Analysis: A combination of weak economic growth, growing inflation and lofty discount rates may threaten unfunded public sector defined benefit schemes.
The government had £1.3tn in unfunded public sector DB pension liabilities at the end of March 2016. Teachers, firefighters and doctors are among the public sector workers who fall under the umbrella.
Some observers have levelled criticism at the methodology behind the discount rate used to calculate employer and employee contributions.
We are quite simply putting that taxation burden on future generations
Allan Martin, ACMCA
Others accuse the government of arbitrarily using a rate that does not recognise the real costs of our public sector pensions, leading to vast intergenerational transfers.
The discount rate is too high
The "superannuation contributions adjusted for past experience" discount rate currently sits at 2.8 per cent above the consumer price index. GDP growth is used to represent a fair assessment of the government's income.
It is based on the Office for Budget Responsibility's assumption of real GDP growth for the period 2016-2050 of 2.2 per cent and a GDP deflator assumption of 2.7 per cent, resulting in nominal long-term GDP growth of 4.9 per cent every year.
Allan Martin, a director at trusteeship and advisory consultancy ACMCA, argued that any shortfall between actual GDP growth and the SCAPE discount rate will increase the burden of public sector pensions upon future government spending.
Reforms led by Lord Hutton in 2011 changed the discount rate from 3.5 per cent above the retail price index to CPI plus 3 per cent. In 2016, this came down to CPI plus 2.8 per cent.
At the same time, public sector pensions were moved from a final salary basis to a career average revalued earnings calculation.
Martin described the SCAPE rate as “challenging, or heroic”. When the country’s growth fails to match this discount rate, “we are quite simply putting that taxation burden on future generations”, he said.
Is this political?
In the private sector, accounting standards dictate that schemes must use the yield on high-quality bonds with terms similar to the term of their liabilities to calculate their discount rates.
The government's ability to calculate discount rates on a different basis has led to criticism by some industry commentators.
Since Gordon Brown’s tenure as prime minister, successive governments have “fiddled how they calculate the annual cost of new public sector pension promises”, according to independent pension consultant John Ralfe.
Ralfe said: “The government uses a higher arbitrary rate to give a much lower annual cost.”
He added: “Across the whole of the UK public sector, official public sector pension costs are understated by around £15bn a year versus the costs using bond yields – a cost being passed on to be paid by our children and grandchildren.”
Steve Webb, director of policy at provider Royal London and former pensions minister, recognised the risk of governments manipulating the calculations behind the discount rates.
“There is a risk that governments use changes in the discount rate simply as a lever to get more money today,” he said. A reduction in the discount rate leads to a necessary increase in contributions from employers and employees.
This effectively acts as a cut to public sector budgets, as organisations such as the NHS are subsequently left looking for more money for pensions, Webb said.
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A HM Treasury spokesperson said: “We want to make sure public sector pension schemes remain affordable for future generations. Therefore, government measures the costs based on long-term GDP growth forecasts, so in line with the tax base which funds the schemes. We held a public consultation on setting the discount rate in 2011 and review the methodology every 10 years and the rate itself at least every 5 years.”
A choice between accuracy and affordability
The government is left between a rock and a hard place. It currently uses a discount rate that needs sluggish economic growth to catch up with growing inflation. It is criticised for passing the buck onto future generations.
Should it elect to lower the discount rate again, however, the government will be viewed as heaping further pressure upon embattled nurses and their employers, who will be forced to raise their pension contributions in order to make up the difference.
Barry McKay, head of LGPS actuarial at consultancy Hymans Robertson, recommended a periodic review of the assumptions used for the discount rate but recognised the government’s dilemma.
He said that with a reduction in the discount rate, “you’re more accurately reflecting what you think’s going to happen, [but] you’ve created a different problem, because it’s an affordability issue.”
