The CBI on public sector pensions (1)
The CBI’s latest report on public sector pensions was released last week (whilst I was away). Naomi has already responded on Left Foot Forward, but I know our friends in the CBI would be disappointed if there was not a TUC critique too . So here is the first of a number of posts.
As might be expected the CBI’s take is far more measured than we have come to expect from the IoD. It’s particularly welcome that they don’t repeat the tired, but deeply offensive “pensions apartheid” cliche that normally punctuates attacks on public sector pensions. And it is clear all the way through that existing benefits built up by staff should be honoured – this is often far from clear in some of the other attacks.
But there are still problems with its analysis which undermine its conclusion that radical cuts in public sector pension provision are needed.
In particular – like much of the other employer/think-tank attacks – it makes far too much of trying to work out the cost of public sector pension liabilities, and it’s this aspect I want to look at today.
Putting a figure to pension liabilities is an attempt to work out the cost of paying the future pensions already built up by public sector workers as a single bill payable in today’s money. In a private sector scheme this is not unimportant. If a company was to go bust tomorrow it would still have pensions liabilities – and it is right to expect its pension scheme to have a reasonable chance of meeting them.
But liability figures provide little or no useful information about the affordability or sustainability of public sector pensions.
For a start it is far from straightforward to work out the cost of these liabilities. Not only are there the obvious difficulties of not knowing how long people will live and what future inflation is likely to be, but also the technical – but highly controversial – issue of how you express a future commitment, in say fifty years time, in today’s money. The usual way of doing this is by using a notional interest rate called the discount rate. Once you have decided your discount rate, you then work how much you would need to invest at this rate of return to fund your future commitment.
In the private sector, schemes can work out how much this would cost by using the interest rate on government bonds and actuarially agreed longevity projections. But in practice pension schemes invest in more balanced portfolios that over time can achieve better returns than simply investing in gilts. The need to use this gilt-based calculation and include it in a company’s main accounts is often cited as one of the reasons for the decline in defined benefit schemes in the private sector. Most pensions experts would rather find another way of doing this in the private sector.
Of course individual public sector schemes and the Treasury should have a handle on future pensions commitments, and future liabilities help set contribution rates. But this calculation of liabilities is not the best way to assess the future affordability of public secto pensions. Small variations in the chosen discount rate can alter the figure hugely when costs go many years into the future. As the National Audit Office say in their recent report on public sector pensions:
Changes in the discount rate lead to large fluctuations in the size of pension liabilities, but have no effect on projected pension payments. For example, the discount rate increased by 0.7 per cent in the year to 31 March 2009 for the four largest schemes. There were no other changes that year to key financial assumptions underlying liabilities, but the discount rate change alone reduced the total liability across all four schemes (teachers, health, civil service, armed forces) by approximately £73 billion.”
Discount rates go up and down with other interest rates. If interest rates are high, the liability figure will go down as you wil have to invest less money to cover future commmitments. Conversely when interest rates fall, the liability figure will go up. But the amount of money the public sector has to find to actually pay its pensions does not depend on interest rates in any way.
This is why the Daily Mail and its ilk can say that the costs of public sector pensions “soared” every time interest rates have fall. Somehow I doubt that they will do the opposite when rates start to rise again.
Private sector complaints that the liability figure can be misleading are even more true in most of the public sector. The public sector will go on in perpetuity. Public sector pension liabilities can never therefore be a red final demand bill that has to be paid in the next seven days.
Most public sector staff are in so-called unfunded pension schemes. These do not have their own pension fund invested in the way that private sector pensions do. Instead employer and employee contributions, which are calculated using the rigorous SCAPE procedure overseen by the Treasury, are paid into the general public finances and pensions are paid out of the same general tax pot. (Unfunded is a really unhelpful term as it suggests there are no contributions paid. This is why “pay-as-you-go” is a much better description.)
Government does not therefore have to invest a certain amount each year to cover future liabilities, but has to be confident that it can fund pensions in payment. The best way to do this is to estimate what they will cost as a percentage of GDP – the wealth created each year. The tax take goes up (or down) in line with GDP. This is how the Treasury estimates the future affordability of public sector pensions. The NAO report endorses this saying:
This report focuses on cash payments because:
- projected cash payments are considered by the government to be the most relevant measure of the cost of UK public sector pay-as-you-go pension schemes over the next fifty years;
- projected annual cash payments can be related to estimated annual Gross Domestic Product as a measure of the country’s ability to pay;
- cash projections include pensions expected to be earned in the future, and are useful for decision-making about changes to schemes, whereas liabilities represent only pensions already earned that would be unaffected by scheme changes; and
- liability calculations can fluctuate substantially because of changes in one significant assumption, the discount rate, which does not affect cash payment projections.”
Liability projections provide nice big scary numbers for those attacking public sector pensions, but do not mean a great deal in assessing their affordability or sustainability. Here are two graphs from the NAO report that show the costs of the big unfunded schemes are not out of control or unaffordable. You can click on them to enlarge.
It is, I think, significant that the CBI do not even consider the merits of presenting the future costs of public sector pensions in this way.
There is a fundamental difference of approach between economists on the one hand and actuaries and accountants on the other. While I’m “none-of-the-above”, the economists are right on this.
As Frank Eich in an interesting paper on public sector pensions says:
When assessing the sustainability of public sector pensions, actuaries and accountants in the UK have generally taken a different approach to that chosen by economists in finance ministries and international organisations. Instead of expressing public sector pension spending as a share of future GDP and assessing sustainability in the context of other spending pressures, they calculate the present discounted value (PDV) of unfunded pension liabilities accrued today. As with all PDV calculations, this approach is very sensitive to the chosen discount rate and generally yields very large absolute numbers which capture flows taking place over several decades. Using this approach, non-government actuaries and accountants have calculated that the stock of unfunded public sector pension liability in the UK amounted to around £1000bn in 2007 and have suggested that this should be added to the government’s national debt to give a clearer picture of the government’s legal obligations.
The British general public appears to have endorsed this latter approach as the appropriate way to assess the fiscal sustainability of public sector pension arrangements and has concluded that these are indeed unsustainable, even though the projected absolute increase in public sector pension spending between 2007-08 and 2047-48 is smaller (at 0.3 per cent of GDP) than for education, long-term care, state pensions or health.
While I am not sure that the general public have any clue about how best to value pensions, the rest is spot on.
I can understand why pensions experts in the private sector, who have seen such a big decline in the defined benefit pension schemes where they have spent their working lives, want to impose the rules that they resent in the private sector on public sector schemes (although the changes in the way that pension scheme liabilities and deficits are reported are not due to the government, but accountancy standards.) The net result however is a race to the bottom. It would be much more constructive to talk about how to improve private sector pensions (and indeed I detect more and more interest in making DC better and exploring new forms of risk sharing among progressive employer groups).
But there is another lobby within the CBI that argues for the transfer of public services from the state to private sector firms. They resent the TUPE rules that protect the pensions of staff transferred from public to private sector. They have an interest in making public sector pensions much worse so that they can take over public sector activities.
In my next post I want to look at waht the CBI have to say about the net cost of public sector pensions.