The £600 billion question
How public sector pension liabilities are being undervalued at the expense of future generations
Author: Neil Record Date: May 2014 The Intergenerational Foundation The Intergenerational Foundation (www.if.org.uk) is an independent, non-­‐party-­‐political charity that exists to protect the rights of younger and future generations in British policy-­‐making. Whilst increasing longevity is to be welcomed, our changing national demographic and expectations of entitlement are placing increasingly heavy burdens on younger and future generations. From housing, health and education to employment, taxation, pensions, voting, spending, transport and environmental degradation, younger generations are under increasing pressure to maintain the intergenerational compact whilst losing out disproportionately to older, wealthier cohorts. IF questions this status quo, calling instead for sustainable long-­‐term policies that ensure younger and future generations are better protected by policy-­‐makers. For further information on IF’s work please contact Liz Emerson: Intergenerational Foundation, 19 Half Moon Lane, London, SE24 9JS www.if.org.uk [email protected] 07971 228823 @inter_gen This work is licensed under a Creative Commons Attribution-­‐ShareAlike 3.0 Unported License 2 Foreword Pensions are central to concerns about intergenerational justice. A pension is essentially a financial promise made today to pay someone an income in the future, paid for by future generations. The relationship between those making these promises today and those who will pay later is one-­‐sided, advantaging those that can argue their case now over future generations who cannot speak for themselves. This is the case with public sector pension promises, which, according to government figures are currently worth £1.1 trillion, to be paid for in the future, largely by our children and grandchildren. It is accepted wisdom that debts should get more manageable as we become wealthier in the future. But what happens when our projections are over-­‐optimistic or simply plain wrong? How can we borrow from the future in a way that is fair and that balances the expectations of those of us who are alive today with the costs borne by future generations? Future generations may well have to contend with long periods of low growth, higher taxation to support an increasingly long-­‐lived population and longer working lives themselves. Government economists use a “discount rate” to estimate the current cost of future liabilities. In this important new paper leading economist Neil Record argues that the government has got its figures very wrong. Record makes a convincing argument that the government should be using a discount rate that reflects the long-­‐term cost of borrowing. This would mean adopting a real discount rate close to zero (reflecting current market conditions), which is far removed from the 2.35% or 3% p.a. figures currently used by the Treasury (the two figures being for pension liabilities and current cost respectively). This report should act as an urgent wake up call for policy-­‐makers that the need to reform public sector pension benefits is greater than it has ever been, and misleading accounting of our future debts is extremely unfair towards future generations. Angus Hanton, IF Co-­Founder 3 About the Author Neil Record founded Record Currency Management in 1983, where he has been principal shareholder and Chairman ever since, having previously spent the early part of his career working as an economist at the Bank of England. He is the author of numerous articles on currency and other areas of risk management, is a frequent speaker at industry conferences and seminars in the UK, US and Europe, and is acknowledged as one of the leading figures in the currency management industry. He is a Visiting Fellow and Investment Committee member of Nuffield College, Oxford, and a Trustee of the Institute of Economic Affairs, London. 4 Executive Summary The issue of the “discount rate” has become increasingly important in the debates over public sector pensions which have taken place during the past few years. At the heart of the matter is a simple question: how much are the future pensions that will be paid to public sector workers worth today? In this provocative analysis, the economist Neil Record argues that the current official estimates of liabilities for the main public sector pension schemes are deeply flawed because they use an artificially high discount rate. If the government was forced instead to use a market discount rate that mirrored the government’s long-­‐term cost of borrowing, then the true size of the liabilities would quickly become apparent, leading to new debates about whether Britain can afford to pay these pensions or not. In particular, Neil Record argues that: • The true cost of the government’s total public sector pension liabilities in 2012/13 was really almost £600 billion greater than the cost according to official