Public Service Pensions Bill

Memorandum submitted by Michael Johnson (PSP 07)

THE APPROACHING CASHFLOW CRUNCH:

WHY COALITION REFORMS TO PUBLIC SECTOR PENSIONS WILL NOT HOLD [1]

THE AUTHOR

Michael Johnson is a Research Fellow at the Centre for Policy Studies (CPS). He trained with JP Morgan in New York and, after 21 years in investment banking, joined Towers Watson, the actuarial consultants. More recently he was Secretary to the Conservative Party’s Economic Competitiveness Policy Group. He is widely recognised as a leading expert on UK pensions, and is the author of a number of influential reports on the subject, including: Don’t let this crisis go to waste: a simple and affordable way of increasing retirement income (Centre for Policy Studies, September 2009); Simplification is the key: stimulating and unlocking long-term saving* (CPS, June 2010); Self-sufficiency is the key: addressing the public sector pensions challenge* (CPS, February 2011) and Put the saver first: catalysing a savings culture* (CPS, July 2012).

* Backed by Conservative and Labour peers

Michael has been invited to present formal oral evidence to the DWP’s Select Committee, as part of its inquiry into Governance and Best Practice in Workplace Pension Provision (19 November 2012).

SUMMARY

· This paper evidences why another round of public sector pension reforms will be required, probably before 2020.

· The catalyst is likely to be the rapidly increasing cashflow shortfall between contributions and pensions in payment.

· These are forecast to rise to an unacceptably high level. In 2005-06 it was an irrelevant £200 million, before growing to £5.6 billion in 2010-11. By 2016-17 the OBR expects it to have increased to £15.4 billion: a 77-fold increase in 11 years.

· This will, eventually, have to be paid for by taxpayers. With employers’ contributions of an extra £17.2 billion, the annual burden on taxpayers will be over £32 billion – the equivalent of £1,230 for every household in the country. Nearly £4 out of every £5 paid in pensions to former public sector workers will come from the taxpayer.

· The Coalition has justified its reforms on the grounds that they achieve a material reduction in the total liability. But the liability is a nebulous concept which does not manifest itself in day-to-day life, and its modelling techniques are unclear. Conversely, the cashflow shortfall, as it emerges, will be both clear and tangible.

· The current reforms will only produce significant cashflow savings after 20 to 30 years, far too late to assuage pressure for further reform. That said, the public’s opprobrium could be fuelled as much by unfairness as unaffordability.

· During that time, public sector workers will enjoy certainty of income in retirement until the day they die, mostly paid for by the 80% of the workforce in the private sector, almost none of whom have that security.

· The Coalition should now:

o put all its modelling assumptions for the reduction of the liability into the public domain; and

o start to prepare the public sector for a risk-sharing arrangement such as a cash balance scheme, en route, ultimately, to a wholly Defined Contribution (DC) framework.

· This approach would, at long last, provide comparable pensions across the UK, irrespective of the employment sector. Not to express such a vision would be to accept that the quality of pension provision in the (wealth-creating) private sector will, from hereon, be second class.

· If action were not forthcoming (before 2020), the government of the day may have to consider actually cutting pensions in payment, to ward off the risk of societal schism, both between generations and between public and private sector employees.

INTRODUCTION

Lord Hutton, the architect of the recent reforms, has clearly had second thoughts:

"What we’ve seen is how very quickly the assumptions which underpinned my assessments of the long-term sustainability of public service pensions have been shown to be too optimistic. That is going to affect the sustainability of public sector pensions in a negative way." [2]

1. THESE FOOLISH THINGS….

1.1 On the 2nd of November 2011, Danny Alexander, the Liberal Democrat’s Chief Secretary to the Treasury, made a statement to the House of Commons concerning enhancements (i.e. government concessions) to the public sector pensions’ reform package. His speech included the following:

I believe this package is affordable. I believe it is also fair, not just to public sector workers, but delivers significant long term savings to taxpayers who will continue to make a significant contribution to their pensions.

If reform along these lines is agreed, I believe that we will have a deal that can endure for at least 25 years, and hopefully longer.

1.2 Notwithstanding the need for political expediency, in time this may prove to be thoroughly misleading. Indeed, robust evidence is already emerging, from government sources, to strongly suggest that this is the case.

2. DISTRACTION POLITICS

2.1 The Government has made much of the reforms to public sector pensions "halving the net liability". The OBR’s July 2012 Fiscal Sustainability Report (FSR) projects spending on public service pensions to fall from 2.2% of GDP (2016-17) to 1.3% (2061-62), a 40% reduction, which is significant. But a half a century away.

2.2 In addition, this forecast entails colossal modelling risk, notably in the assumptions used for GDP growth (primarily driven by what may prove to be an excessively optimistic underlying assumption for productivity growth [3] ), life expectancy, inflation, wage growth, the discount rate and the future size of the public sector workforce. The OBR should rerun (and extend) its cashflow forecasts using a range of lower GDP growth rates, and put all of the modelling assumptions, and results, into the public domain.

