The gaping hole in the Public Sector Pensions Commission report
Nigel has already looked in detail at the IoD sponsored report of the Public Sector Pensions Commission. As he says, the report is based on challenging current assumptions about how you measure in today’s money the cost of pension commitments that go many years into the future.
Their main complaint is that the Government currently assesses the cost of unfunded pension liabilities using a discount rate of 3.5%. They say that this is “artificial” and that it involves “accounting sleights of hand”. There is even the suggestion that the current figures lack “honesty”.
Suggesting that the Treasury, who produce these figures, is dishonest is fighting talk. One would expect, therefore, that the report would give considerable attention to describing and attempting to rebut the basis upon which the figure of 3.5% is chosen. But far from it. The report simply says that the continued use of 3.5% is “unexplained”. But this statement is simply untrue.
The basis for choosing the figure of 3.5% is explained in the following Government publication: “HM Treasury, The Green Book. Appraisal and Evaluation in Central Government”. This is freely available on the web here. The argument that is presented in the document is relatively straight forward and the key paragraph reads as follows:
“5.49 For individuals, time preference can be measured by the real interest rate on money lent or borrowed. Amongst other investments, people invest at fixed, low risk rates, hoping to receive more in the future (net of tax)to compensate for the deferral of consumption now. These real rates of return give some indication of their individual pure time preference rate. Society as a whole, also prefers to receive goods and services sooner rather than later, and to defer costs to future generations. This is known as ‘social time preference’; the ‘social time preference rate’(STPR) is the rate at which society values the present compared to the future.
The discount rate is used to convert all costs and benefits to ‘present values’, so that they can be compared. The recommended discount rate is 3.5%. Calculating the present value of the differences between the streams of costs and benefits provides the net present value (NPV) of an option. The NPV is the primary criterion for deciding whether government action can be justified.”
This blog is not the place for a full explanation of all the economics of this. But, in essence, what the Green Book explains is that when decisions are made about the future there is a proper distinction to be made between the discount rate that it is appropriate for individuals to use and the one that should be used for society as a whole.
And one of the key properties of the latter, i.e. the STPR, is that it does not go up and down with movements in markets, but is set for the long-term.
There is actually an extensive literature on the subject, with many learned academic papers. An easy point of entry for those interested in knowing more is the Wikipedia entry on the social discount rate. The issue has also been explained in a recent discussion paper sponsored by the actuarial profession here. So there really is no excuse for ignorance on the subject.
Now, you may agree or disagree with the Government’s approach and the specific conclusion that it is reached, but the Green Book clearly counts as an explanation and one that requires serious consideration, particularly given its source.
But the authors of the report appear to be unaware that it even exists, casting real doubt on the value of their contribution.