estimates; • The government officially estimates that these liabilities are worth £1.1 trillion, when in fact they are worth nearly £1.7 trillion using a more realistic discount rate; • The Government uses a variable artificial discount rate to calculate the outstanding public pensions liability. At 31 March 2013 this was 2.35% p.a. over CPI. A more realistic discount rate would be the yield on index-­‐linked government gilts over RPI adjusted for the expected RPI-­‐CPI difference – or 0.26% p.a. over CPI at 31 March 2013. • Oddly, the Government uses a different (and fixed) discount rate to calculate the annual ‘cost’ of pensions. This was fixed in March 2011 at 3% p.a. over CPI, and is “wrong in every respect” as it drastically understates the real cost of providing pensions. • The result of these artificially high discount rates is that all parties – politicians, taxpayers and unions – have been misled about the true cost of public sector pensions and the impact of the most recent round of reforms. Neil Record concludes by making a forceful case that future generations will be the biggest losers overall from the current use of inaccurate discount rates – “rewarding an older generation at the hidden and unrecognised expense of a younger generation until it is too late is morally indefensible” – and urges the government to reconsider using a market discount rate instead. 5 How using the wrong discount rate hurts future generations One of the areas of almost unanimous agreement when the Coalition was established was the desire to reform public service pensions. Hence, the Chancellor got to work, and we now have the Public Service Pensions Act 2013. On 20 June 2010, the Chancellor announced the formation of an Independent Public Service Pensions Commission chaired by Lord Hutton, who had previously served as Work and Pensions Secretary under Labour. In the Commission’s Terms of Reference the Chancellor asked for “recommendations to the Chancellor and Chief Secretary on pension arrangements that are sustainable and affordable in the long term, fair to both the public service workforce and the taxpayer…while protecting accrued rights”.1 However, two days later, in the June 2010 Budget Report, George Osborne undermined this pledge to protect accrued rights by changing the basis of indexation of public sector pensions both in payment and deferred from RPI to CPI. This was, in my opinion, poorly thought out and rushed through to close a short-­‐term funding gap. I think it endangered the British Government’s reputation for treating its creditors fairly and respecting the rule and spirit of the law. The impact this had on the total liabilities – which have subsequently started rising again – is shown below in Fig.1: Fig.1 UK public sector unfunded occupational pension liabilities, £bn2 Most economists regard the likely difference between the two inflation indices to be about 0.7% p.a. (or possibly a little higher), with CPI the lower (because it doesn’t include housing costs and uses a different weighting methodology). 1 HM Treasury (2010) Chancellor announces John Hutton to chair commission on public service pensions (Press Release) London: HM Treasury 2 Estimates correct as of March 2013, government’s own figures 6 For a difference of this magnitude, a typical final salary public sector pensioner would lose about 10% of the net present value (i.e. the value today) of his or her lifetime stream of pension payments. The loss to Career Average Revalued Earnings (CARE) schemes is likely to be rather more, because of the importance of the price index in historic salary revaluation. Lord Hutton’s report made two major recommendations for structural reform, both of which the Government accepted. One was to raise the pension age in public sector pensions from generally 60 (occasionally 65) to the new State Pension Age, equating men and women at 65 – then rising to 68 by 2046 (now accelerated). The other was to change the basis of calculation of the pension from ‘Final Salary’ to CARE. The imposition of the raised pension age has reduced the value of public sector pensions, as has the change to CARE (although modestly). Lord Hutton also recommended raising employee contribution rates, particularly for the higher paid, and the Government has also implemented this. These reforms to the schemes’ design (excluding perhaps the CARE reform) were necessary, but they have not gone far enough (see below). The indexation change, although very effective at reducing at a stroke the Government’s liability, was, I believe, a breach of the spirit of the pension covenant. But one glaring third reform was needed to eliminate a hidden subsidy in public sector pensions, and that was the removal of the artificial discount rate used to calculate the cost of pension provision – and its replacement with a market discount rate. This may sound esoteric, but the distortions introduced by an artificial discount rate are huge. Why? Because the cost of an unfunded public pension