2.3 That notwithstanding, focusing attention on the liability (funded or unfunded) is a red herring; it is a tabloid, nebulous concept that does not manifest itself in day-to-day life. Consequently it imposes no meaningful political pressure, as well as diverting attention to unconstructive debates concerning the underlying modelling assumptions. What matters is cashflow, as any (private sector) businessman knows, but on this, the FSR is silent.

3. CASHFLOW FORECASTS

3.1 The Treasury’s Public Expenditure Statistical Analyses (PESA) annual report provides a forecast for the cashflow gap between contributions (from employers and employees) and pensions in payment to former public sector workers. The data is in respect of the unfunded (i.e. pay-as-you-go, PAYG) schemes, which cover roughly 85% of public sector employees (the principal exception is the funded Local Government Pension Scheme, LGPS). Table 1 compares the 2011 and 2012 PESA reports’ cashflow forecasts.

Table 1: Cashflow shortfall: comparison of 2011 and 2012 PESA reports

3.2 As Table 1 shows, since 2005-06 an alarming cashflow shortfall has developed, and it is forecast to continue to deteriorate. Particularly surprising, indeed shocking, is the increase in the forecast shortfall between the two reports, because the 2012 report includes the recent (cost-saving) reforms. One would expect the forecast shortfall to start reducing after 2014, when the reforms are implemented…..but the opposite is expected to happen. Over the four year period commencing in 2011-12, the forecast aggregate shortfall is nearly £10 billion more in the 2012 PESA report than the prior year’s. The shortfall has to be plugged by the Treasury, i.e. taxpayers (who are already funding the employers’ contributions).

3.3 Another source of cashflow data is the OBR, which provided the data and calculations for the recent Budget reports.

Table 2: Successive OBR cashflow forecasts

3.4 It is clear that the OBR (in the Budget 2012 report) and the 2012 PESA report are in broad agreement that, following implementation of the reforms, the annual cashflow shortfall is expected to rise further. Why is this, when the reforms include moving from a final salary to a career average basis of accrual, linking pensionable age to the (retreating) State Pension Age, and increasing the employees’ contributions?

4. THE TIDE IS COMING IN

4.1 There are several reasons why the Budget 2012 report’s forecast for the cashflow shortfall shows a marked increase on what was expected only a year earlier, in spite of the reforms in the interim period:

(i) the inclusion of the Royal Mail pension scheme between the last two Budget reports, adding (from 2012-13) some £1.5 billion per year to the forecast shortfall;

(ii) less income from contributions than was forecast in Budget 2011, care of the public sector wage freeze (contributions are linked to wages). Meanwhile, pensions in payment continued to rise with CPI; and

(iii) a marked acceleration in forecast pension and lump sum payments. This could be partly explained by the anticipation of more redundancy-induced, and very costly, early retirements, over the next few years, along with further improvements in longevity.

4.2 The reforms’ increase in employee contribution rates (by an average of 3.2% of income) is expected to raise an additional £1.2 billion (in 2012-13), rising to £2.9 billion in 2016-17. [4] This additional income is included in the 2012 Budget report, but it is dwarfed by the scale of the relentlessly increasing pensions in payment. Hence the rising forecast for the annual cashflow shortfall.

4.3 Defenders of the status quo will point out that the unfunded schemes’ contributions are set to meet the cost of the accruing benefits, not the cost of meeting pensions in payment. But will the general public care (or understand) the nuances of how a PAYG scheme is supposed to work when, come 2016-17, the OBR is expecting a cash shortfall of £15.4 billion? This, added to that year’s forecast for employers’ contributions (£17.2 billion), means that taxpayers will then be contributing nearly 80% (£32 billion) of the cost of paying pensions to former public sector workers.

4.4 Essential, public sector pensions have, for decades, been hugely under-priced (on a PAYG basis), contributions being woefully insufficient to meet the accruing benefits. The legacy of successive governments’ inability to implement the necessary radical reforms is now manifesting itself as a rising tax burden on today’s workers.

4.5 Yet, following the latest reforms, most employee contributions will still be less than 10% of incomes. Danny Alexander made this point himself, in his November statement to the House of Commons, when describing the pensions that a teacher and a nurse could expect: "to earn the equivalent pension in the private sector…..both would require an annual contribution of around a third of their salary".

5. THE REFORMS’ FATAL ERROR: GRANDFATHERING

5.1 Danny Alexander’s November statement also contained the following sentence: "anyone ten years or less from retirement age on 1 April 2012 are assured that there will be no detriment to their retirement income". At a stroke, this concession to the unions vaporised the prospect, for at least the next decade, of exerting any significant control on the widening cashflow shortfall.

5.2 To get a deal done, the Government punted the prospect of smaller pensions sufficiently far into the future, so as not to concern many public sector employees (including, given their ages, the unions’ negotiating team). Consequently, the recent reforms only deliver material savings in the long term so, as the OBR and PESA reports illustrate, the growth in pensions in payment will continue to accelerate ahead of post-reform (i.e. increased) employee contributions.

