The correct pension discount rate

Last week’s publication of Lord Hutton’s report on UK public sector pensions, recommending a move to career average and an increase in the normal retirement age, has overshadowed the Treasury consultation on the correct discount rate for new public sector pension promises, which has just closed.

This is not just a technical issue; if we overstate the discount rate – currently inflation plus 3.5 per cent – we understate both the current economic cost of public sector pensions and the real economic savings from the Report’s recommendations.

Furthermore, overstating the discount rate, and understating pension costs means individual public sector bodies cannot be run efficiently, and at the macro-level, the current generation of taxpayers is passing on an economic cost to be paid by future generations.

The Treasury suggests four possible discount rates: the index-linked gilt (ILG) rate, the corporate bond rate, the expected GDP growth rate and the Social Time Preference Rate, used in public sector cost-benefit appraisals. The current discount rate was fixed in 2001 at 3.5 per cent real, the same as the STPR and the Treasury’s estimate of average gilt yields.

The correct discount rate to measure the economic cost of new public sector pension promises must be the yield on long-dated ILGs, since they share similar characteristics: both are obligations of the UK government, both are contractually committed, legally-binding contracts and both are inflation-linked (subject to the differential between RPI and CPI indexation in public sector pensions).

The ILG yield should be the forward-looking market rate at the beginning of the year, like IAS19, the the double A corporate bond discount rate that applies to private sector pension schemes, not a “smoothed” historical average.

Public sector financial reporting has moved away from cash accounting to proper accrual accounting – recognising a cost when it is incurred not when it is paid. As a practical matter, each public sector scheme would calculate its annual cost, as a percentage of salary, based on the ILG rate, which employers would use in their management and financial accounts.

Annual cash contributions may change at each actuarial valuation, with changes in ILG yields and mortality, but should be similar to the economic cost in the accounts over number of years.

What about the Treasury’s other suggestions for the discount rate?

A corporate bond discount rate for funded private sector pensions reflects their credit risk. Since there is no such credit risk in public sector pensions, backed by the government, a corporate bond rate would understate their economic cost.

The consultation suggests the possible argument for using expected GDP growth is that pensions are “paid for out of future tax revenues”.

But gilt interest and principal payments are also paid for out of future tax revenues. Surely this does not mean that new gilt issues should be valued by discounting payments in line with expected GDP growth, rather than the market gilt rate?

The consultation suggests the possible argument for using the STPR is that “it represents the alternative public sector investment opportunities for the funds used to pay public sector pensions”.

But could this same argument be used to discount gilt coupons and principal payments at the STPR? Like expected GDP growth, no one would assert that new gilt issues should be valued by discounting payments in line with the STPR.

Some well-respected bodies have argued for expected GDP growth or the STPR; they must explain how an obligation to pay a public sector pension differs from an obligation to pay gilts or acknowledge that it is also correct to discount gilts payments at expected GDP growth or the STPR.

The official cost of unfunded public sector pensions, based on a real yield of 3.5 per cent, is around £15bn ($24bn) a year, but the real economic cost, based on an ILG yield of 1 per cent, is double at £30bn.

A discount rate based on expected GDP growth or the STPR leads to nonsensical conclusions. We must be clear that public sector pensions are not discretionary government spending, like health or education, which, subject to the ballot box, can be reduced to maintain affordability. They are deferred pay earned as part of a legally binding contract of employment, the equivalent of giving ILGs to be redeemed at retirement.

John Ralfe is an independent pensions consultant (

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