Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 20-39)

MR CHRISTOPHER DAYKIN, MR ANDREW JOHNSTON AND MR KEVIN DOWN

1 NOVEMBER 2006

  Q20  Peter Viggers: Actuaries navigate by the rear view mirror, do they not? They look at statistics from the past rather than trying to project those figures through into the future.

  Mr Daykin: They try to project them into the future. What we do not have, I am sad to say, is a crystal ball which tells us what the future will be. So, inevitably, our view of the future has to be coloured by our view of the past, but we attempt as far as possible to translate that into an understanding of what the underlying processes are; not just an extrapolation of the past but to understand what has happened in the past, how it is changing and how that could affect the future.

  Q21  Peter Viggers: Of course, the actuaries were working until quite recently, were they not, on what is known as the 92 series of continuous mortality investigation? Those are statistics gathered between 1989 and 1992, and only this year have they moved to the 00 series which, again, is only based on statistics from 1999 to 2002.

  Mr Daykin: That is true in relation to the actuarial profession's tables based on insured pensioners and annuitants, which are appropriate for use by insurance companies.

  Q22  Peter Viggers: In the last eight/nine years, from a situation when the pensions industry generally and final salary schemes appeared to be buoyant three things have hit them: one is an increase in longevity; the second is a weakness in the Stock Exchange and the third one is the £3 billion a year tax by the Chancellor of the Exchequer. Those things have had a devastating effect on private sector final salary schemes and a very large number have closed. So adjustments have had to be made in the private sector—I think you will agree with that.

  Mr Daykin: I agree with that in relation to the private sector, and I think it is true to say that many actuaries in the private sector did not regard mortality as the most important assumption they have to make for the future because the results of actuarial evaluations were much more sensitive to financial considerations. Also, many of the schemes that they advised were of a modest size and did not, therefore, support full demographic analysis. Our situation in the Government Actuary's Department is somewhat different because we advise some of the largest pension schemes in the country which have very large numbers of members and pensioners, and our practice has always been to analysis the mortality of the schemes in question, to compare that with tables that are provided by the actuarial profession, just to use that as a baseline. However, in principle what we are doing is setting the mortality in relation to the scheme's own experience and then, for the future, we are allowing for projections based on our work in the national population projection area rather than what the profession are doing, because we feel we are in advance of the profession in understanding these issues.

  Q23  Peter Viggers: Private sector companies have had to make, in many cases, massive injections into their pension funds—British Airways' pension fund, for instance, is many millions of pounds short of the amount it needs. Has the experience in the private sector been read across into the government service and taken account of so that extra reserves have been put aside in government?

  Mr Daykin: It has not arisen so much in the schemes that we advise because we have had a more cautious approach in the past. We still have some schemes that are in surplus. You mentioned a number of factors which led to the problems in the private sector. I would put the single largest factor as being the legislation in 1986 which encouraged employers to take contribution holidays, because that instigated a whole attitude within private sector schemes that you should fund at as low a level as you could and take holidays for as long as you could. On the whole, in the public sector that did not happen, so we did not have that weakening of schemes taking place which took place in the private sector over that period.

  Q24  Peter Viggers: To take one example: the Principal Civil Service Pension Scheme, which was I think one of your larger clients, has now been passed over to Hewitt Bacon & Woodrow, who are now the actuaries of that scheme. I believe that is correct. The approach adopted by your office was for Accruing Superannuation Liability Charges, because it is an unfunded scheme. Passing this over to Hewitt Bacon & Woodrow, they have recommended that there should be an increase in the amount which is notionally set aside for future pensions. It has been calculated that if this private sector actuary had done its calculations on the basis that you would have done with your previous method of evaluation a further 738 million would have been required. What I am saying is that the private sector actuary is applying different standards to yours and that less has, therefore, been reserved.

  Mr Daykin: Andrew is head of public sector pensions at GAD, so it is really very much his field.

