Here is an advance warning: this column is about discount rates, specifically the appropriate discount rate for UK unfunded public sector pension schemes.
Why, you may ask, would anyone want to discuss such an arcane topic? Who cares? Well, if you have to ask, you haven’t been paying attention to pension issues in recent years. Discount rates are key to determining how much members and employers need to pay into schemes. The rate used is effectively the return needed to ensure the pensions that have been promised can be paid. The higher the rate, the lower the cost of providing pensions appears to be.
The UK government announced in the March Budget it has decided to use a discount rate for unfunded public sector schemes of expected gross domestic product growth above inflation, following a consultation. This has annoyed a bunch of accountants and actuaries, who have written to George Osborne, UK chancellor, to complain.
They think the discount rate should be based on the yield on long-dated index-linked gilts, because public sector pensions are inflation-linked and guaranteed by the government – just like linkers.
They dismiss the argument put forward in the summary of responses to the consultation paper that expected GDP growth is the right number because pensions are paid for out of future tax revenues. Gilts are paid out of those revenues too, says the letter, which was organised by John Ralfe, an independent pensions expert. Pensions are debt the government is committed to pay, just like gilts, so how can the future liability be discounted at different rates?
Using expected GDP growth will understate the true cost of providing pensions, with “serious pernicious consequences”, the letter claims.
The government has settled on 3 per cent as the figure for expected GDP growth. This compares with a yield on 2035 index-linked gilts of 0.76 per cent, according to Friday’s FT. Valuing pension liabilities using the latter figure would see them balloon to unaffordable dimensions. The government would have to demand much higher contributions from members, or slash future benefits, or both – not an easy deal to sell to trade unions. No wonder it prefers to fudge the figures.
The 3 per cent figure is lower than the 3.5 per cent currently in use, but still far too high for those who insist on financial correctness. Neil Record, one of the signatories to the letter and author of several publications on pensions, points out in a blog on the Institute of Economic Affairs website that “average real GDP growth in the UK over the past 20 and 40 years has been about 2 per cent pa”.
He is more worried, though, about the unfairness the government decision will perpetuate. Public servants will continue to enjoy “the best type of pension”, while private sector workers will have to make do with defined contribution schemes, which he believes will bring “huge disappointment, anger, poverty and taxpayer-burden”.
The government has opted for political expediency over transparency and fairness, he concludes.
Transparency is partly what did for DB pensions in the private sector. Most are now closed to new entrants and some to existing members too. Accountants succeeded years ago in forcing schemes to use the double A corporate bond rate to discount liabilities, at least for the purpose of reporting deficits on company balance sheets. Triennial actuarial valuations are often based on gilt yields, or the swap equivalent. Before these reforms, pension schemes used the expected return on their assets to calculate the level of contributions required. In the bull markets of the 1980s and 90s, when schemes were heavily invested in equities, this allowed employers to take long contribution holidays.
It didn’t matter much if the sums turned out to be wrong, as employers could dump their pension liabilities relatively easily. Regulation put a stop to that in 2003.
The government is taking a similar approach to measuring costs as private sector schemes did in the old days. But it cannot avoid paying up if its sums are wrong. Why should it be able to calculate its costs differently?
The government argues that it need not account in the same way because public sector schemes are unfunded.
There is a strong suspicion the consultation was for show, and it was a waste of time responding as the decision on the rate had already been made.
Tellingly, a freedom of information request by Mr Ralfe for the briefings given to ministers on the subject was turned down, on the basis that the public interest in withholding the information outweighed that of disclosing it.
It looks like the bean counters will not get their way this time.