of assets to back these promises to pay future state pensions – rather they will be made out of future tax revenues on a ‘pay as you go’ basis. But current and future governments can and sometimes do change the rules as to exactly what age these state pensions will be paid at and how they will be indexed (e.g. to CPI, RPI or average earnings). If the state pensions bill proves too costly this is one way the circle could be squared – higher taxes on future generations are another option.

In addition to state pensions, current and past governments have also made unfunded pension promises to their employees, totalling around £850 billion at the end of 2010 according to these new ONS estimates. These will also have to be met by future taxpayers although the latest projections by the Office for Budget Responsibility (OBR) in July 2011 suggested that this cost, while rising in the short term, will be affordable in the long term even before the latest hotly contested round of reforms to public sector pensions has been implemented. This is largely due to a past decision to index these public pensions to CPI rather than RPI, which sounds like a technicality but saves the government a lot of money in the long run (£127 billion in present value terms according to ONS estimates).

Nonetheless, around two-thirds of total UK pension entitlements (around £4.7 trillion as shown in the penultimate row in the table above) take the form of promises by current and past governments to be funded by future generations of taxpayers. That could clearly cause some generational tension down the line.

The funded pension entitlements are mostly in the private sector (around £2 trillion in total) and, for now, mostly relate to defined benefit (DB) company schemes that have total obligations of over £1.3 trillion according to these ONS estimates. Most of these private sector DB schemes are now closed, either totally or at least to new members. But companies will still be on the hook to pay these pensions for many decades to come and, in doing so, will have to absorb both market risks on the future value of the assets in these schemes and longevity risks as reflected in future annuity rates. Managing legacy DB pension liabilities will remain a huge issue for many UK companies for a long time to come.

For the moment, defined contribution (DC) schemes make up a relatively small share of total UK pension entitlements – only around 10% if we add up both workplace and individual DC schemes. But this share will rise gradually in future and, while companies may contribute to these schemes (including the new NEST scheme to be launched by the government shortly), it will be individuals who bear the market and longevity risks associated with these kinds of pensions. If asset returns and/or annuity rates continue to disappoint as they have done for most of the period since 2000, then future generations will have to contribute significantly more and/or work significantly longer than current pensioners.

For other similar articles, view our Economics in Business blog: http://pwc.blogs.com/economics_in_business

Contact: John Hawksworth | Tel: +44 (0)20 7213 1650