Should the state pension age go up in countries with ageing populations?

In the developing world, falling fertility and rising life expectancy are leading to ageing populations. This has big implications for public spending, including on pensions. In response, many countries are raising the state pension age and/or debating whether it should go up further.

The state pension age is rising in many developed countries around the world as they grapple with the demographic time-bomb of an ageing population and a shrinking workforce.

Recently, these pension age changes have hit the headlines in the UK, following the publication of the Parliamentary and Health Service Ombudsman’s final report on the changes to women’s pensions implemented after 2010.

These changes were embedded in the 1995 Pensions Act and required a gradual equalisation of the pension ages of men and women between 2010 and 2020. The problem was that details of these changes were not shared directly with the people involved.

The report deemed there had been maladministration concerning the communication of these changes by the Department for Work and Pensions (DWP). Importantly, the complaint was not about changes to the pension age, but how it had been communicated, particularly after 2005 when surveys by the DWP revealed that those affected were not aware of the impending changes, hence limiting their ability to make informed decisions around finances on retirement (see BBC and Parliamentary and Health Service Ombudsman).

Why might state pension ages need to rise?

Figure 1 shows the increase in life expectancy at birth over the last 50 years in the UK and the rest of Europe, and the projected increases over the next 100 years. Except for a blip during the Covid-19 pandemic, life expectancy continues to rise over time due to improvements in healthcare and rising standards of living. Babies born in 2023 can expect to live until the age of 83, and their grandchildren can expect to live until they are 90.

Figure 1: Trends in life expectancy and fertility: historical and projected values

Source: 2022 United Nations DESA, Population Division

The bottom figure shows fertility in the UK and the rest of Europe with the well-documented post-war baby boom of the 1950s followed by a dramatic fall to roughly 1.5 live births per woman from 2000 onwards. The patterns in the UK are similar to those of other European nations.

Table 1 shows the demographic old age to working age ratios for a number of developed countries over time. This ratio is defined as the number of individuals aged 65 and older as a percentage of those of working age (between 20 and 64).

Table 1: Demographic old age to working age ratios, 1950-2080

Source: United Nations, 2019; for future periods: medium-variant forecast

Table 1 shows that this age-dependency ratio is increasing in all countries. In the UK in 1950, there were approximately five people of working age for every one retired person. By 2050, it is predicted that the ratio will be 2:1; and for some countries, such as Japan, it will be getting close to a 1:1 dependency ratio.

The increase in the age-dependency ratio is a consequence of the twin demographics illustrated in Figure 1: lower fertility and increased life expectancy. These factors result in an ageing population and they have a number of implications for social policy.

How have state pension ages changed?

These changes will bring different economic needs and consumption patterns (for example, more spending on healthcare and long-term care); different behaviours, such as working less and lower savings; and political pressures on the sustainability of pay-as-you-go (PAYG) pension systems. In 1908, when state pensions were first introduced for people aged over 70 in the UK, life expectancy was 58 years.

One way in which governments have responded to the demographics of an ageing population is to change the definition of being old, by changing the age at which individuals are entitled to state retirement benefits.

As a consequence of a directive from the European Economic Community (EEC) in 1978 on equalising social security payments across genders, this process started in the UK with the Pensions Act 1995.

This legislation announced that the pension age for women would increase from 60 in 2010 by one year in every two, equating the pension ages of men and women to 65 by 2020. The Pensions Act 2011 superseded this earlier change, which, under the coalition government’s austerity measures, increased the state pension age to 66 years for both men and women.

There are two further increases in the pipeline: a gradual rise to 67 for those born after April 1960; and a gradual rise to 68 for those born after April 1977.

The UK is not alone in increasing the state pension age. Table 2 shows changes to statutory pension ages over time in a number of major European countries.

Table 2: Statutory pension ages in European countries

Source: Harker, 2022

Changes to the pension age are often met with fierce resistance. In France, for example, a new parliamentary bill in 2023 that proposed to raise the official age at which people can stop work was met with nationwide demonstrations and strikes.

