CPI shift makes public sector pensions much poorer value
Many commentators stress the notion that “fairness” is profoundly subjective.
I will offer the following simple way of measuring fairness in pension saving. The proportion of our national output that we pay in contribution savings today should equal the proportion of national output that we receive as pensions in retirement.
This seems eminently reasonable for any scheme member whether they work in the public or private sector. If you don’t get back what you contribute in this way, then the incentive is to consume today, rather than to provide for your retirement. If I get back what I have put in real and relative terms – if my share of the national cake is unchanged – that is fair.
This gives us a way to assess the recent change in pensions indexation from the retail price index (RPI) to the consumer price index (CPI) for public sector (and many private sector) pensions.
Contributions for public sector schemes are determined by assessing the cost of future pension commitments and then working out what would need to be contributed today to pay for them. This process is known as SCAPE (Superannuation Contributions Adjusted for Past Experience).
A key issue in setting contributions in any pension scheme is assessing how contributions will grow before they are used to pay for pensions. In private sector and the local government scheme, funds are invested and pension schemes therefore have to take a view about how they will grow.
The big public sector schemes do not invest their funds. Instead members of these ‘pay-as-you-go’ funds pay their contributions to the Treasury who in turn pay out pensions. Although the funds are not invested and are treated as part of the ebb and flow of public finances, there are still notional funds that are assumed to grow in line with an interest rate called the discount rate.
This is entirely legitimate. The tax payer gets the benefits of the contributions in the scheme until they have to be paid back as pensions. Scheme members are loaning their contributions to the Treasury and it is right that they should get an investment return on this.
Until recently the Treasury SCAPE (Superannuation Contributions Adjusted for Past Experience) discount rate was RPI plus 3.5%. With GDP having grown in the 2.5% – 3.0% range over the past few decades, it implied a small relative gain. It was, perhaps, marginally generous.
As we shift to the new SCAPE formula of CPI plus 3%, we need to adjust for the difference between RPI and CPI growth rates. CPI is normally lower than RPI because it excludes some goods and services such as housing costs and a technical difference in the way they are calculated. The independent Office for Budget Responsibility now says that this difference over the long-term future will be between 1.3% and 1.5% annually.
The equivalent change from the old formula to the new is then from RPI plus 3.5% to RPI plus 1.5%/1.7%.
To this must be added another technical effect. The reported rates of GDP growth are also increased by the shift from RPI to CPI – by about 0.3% annually.
This means that the RPI to CPI shift can then be seen as from RPI plus 3.5% to RPI plus 1.2%/1.4%. This difference is not the widely promoted 15% cost. The new arrangement actually delivers just 34% to 40% of the old return.
This is all rather technical. And it takes no account of the other changes in terms; in retirement ages, contribution rates and the like.
It might be simpler to say that the old style public sector pension would have been unfair to a pensioner when GDP growth exceeded 3.5% – not that often. In future it will be unfair whenever GDP growth exceeds 1.2% to 1.4%. Historically this happens most years.
Public sector workers are therefore being asked not just to lead the austerity drive today, but are also being excluded from participation in any good times that may lie ahead. Where’s the fairness in that?
Perhaps more importantly, there is no incentive for the public sector employee to promote growth in excess of this lower amount even though our national capacity to grow is perhaps closer to 2.5%-3.0% p.a., since that only worsens their relative position in retirement. What sort of incentives are those?