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The public-sector pension gap

Stephanie Flanders | 08:45 UK time, Wednesday, 7 July 2010

The government has stolen some of the Public Sector Pension Commission's thunder by putting public sector pensions on the agenda so soon after the election. But ministers will be grateful to this independent group for putting so many eye-popping statistics into the public domain.

public sectorPublic sector unions will note that the report has been sponsored by the Institute of Directors and the free market think-tank, the Institute of Economic Affairs. But at least one of the report's authors - Ros Altmann - has often been on workers' side in calling attention to the dwindling state of private pensions. Others, such as Peter Tomkins, of the Institute of Actuaries, are recognised experts in the field.

Many of the key facts and arguments in the study will be familiar to readers of my and Robert Peston's recent posts on the subject. In essence, the report says that the official statistics are not capturing the true cost of the promises being made to public sector workers in unfunded pension schemes (which means most of them - the big exception being workers in local government, which have funded pension schemes.)

When the government estimates what its future pension liability is worth, it uses a fixed real discount rate of 3.5%. If you do that, the future promise of a guaranteed pension that members of public sector schemes clock up each year is worth about 20% of their salary - which is roughly what employers and employees pay the Treasury to take on that future obligation.

But right now, real interest rates are much, much lower than 3.5% - meaning that you would need to put aside a lot more than 20% of salary today if you wanted to meet that future pension obligation in the future. (Anyone who has recently looked into the price of annuities will grasp the problem.)

If you discount the pension promises by 0.8%. which is the current real interest rate on indexed-linked government debt, the report shows the true cost of these schemes is more like 40% of salary - or more than 70% in the case of police officers and firemen.

Is that the right way to value the promises? I think it depends what you are trying to capture.

If you want to show public sector workers what their pensions would cost if they were replicated in the private sector, then this is clearly the right figure. Right now, 40% is what a funded pension scheme would need to put aside to be sure of meeting the future obligation (the report recounts the Bank of England going through exactly this process with respect to their scheme).

This is worth doing - as I said in that earlier post, public sector workers ought to know what their pensions are worth, for the sake of transparency and for their own sake in comparing their public sector job with one somewhere else.

Equally, if you want to "mark-to-market" the obligation on the government's balance sheet, as many private companies must, this is right discount rate to use. But there is a reason that these schemes are not funded - it is because they are provided by the government.

The government can do things that private companies can't, because it has the unique capacity, through the generations, to raise tax revenues to meet its future obligations. It doesn't have to go out and sell gilts on the market right now to meet all those future promises (even if some people would like it to).

So you could also make a case for discounting the stock of liabilities at a long-term average real cost of borrowing for the government, rather than the rate at this one point in time. On that basis, the government discount rate still looks too high - but not quite as bad as the commission suggests. For 10-year index-linked gilts, the average yield since 1984 has been 2.9%, though that average is clearly falling over time.

Apparently, the Treasury put a similar argument to the commission. In response, the report calculates what public sector pensions are worth using a discount rate of 2%: the 40% figure falls to about 27%.

Anyone involved with private sector pensions knows how much "pension deficits" can change, depending on the discount rate used. The answer given by economists tends to be that there is no right answer - you use different rates to capture different things.

But the basic argument of the report is hard to quibble with: public sector pensions may be "affordable" in their current form, but it is difficult to believe they are sustainable, at a time when private-sector pension provision has fallen so far.

Only 11% of private sector workers are in final salary schemes today, but 94% of public sectors workers are. Well over 50% of private sector workers don't have any employer-sponsored pension scheme at all.

This report's greatest contribution to the debate lies less in the scary numbers but in the range of options it offers for reform, and in the words of good sense it offers to those who must come up with proposals on this for the government - for example, they make the point that the prime minister's promise to cap public sector pensions at £50,000 a year will do very little to cut costs because it would affect relatively few retirees. The real savings come from capping the salary on which pension benefits can be accrued. The report reckons that a £50,000 cap on pensionable salaries in the civil service would cut costs by 2.3% - not a huge amount, perhaps, but far more than a similar cap on the pension that can be paid out.

This is no page-turner (at least for normal human beings). It is, after all, about the ins and out of public sector pensions. But any minister who wants to lay down the law on the subject would be well advised to give it a read.

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