5.3 To-date, the lack of transparency inherent in public sector pensions’ PAYG structure has allowed successive governments to avoid the political inconvenience of facing reality. But the rapidly growing, and highly visible, cashflow shortfall means a larger tax burden, and that will translate into a political pressure point that readily punctures the recent reforms’ upside of a smaller liability, as espoused by the Government. The latter is too remote from individuals’ day-to-day experience (as, indeed, are subjective concepts such as affordability or sustainability). Conversely, higher taxation is immediate and unambiguous, and is likely to be accompanied by a growing appreciation of the (media-fuelled) unfairness of the public sector’s pension arrangements. Post-reforms, public sector workers will continue to enjoy certainty of income in retirement until the day they die, predominately paid for by the 80% of the workforce in the private sector, almost none of whom enjoy such certainty.

6. THE NEXT STEPS IN UNFUNDED PUBLIC SECTOR PENSIONS REFORM?

DIAMETRICALLY OPPOSED VIEWS

6.1 The position of the TUC and the public sector unions is that private sector employers should do more for their workers and improve the quality of pension provision. The business perspective is the reverse, namely that the relative generosity (i.e. cost) of public sector pensions should be curtailed, as Figure 1 illustrates.

Figure 1: Different perspectives on pensions reform

Resolving this difference in opinions is akin to trying to push together the wrong ends of two magnets.

A LIGHT IN THE DARK: DEFINED AMBITION?

6.2 The DWP is currently overseeing work to give some definition to Steve Webb’s defined ambition approach, a pensions "third way" between the disparate worlds of DC and DB. Working groups are examining what "DB Lite" and "DC Plus" could look like, seeking an accommodating environment for risk-sharing between employer and employee, somewhere in the regulatory No Man’s Land that today separates the very different DB and DC regulatory regimes.

6.3 Defined ambition was born out of Steve Webb’s laudable desire to resuscitate private sector occupational schemes: it is unlikely that public sector pensions are on his radar. But amongst the myriad of potential structures, one in particular would lend itself very well to providing the next step in public sector pensions reform: a cash balance scheme.

THE "PAY TWICE" PROBLEM

6.4 Cash balance schemes were first developed in the US, to replace conventional (funded) DB schemes. Much as we should wean ourselves off an unfunded framework, with its lack of transparency and attendant generational inequality, we face the "pay twice" problem. Adopting a funded framework would mean that today’s workers would have to contribute both to their own pension pots and contribute (directly or via taxation) towards paying for the previous generation’s on-going pensions in payment. This could be thought of as a hangover, following addiction to the convenience of an unfunded, PAYG, framework.

6.5 Consequently, introducing a cash balance arrangement would (initially) have to be on an unfunded basis. Employee and employer contributions would be notionally credited to each employee’s personal retirement account, the actual cash returning to the Treasury, to help it continue to meet pensions in payment. The accumulating notional balance would grow at an assured rate of return, such as CPI, the yield on a Treasury bill or, given the context, the discount rate used to determine the size of the public sector pensions liability. Consequently, employers assume the investment risk, up until retirement. At retirement, the "cash balance" is passed to the retiree who is then encouraged to purchase an annuity at the prevailing market rate, thereby creating certainty of income in retirement; a "pension". Thus, crucially, longevity risk (arguably the most significant risk) resides with the individual, not the state.

6.6 Subsequently we could slowly transition to a funded structure. The implementation of this, and the aforementioned introduction of a cash balance arrangement, are described in considerable detail in Self-sufficiency is the key [5] , a paper backed by Conservative and Labour peers.

6.7 For legal purposes, in the US cash balance schemes are still treated as DB schemes. However, the promised benefit is the size of an account balance at retirement, not a specific, on-going, income in retirement. Ideally a similar legal accommodation could be obtained in the UK. [6]

7. CONCLUSION

7.1 After the recent Lord Hutton-inspired reforms have been implemented, weakened by subsequent concessions, public sector pensions will remain unsustainable. Over the next few years it will be become impossible to ignore the furiously ringing alarm bell that is the burgeoning cashflow shortfall between contributions and pensions in payment.

November 2012


[1] NOTE : This paper’s focus is the public sector’s unfunded pension schemes, covering roughly 85% of the workforce. A subsequent paper will examine the financial health of the funded Local Government Pension Scheme (LGPS), which covers most of the other 15% of the workforce.

[2] Interview with BBC Radio 4’s World This Weekend , broadcast on 4 th December 2011.

[3] This assumption, at 2.2% per annum , has been unchanged for years . This may well be too generous: indeed, it would be prudent to assume that our ageing population will become less productive over time .

[4] The OBR’s forecasts in the Budget 2012 report used the Hutton reform contribution increases set out in Table 2.13 from the Autumn 2011 Economic and Fiscal Outlook (EFO).

[4]

[5] Michael Johnson, CPS, 2011 .

[6] Morrisons , the supermarket operator, has just announced (October 2012) a cash balance scheme for its employees, but most details (including the regulatory treatment) are not yet in the public domain.

Prepared 7th November 2012