Brighton Rock's Con Keating defends the UK government's take on the correct discount rate for public sector pension schemes.
In the best tradition of African kleptocrats and election results, John Ralfe refuses to accept the considered decision of the chancellor of the Exchequer and HM Treasury - arrived at after a full and formal public consultation - on the correct discount rate for use in public sector unfunded pension schemes. After the fashion of Casablanca's captain Louis Renault, it appears he has rounded up the 'usual suspects' in his search for some added gravitas for his latest missive - an appeal to the chancellor, George Osborne, to "reconsider" the decision to use a discount rate related to GDP growth.
In fact, the letter contains nothing whatsoever new. Every argument deployed in it was represented in one or more of the original submissions to HM Treasury, and they were correctly dismissed. In a manner reminiscent of the caricature Englishman overseas, when he doesn't understand, he just shouts louder.
Ralfe, in fact, wrote an earlier article that appeared in FTfm on 14 March espousing the view that the correct discount rate is the yield on index-linked gilts and invited responses. I made one such response - which is freely available here. Surprisingly, that article preceded the 6 April publication of the reasons for the choice of a GDP growth-based discount function. Was that, I wonder, a case of getting one's retaliation in first?
The letter asks a very basic, but foolish question: how does a public sector pension obligation differ from an obligation under a gilt-edged security? There are many technical reasons that are detailed in the earlier response, but as that was obviously not understood, I shall explain again in different terms.
A pension is part of the labour contract with public sector employees. It is deferred compensation. Economically, it is a claim on future production. Public sector employees forego some current income in return for this claim. The absence of this current wage cost allows the population at large to benefit from lower current taxes and higher disposable incomes. The result of this is that, as a society, we have a higher current and future standard of living - production is improved.
By foregoing current wages, the public sector employee is foregoing a claim on current production. It is only equitable that the employee should be offered an equivalent future value in terms of the share of production foregone today. Put another way and simplifying grossly, if these wages foregone are 1% of current GDP, then the pension should be 1% of GDP when paid. This is a question of GDP growth.
In fact, if we use a discount rate lower than this, such as the yield on index-linked gilts, we are misrepresenting the current value of the pension. We are overstating employees' current wage costs. This is a transfer of wealth from today's employees to future generations. This, of course, is feasible, being no more than the heart of savings transfers. By contrast, the converse, leaving costs for our children, is not. In the immortal words of Paul Samuelson: "To fight a war now, we must hurl present day munitions at the enemy - not dollar bills, and not future goods and services."
When investors buy index-linked gilts, voluntarily in free markets, they are acquiring a claim on future production. When the state borrows at these rates, it does so because the cost of this claim is less than the resultant growth in output production in the economy overall. Society benefits from the difference between the cost of finance and the production achieved.
There are many reasons for investors to accept rates of return lower than GDP growth - notably, these securities are negotiable, while pensions are not. They also serve as stores of liquidity, for domestic and international savers. A pension is not pledge-able; it has no value as collateral.
The question, in essence, for pensions offered by the public sector is: what is its cost of production of the output to meet these liabilities. The answer to that is the rate of GDP growth. That is incidentally also the rate of growth of the tax base.
The author make's the mistake of anthropomorphising the market: "The other possibility, that gilt payments should be discounted at the expected GDP growth rate, is immediately contradicted by the market". Markets are profoundly unnatural institutions, but they can do no such thing. It is Ralfe's flawed interpretation of this market that is exposed.
The logic goes badly awry in another area: "The government's approach implies it is cheaper for it to promise an inflation-linked pension payment to a public sector employee than it is to pay the coupon and principal on an index-linked bond." It does not.
Unlike a gilt yield, the use of a GDP-based measure is time consistent. When GDP declines, gilt yields rise, reflecting the increased debt service burden they represent. If some gilt rate is used, the apparent cost of public sector pensions declines precisely when they become more burdensome.
The "serious pernicious consequences" of the letter are illusory. The malign consequences of using an index-linked gilt yield to discount public sector pensions are not.
Con Keating is head of research at Brighton Rock Group
The EFFAS-EBC submission to the Treasury on this consultation is freely available here.