Defusing the bomb

The term "demographic time bomb" has become common currency in discussions related to pensions planning. It refers to the changes that are expected to take place within the UK population over the next 40 years. A declining birth rate and improved medical capabilities mean that pensioners, with their additional care costs, will represent an increasing proportion of the population.

As their numbers increase, pensioners will place a growing burden on the tax-paying - and shrinking - working population. The proportion of people in work is set to fall dramatically relative to the number of people in retirement, from 2.2 contributors per pensioner today, to 1.8 in 30 years' time. This is known as the dependency ratio. In effect, the argument runs, we will not be able to afford even the limited state pension now on offer to our elderly citizens.

It sounds horrific. However, as Corporal Jones was wont to say, don't panic. The UK population may be ageing but it is a slow process, so there will be time to defuse this time bomb.

Professor David Simpson, economic adviser to Standard Life, offers a less than apocalyptic view when he says that: "The dependency ratio is not going to detonate suddenly in the UK; it will decline at a slow and manageable rate until 2030, after which it will either level off or start to improve."

That said, the trend cannot be ignored. Concern focuses on that half of the 27.5 million working population who are not in occupational or other funded pension schemes. As things stand, their well-being in retirement will be the government's (read taxpayers') responsibility through the unfunded state benefits system, including Serps. And that will be the worry for any government - that the cost of paying pensions to an increasing third-age population may be an unacceptable burden for working tax payers and National Insurance contributors. Many future third-agers might be prepared to save into a funded pension scheme if:

l they could afford it;

l the scheme would be appropriate to their needs;

l administration costs would not eat up a large proportion of their savings.

It is partly the absence of these factors that dissuades many modest earners from saving for their retirement.

The first point might be covered by developing a second-tier pension scheme similar to the industry-wide schemes available in Australia. These schemes, essentially occupational schemes with wide access, offer to all Australians a funded (paid for by the beneficiaries, not the current working population) second-tier pension facility. The size of the scheme keeps costs down.

Affordability also has to take into account access to funds which, with pension funds, is difficult, in exchange for favourable tax treatment for contributions and investments; the saver forgoes access to the fund before retirement. This is believed to deter many modest earners who, even if they could afford savings, would be loth to invest in a fund which would effectively be closed until retirement.

While access to pension funds may not be ideal, if it encourages more people to save into funded schemes, it will help reduce the burden for future taxpayers. Also, the Labour Party is studying funded second-tier provision options industry wide - in Labour parlance of the day, this means stakeholder pensions. These should reduce costs.

For some, modest means are not the issue. There is no doubt that some comparatively affluent groups have the resources of fund pension provisions the equal of any working income. For instance, the post-war home ownership boom has left many people as beneficiaries of substantial capital legacies which could largely fund their retired life.

It is estimated that the current value of UK domestic residential property is pounds 1.2 thousand billion, while the total mortgage book for all lenders stands at about pounds 400bn. On the basis of those figures, there is some pounds 800bn of free equity currently available in the UK domestic property market.

Many will remember with concern the home equity plans of the late Eighties which saw some unfortunate pensioners risk losing their homes. However, lenders are back with new ideas, some of which should certainly permit the use of free equity without the twin concerns that the home-owner might be made homeless, or that their family would be denied any value on their death.

One such scheme has recently been launched by the Bank of Scotland. The Shared Appreciation Mortgage allows those in or near to retirement to utilise some of the equity in their homes to fund pension or long-term care arrangements.

The scheme offers a choice of two interest rates. With the first, borrowers pay a long-term fixed interest rate of 5.75 per cent (at time of writing). Borrowers on the second scheme pay 0 per cent interest. At death or surrender, the bank will receive the original amount lent plus a percentage of any capital appreciation since inception.

Where the 5.75 per cent rate is chosen, equity appreciation will be shared according to the original loan to value (LTV): 65 per cent LTV means that the bank will take just 65 per cent of any appreciation between inception and surrender. For borrowers selecting nil per cent interest, the bank's share of any appreciation will be three times LTV, so that 20 per cent LTV will mean the lender taking 60 per cent of any appreciation.

The government could also assist in the task of time bomb disposal. According to the National Association of Pension Funds: "The vast array of complex Inland Revenue regulations is totally unnecessary as only 1 per cent of individuals make full use of the tax system to benefit from a full pension."

NAPF also calls for an increase in personal contribution limits to occupational schemes, so that members (especially older ones, who have the resources and whose need is most imminent) have the same opportunities to invest in pension provision as do holders of personal pension schemes.

None of this means that the demographic time bomb does not exist. But it does mean that through greater legislative flexibility, administrative efficiency, innovative scheme design and releasing some of the large amount of free equity locked up in housing stock, it should be possible to defuse the bomb and ensure that we get past the peak of the problem in 2030 without mishapn