The government says that when in introduces the flat-rate pension it will also honour contributions to the current system. This should mean that when retirees have accrued rights to an earnings related state pension that, when added to the basic pension, is more than the flat-rate, they will continue to get the higher amount. But this poses a problem if the government sticks to the aim of no increase in public spending on state pensions, as some resources will be needed to pay the higher pension to those that have accrued less than the flat-rate amount. Put simply, it means that you can’t have any gainers without any losers, with the clear implication that the government expect the money to come from other pensioners.

An important consequence of moving to single tier provision, according to the Budget Report, is the end contracting-out for defined benefit pension schemes. However, the Government says that it will investigate the potential impact of this on employees and schemes in both the private and public sectors. This is crucially important, as abolishing contracting-out for defined benefit pension schemes would mean, all else being equal, increased contributions for both employers and employees that still have such arrangements. This is bound to lead those employers who are affected to seek to renegotiate their schemes, with all the momentum leading to fundamental rather than minimum change. Experience suggests that this is bound to mean that members will end up being worse off. The future for defined benefit schemes is already bleak enough without the abolition of contracting-out for such schemes adding to their problems.

One notable point in the section on the green paper is the statement that the new flat-rate pension would still be “contributory”, i.e. entitlement will depend on the payment of contributions while at work. What this means is that the government has already ruled out, even in advance of the consultation, the idea of a “citizenship pension”, i.e. one that is paid to everyone, regardless of the contributions they have paid. Consequently, some system of state pension contributions will have to be maintained. This is despite the parallel announcement in the Budget that the government will also be consulting this year on integrating the “operation of income tax and National Insurance Contributions (NICs). The way this proposal is worded suggests that the government has rejected the idea of consolidating the two deductions into a single tax on incomes. It’s only the “operation” of the two deductions that is being integrated, rather than aiming at having a single tax. My assumption is that the Treasury has worked out that the distinction between the two types of deduction needs to be maintained, with NICs surviving in some form, so that it can maintain the contributory principle for the state pension. It will also make it easier to avoid the political suicide that would be involved for the government if the single deduction were extended to earnings above State Pension Age or to other forms of income, such as pensions, savings and dividends.

Finally but not least as far as state pensions are concerned, the government has said it will bring forward proposals to manage future changes in the State Pension Age more automatically, including the option of a regular independent review of longevity changes. Few details are given of what the government has in mind on this but it is possible that it is deluding itself about what might be possible to achieve. The problem is that people have to plan for their retirement and, as part of that, they should have a right to know reasonably far in advance when they will receive their state pension. So this means the independent review would need to know not what longevity is now, but what it will be many years in the future. And this is not just unknown, it is unknowable.

So what we have on state pensions are a green paper on a flat-rate pension for new retirees; an investigation of what that means for contracted-out defined benefit schemes; a consultation on integrating the operation of income tax and NICs; and proposals for a mechanism to decide on further increases in State Pension Age. Lots of questions but no real answers

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.

The change is the Government’s proposal to adopt the CPI rather than the RPI for the indexation of benefits, tax credits and public service pensions from April 2011. So the change directly affects every current or future pensioner who is entitled to a State Second Pension (previously SERPS) or to a pension from a public service pension – that means almost everyone who has ever been employed.

The Consumer Prices Index (CPI) and the Retail Prices Index (RPI) are both measures of the cost of living. One important difference between them is the basket of goods and services upon which they are based, with only the RPI including housing costs. So whenever housing costs increase faster than other prices, increases in the RPI will be higher than those in the CPI. But the reverse also applies, like at present, and the CPI can be higher than the RPI. In the long term the effect should be neutral, except to the extent that people consistently spend more (or less) on housing. In the short-term housing costs are expected to increase faster than the average, as interest rates return to more normal levels, so the RPI is likely to be higher for some years to come.

But there is also a significant technical difference in the way that the RPI and the CPI are calculated. The RPI is an arithmetic mean of price changes (the increases are added together and divided by the number of increases), while the CPI is a geometric mean (the increases are multiplied together and the nth root is taken – where n is the number of increases). While this appears abstruse, of interest only to mathematicians, the Treasury have estimated that:

“… the CPI annual rate would typically have been about 0.5 percentage points higher if the elementary aggregates had been calculated using arithmetic means as in the RPI.”[1]

In other words, pension increases will in future average about 0.5% less each year, simply because of the change in the way the index is calculated.

So which index is the right one? This is a topic of much debate among statisticians and, of course, there is no single correct answer. It all depends on what you are trying to measure. But for most people, looking at what they buy themselves at the shops and elsewhere, there is little doubt. They want to know how much more their basket of goods will cost today, compared to what it cost yesterday. And this is shown by an arithmetic mean.

As a very simple example, imagine the basket of goods is a loaf of bread and a kilo of potatoes. Initially they cost 50p each so the total cost is £1.00. But then, over the year, the price of bread increases by 4%, while that for potatoes increases by 8%. So the bread costs 52p and the potatoes cost 54p, which means the basket now costs £1.06, an increase of 6%. It can be seen that this is the weighted average of 4% and 8%.

But the geometric mean of increases of 4% and 8% with equal weights is 5.98%. In this example it makes only a minor difference in the result but, as mentioned above, the Treasury estimate that in practice it means a difference on average of 0.5% per annum, when compounded across a whole basket of goods.

Table C2 in the Budget report shows the pension increases that can be expected over the next 6 years, i.e. the increases due in April of the respective year, based on the forecast price increases in the previous year. These are summarised in the following table:

What this shows, using the Government’s own figures, is that over the next six years increases in SERPS/S2P and public service pensions will total 13.7%, rather than the 22.1% that was previously expected. This is, in effect, a cut of 7.4%, of which I estimate that 4.3% is due to differences in the coverage of the index and 3.1% is due to the way it is calculated. So you might have thought that the question posed in the title is only of technical interest, but it is actually going to cost a large number of people significant amounts of their pension.