is best described as follows: “The cost of a public sector pension is how much of a salary increase the government would have to give its workers in exchange for cancelling their future pension rights while leaving them in a position to buy exactly the same pension in the market using the additional salary. Government would have to borrow the money to fund the salary increase in such a way that its future cash flows would be identical to the cancelled pension promises. Such a calculation is determined by the yield on UK Government index-­linked (IL) gilts, which are also the securities that the pensioners would buy.” The Coalition Government inherited an artificial public sector pension discount rate of 3.5% p.a. above RPI. Using this discount rate, it appeared that a pre-­‐reform NHS pension (Final Salary; 1/80th accrual; lump sum 3x pension; retirement at 60) cost 22% of pay, of which the employees paid 6%, so the net benefit appeared to be about 16%. Other schemes (such as the Teachers’ and Civil Service pension schemes) were very similar. But this is a grossly inaccurate calculation. The market rate at 31 March 2013 for 20-­‐year duration IL Gilts, and the Government’s own borrowing rate, is minus 0.44% p.a. over RPI. Using this rate, and leaving RPI as the index, the NHS pension above costs 69% of pay, not 22%. This is the ‘real’ cost, as described above, so this is not an esoteric point. After a public consultation, in March 2011 the Government announced a new public sector pension discount rate to calculate pension costs – in theory the growth rate of GDP – but interpreted as 3% p.a. over CPI. As an aside, the Government uses a different, but also artificial, discount rate to calculate outstanding pension liabilities. For 31 March 2013, this was 2.35% p.a. over CPI. Setting aside the 3% p.a. ‘growth’ sleight of hand (GDP real growth has averaged 2% p.a. over 40 years), this is not a rate at which Government is borrowing or lending, nor at which private sector pensioners can invest their pension contributions. But this discount rate has been deemed to be the basis for all public sector pension “costs” on the grounds that since public 7 sector pensions are paid out of future taxes, then the discount rate should be the prospective nominal rise in the tax take. This argument is wrong in every respect: public sector pensions are not a public good, they are a private reward for employment. The calculation of their cost should be with reference to the cost to any (not specially privileged or subsidised) member of the public. Even if all pensioners were given this pension, I would still argue that the principle is wrong, because rewarding an older generation at the hidden and unrecognised expense of a younger generation until it is too late is morally indefensible. Table 1 below shows the NHS pension “cost” (as % of pay) using (a) the recently adopted, artificial discount rate and (b) market interest rates at 31 March 2013. The left-­‐hand column is very similar to the calculations produced by the Pension Policy Institute when they attempt to estimate the savings from public sector pension reform, but using only the government’s official discount rate.3 NHS Pension Promise Cost as % of salary using different discount rates (a) At 3% over CPI (b) At market rates 31 March 2013 4
Pre Reform: 32% 69% Final Salary, retire at 60, RPI indexed As above + retire at 65 28% 61% As above + change to CPI 26% 56% As above + retire at 68 24% 52% As above + CARE 22% 49% Table 1. Estimates of the cost of providing NHS pension promises as a percentage of salary using different discount rates and reform scenarios The difference between the official estimate of the government’s total public sector pension liabilities over time and what these would have been if a market discount rate had been used instead is shown in Fig.2. 3 Pensions Policy Institute (2012) The implications of the Coalition Government’s reforms for members of the public service pension schemes London: Pensions Policy Institute 4 This pension would cost 22% of pay if discounted at 3.5% over RPI. In this report, 3% over CPI is assumed to be the same as 2.3% over RPI, and the difference between 22% and 32% is wholly accounted for by the change in the artificial discount rate from 3.5% to 2.3% over RPI. 8 Fig.2 UK unfunded public sector pension liabilities estimated using different discount rates, years ending 31 March, £bn In summary, this Government has explicitly chosen to adopt an artificial discount rate which massively understates the true cost today of accruing new public service pension obligations, and as a result all parties (politicians, taxpayers, unions) are ignorant of the real effect of the reforms, and at the very least, taxpayers will continue to offer extremely generous pensions to public sector workers (but with the extent of the generosity hidden), to be paid for by future generations of taxpayers who are unable to discover the extent of the promises made on their behalf. 9