  Mr Johnston: I will not comment on the detail of the valuation approach which HBW have adopted but I think it is clouding an issue there to say that their approach is radically different from our own. The financial structure in which the Principal Civil Service Scheme was operating at the time we were advising has since changed. The Treasury decided it would adopt a system known as SCAPE—Superannuation Contributions Adjusted for Past Experience—which essentially takes the investment elements, as it were, out of the equation. In the days when we were advising the PCSPS the Treasury's philosophy was that the pension scheme of public service should adopt the approach which mirrored very closely that applying to the private sector. So it had a notional investment portfolio, which included, for example, a sizeable element of equity content. As in the private sector, back in the days when we were advising, it led to some sizeable notional investment profits, so that there was some reduction there for the contributions which were being paid in recognition of this notional surplus that was said to exist in the scheme following the Treasury's guidance and the way they wished the scheme to operate. That changed at the same time as HBW came on the scene, so all the public service schemes are now moving to this SCAPE approach, which essentially takes away this idea of mirroring the investment policies of the private sector and in place of that put in place an asset scheme—it is a hypothetical asset—which yields a fixed return of 3.5% after price inflation. There is a philosophical difference there that has been masked, but it has to be said that different actuaries take different views, and as ourselves we review schemes on a three-yearly/four-yearly basis and the demographic assumptions that we are making (we talked about mortality) change; views change, views develop, and naturally you would expect some movement as we move between schemes. You will see with the schemes we have advised, both before the time HBW and afterwards, a natural progression in the contribution costs over time.

  Q25  Peter Viggers: Would this change in methodology have caused you problems if the Government Actuary's Department had still been the actuary to the Principal Civil Service Pension Scheme?

  Mr Daykin: I do not see why it should. We are using the same methodology for other public service schemes because the Treasury introduced SCAPE for the other schemes as well. So for teachers, for example, we have done valuations under SCAPE and for the National Health Service also.

  Q26  Peter Viggers: You are in a unique position as the independent adviser. How confident are you that the new SCAPE method is fairly valuing the public sector pension liability?

  Mr Daykin: I think the concept is all part of the Treasury financing of public sector liabilities, so whether it is a true value or not depends on your understanding of what the cost to government of providing pensions would be. The concept within SCAPE is that the cost to government of providing pensions is not directly dependent in any way on the market; it is to do with the Government's ability to raise taxes in the future and to finance its long-term liabilities. So from one point of view, from government liabilities, it should just be looked at as a cash flow issue as to what the call on the budget and on borrowing will be in the future—what the percentage of GDP will be that is allocated to paying for these liabilities. From another perspective the valuation process is intended to place a discipline on the employers and employees of public sector pension schemes, and the mechanism that we have does that without making it unduly volatile. It does ensure that the costs are brought home to the employers and employees at the time, whilst not subjecting those changes to the volatility of using market interest rates.

  Q27  Peter Viggers: I think you will see the cause of my concern. In the private sector unprecedented, massive amounts have needed to be injected into pension funds and yet in the government sector there seems to have been devised a method to reduce the amount of provision from what was previously arranged.

  Mr Daykin: I suppose there are two aspects to that: one is that the Government has not withdrawn funding in the past in the way that the private sector did, and so it has not got a lot to make up. Many of the increases in private sector funding have been necessary because of the under-funding that has taken place in past years. The other aspect is that the funding basis for private sector schemes is driven very much by the precise position in the marketplace and the costs of buying out liabilities with insurance companies, neither of which are relevant factors for the Government in providing its benefits to public sector workers.

  Q28  Peter Viggers: So you are blaming the under-funding of pension fund schemes in the private sector. Who was the person responsible for advising the Government as to whether private sector schemes were properly funded or not in 1986?

  Mr Daykin: The Government had a very relaxed approach to funding. Under the pensions regulator as was in place at the time—the OPRA—who were responsible for overseeing the funding of private sector schemes, a whole range of possible funding levels was permitted; there was a minimum funding requirement but the minimum funding requirement, as has been discussed on many occasions, was not a very strong requirement and schemes did not find much difficulty in meeting the minimum funding requirement, or working towards the minimum funding requirement, whilst still maintaining quite a low level of assets relative to the cost of buying those liabilities out. This partly reflected the fact that until the last few years pension schemes have always been regarded as long-term enterprises; things that would go on almost forever—certainly for the long-term—and could be thought of in going-concern terms. However, since the atmosphere has changed quite dramatically in the last few years—employers are closing schemes, they are thinking about buying them out—the whole perspective and horizon has become much more short-term; an entirely different approach because we are now looking at the costs of buying out, the costs of rescue by the Pension Protection Fund—all of which then become more immediate and quite different issues from the long-term, going-concern financing issues that were driving matters previously.

