The debate about the “fairness” of offering some people “gold-plated” defined benefit schemes and others no more than the auto-enrolment minimum is familiar to everyone in the UK.
Sometimes, it’s useful to look at the same debate from a different angle (perspective). I got a shock this morning when I got copied into a string of vitriol on linked in , involving Americans in the private sector letting their feelings be known about public sector workers accruing better pensions than they did. I won’t quote the whole thread, you should be able to access it here.
Here’s a sample.
Bill Motion(GB) seems to be trying to rope me in to the Zeitgeist against unions, proper pensions and those trying to destroy what’s “for the good of the tax-payer and the country”.
I had to explore the thread a little till I got to the source of this bile, an article by a Financial Economist called Andy Biggs (no relation to the CEO of Aviva in the UK).
Have public pensions become more generous or less?
This is the title of Andy Biggs article and you can read it here
This is how it starts.
There’s a debate going on about public employee pensions. One study finds that government pensions have become more generous over the years. But a prominent academic replies that public sector retirement benefits have remained steady in generosity and taxpayer costs have actually fallen because public employees are paying more for their pensions.
Who’s right? Me, that’s who
The “prominent academic”, who should walk warily in view of some of the posts on the thread, argues very sensibly that the promise being made to public sector workers is the same promise that has always been made by the US public sector.
The value of the promise has not increased, only the cost of servicing it, which is currently very high due to interest rates in the US. The academic (Alicia Munnell) argues that because members are being asked to pay more to accrue future benefits, the true cost of providing the benefits is actually less to the sponsor.
Munnell points out that using a consistent discount rate since 2001, the cost of US public sector pensions has remained steady.
But that the American public sector sponsors have been reducing support for these plans and passing these costs on to employees.
Alicia Munnell goes on to point out that future pension awards to public servants will cost less – because they are less generous, so the normal cost of benefits will decrease in years to come.
Normal cost
The idea that their can be a “normal cost” of providing a pension accrual is one well understood in the UK. It is what gives those who think in the long-term, confidence that defined benefit schemes can and should stay open.
The “normal cost” of a pension is the internal rate of return assumed at the outset of the plan, based on economic science that thinks over generations and not from day to day.
Having the confidence to refer to the “normal cost” of a pension , is something that few people have these days. This is because of the flak they receive from financial economists who would have the cost of pension promises marked to market.
But it is good , that amidst the noise, the still small voice of Alicia Munnell holds firm. She concludes her article
In short, the generosity of benefits is not driving increased pension costs. If anything, benefit generosity has declined. The problem is that many governments have not made adequate contributions to fund their benefit promises (and their initial assumptions regarding the cost of benefits turned out to be optimistic).
From time to time, academics, actuaries and economists have to accept that their forecasts were wrong. Alicia Munnell is suggesting that this is what has happened in some grossly underfunded American Municipal Schemes.
But by inference, if the initial assumptions are correct, then schemes can remain open and – over time – remain affordable.
Levelling up or down?
So if we believe there could be a “normal cost” of pensions, why aren’t we spending more time finding out what this could be. Why can’t those schemes in dispute over funding (I’m thinking USS) , do what Alicia Murrell is suggesting – and find their normal cost?
If the normal cost of a pension is too high, then the benefit may be unaffordable and the benefit may have to reduce or the employee contribution rise to meet the normal cost or the sponsor contribution has to increase (meaning that wages in the long term will be lower).
There seems to me an underlying equilibrium in pension funding which is immutable and that most of the arguments we are having today , could be addressed by establishing and splitting out “the normal cost” and comparing it to the mark to market accounting positions of schemes at any single point.
In his central argument , Andy Biggs makes a simple logical mistake
..the answer is, yes, public sector pensions have become more generous and more expensive, because it costs more to provide a guaranteed benefit when the interest rates available on guaranteed benefits are low
The true cost of the promise is the same, the book-cost changes. We see the book costs of UK pensions swing from surplus to deficit and back again, but the normal cost remains constant. This is why we should understand and use the normal cost of a pension and not flip-flop with the book-keepers.
But few (other than Con Keating) is making this argument right now. Which suggests to me that we’ve rather lost sight of the wood for the trees.
So long as we see pension costs as wildly volatile, we will reduce our promises towards the lowest possible rate , the defined contributions of auto-enrolment.
But this is not necessary, we can afford more, if anything, we should aspire to level up our pension benefits.
We are not about to see the sky fall on our heads
For all the prophecies of doom over the past 20 years, and the promises of doom post March 2019, the sky is not going to fall on our heads.
The normal costs of pensions will remain the normal costs.
Markets will continue to go up and down and people’s views on liabilities (especially mortality) will change. But pensions are long -term things, they will outlast us all, as will our universities, schools and the apparatus of our whole public sector. In truth, much of the infrastructure of the private sector will outlive us too.
To suppose that pensions won’t be needed in years to come is daft, we will all need pensions and the plans we started decades ago, need to be continued if we are to get them.
We therefore need more common sense of the type displayed by Alicia Murrell and a good deal less of the nonsense pedalled by Andy Biggs and the wrecking crew of malcontents he has assembled behind him.