In the UK, the Pensions Act 2014 requires there to be a regular review of the age at which people qualify for the state pension. The latest review, published in March 2023, confirms that, as planned, the state pension age will rise to 67 between 2026 and 2028, with a further review scheduled for within two years of the next parliament.

How have pension policies changed to accommodate ageing populations?

The shrinking working population relative to the total population has caused governments to move away from PAYG pension systems and towards defined contribution schemes, which are just tax-efficient savings arrangements.

With a PAYG system, the working population pay taxes that pay the pensions of the retired population. This is a pure transfer between one section of the population and another. The working population enter this implicit contract on the understanding that, when they retire, the future cohort of workers will pay their pensions. Under a defined contributions system, workers contribute to a fund that accumulates over time and which they can then run down on retirement.

In the UK, as well as the basic state pension, there is a myriad of occupational or work-based pensions and personal pensions for the self-employed, with pension dashboard legislation due to take effect in the summer of 2024.

This 2022 legislation sets up an online portal through which individuals can access information about the value of all the different pension schemes to which they are entitled during their working lives.

Since 2012, under ‘auto-enrolment’, all employers are required to provide a pension scheme for their employees. They are automatically enrolled into pension schemes that are typically defined contribution types, such as the National Employment Savings Trust (NEST).

Employees contribute a minimum of 4% of their salary, employers 3% and the government 1% via a reduction in national insurance. Auto-enrolment – with its ‘nudge’ policy of requiring opt-outs rather than opt-ins – is widely regarded as a success and it has had bipartisan support when legislation was passed in 2010 and upheld by successive governments.

According to the Office for National Statistics (ONS) in 2020, 79% (22.6 million) of eligible UK employees were participating in a workplace pension; up from around 10 million before 2012.

From the government’s perspective, defined contribution pension schemes put the onus on individuals to provide for their own pensions with nudges and tax savings. On retirement, the accumulated pension pot can be accessed to provide an income in retirement through a number of routes: cash withdrawals; the run-down in capital via income drawdown arrangements; or the more traditional annuity.

Under the headline of pension freedoms, the chancellor abolished the compulsory annuitisation requirement associated with tax-advantaged defined contribution pension schemes in 2014. Since then, the demand for voluntary annuities has fallen to a quarter of their previous amounts (Cannon et al, 2016).

The amount of money accumulated in a defined contribution pension depends on the investment allocation and the returns on these investments. Such schemes allow employees the flexibility of deciding when to retire (after the age of 57). With sufficient funds they can retire early, or if there are insufficient funds in the pension pot, employees can continue working.

Research estimating the likely returns and risks of defined contribution pension schemes, taking into account the historical returns on savings vehicles throughout the 20^th century in 16 different countries, suggests that these pensions may result in acceptable pensions on average. But there are worst case scenarios where the pension is far too low (Cannon and Tonks, 2013).

A useful benchmark for the size of a pension at retirement is the replacement ratio, which compares the amount of the initial pension with the final salary, and represents a measure of sustainable living in retirement. Some countries such as France, Italy and Norway face a 10% probability of having a real replacement ratio of about one-quarter.

Conclusions

This article examines the use of the retirement age as a policy instrument that governments may use to balance transfers between the working and retired populations. When the government changes the state retirement age – the age at which individuals can access their state pension entitlements – effectively the government is changing the ratio of the size of the working population to the size of the retired population. It will do this to ensure that the state pension system is sustainable.

Where can I find out more?

The value and risk of defined contribution pension schemes: International evidence: Article in the Journal of Risk and Insurance by Edmund Cannon and Ian Tonks.
Pensions: International comparisons: Research briefing from the House of Commons Library.
World population prospects: From the United Nations, Department of Economic and Social Affairs.
The effect of the reforms to compulsion on annuity demand: Article in the National Institute Economics Review by Edmund Cannon, Ian Tonks and Rob Yuille.