  Q29  Peter Viggers: Have you made any calculation of the amount of money that will be involved overall if the Government had continued with its previous level of funding prior to SCAPE?

  Mr Daykin: Have we? I do not think so.

  Mr Johnston: The liability has remained unchanged as far as government is concerned; it has made promises, it has passed legislation to pay benefits to public servants in various forms. That liability has remained intact. In a sense the call on the economy in the future, as shown in the Long-Term Public Finance Report, has remained there regardless of the methodology used for assessing the contribution costs which should be borne by employers at the time the benefits are accruing. In that sense, although it may have affected the charges made to employers, it would not have affected the outcome, in the sense that employees would still have achieved the same benefit promises and the burden which falls on the economy would remain the same.

  Peter Viggers: The taxpayer is always there, at the end of the day?

  Q30  Mr Newmark: What we are saying is that what we should really be bringing is the same disciplines we are asking of the private sector to the public sector. For shareholders in ABC Co, the obligation of the company is to let them know what those pension liabilities are today. The shareholders of UK plc are the taxpayers and surely they should be expecting the same idea—we call for greater transparency in government—as to what those liabilities are.

  Mr Daykin: Yes, and we have that.

  Q31  Mr Newmark: No, you do not say, because your answer is the taxpayer is there at the end of the day, so it does not really matter how much we owe them.

  Mr Daykin: I do not think that is what I said. I said that the considerations that enter into the Government's financing are different considerations from those that apply in a private sector scheme. However, we have full transparency of the resource account liabilities; we have projections of the public sector costs of pensions in the Chancellor's Budget Report.

  Q32  Mr Newmark: We do not have transparency because those numbers are not on balance sheet. So public sector pension liabilities are held off balance sheet, so there is not that transparency.

  Mr Daykin: They are published in the resource accounts.

  Q33  Mr Newmark: If it were the Chancellor sitting in front of me and I said to him: "What is the current state of the balance sheet today?" he will say: "There's £450 billion of debt." Actually, public sector pension liabilities adds almost another trillion pounds of liabilities there, yet the public are not aware of that.

  Mr Daykin: That is quite small compared to the social security debt and the education debt and the defence debt. This goes into a whole different area of public sector balance sheets, and at the moment there is not such a thing as a comprehensive balance sheet of government liabilities.

  Q34  Mr Newmark: Do you think there should be a comprehensive balance sheet?

  Mr Daykin: Quite possibly, but it goes well beyond my area of responsibility.

  Q35  Mr Newmark: I will ask an easier question now. I am going to look at the discount rate now. How appropriate is it that public sector pension liabilities and the current pension contribution rates are being calculated using the AA Corporate Bond discounting rate, rather than the lower index-linked gilts rate?

  Mr Daykin: The Corporate Bond rate is that which is required under FRS17, and I think the process has been for Treasury, as advised by an organisation called FRAB, to move towards using the same approach for the Government as for the private sector in relation to that.

  Q36  Mr Newmark: But the risks with government are less than with companies, though. Is it not?

  Mr Daykin: You could argue the other way round. There is a perfectly respectable argument that they should be calculated on the 3.5% basis of SCAPE.

  Q37  Mr Newmark: Why?

  Mr Daykin: Because that is deemed by the Treasury to be the long-term costs of financing—

  Q38  Mr Newmark: But it is not, because the long-term gilts rate, we know, is 1.2% or 1.12%

  Mr Daykin: That is not the long-term cost to government, that is the marginal cost of transactions taking place in the index-linked gilts market.

  Q39  Mr Newmark: That is where risk is today. That is where risk is assessed.

  Mr Daykin: It is if you want to buy an index-linked gilt but the Government does not want to buy an index-linked gilt. If it were to issue explicit securities to cover all of these debts it would massively transform the whole securities market; it would be quite a different market from where it is at the moment. So there is no direct relevance of the current market yield to government liabilities.


 
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