Con Keating, head of research at Brighton Rock, explains how too much of the debate surrounding public sector pensions - and the Hutton Report - is based on misconceptions and the politics of envy.
In a recent FT article, John Ralfe again asserted: "The correct discount rate to measure the economic cost of new public sector pension promises must be the yield on long-dated ILGs, since they share similar characteristics: both are contractually committed, legally binding contracts [Sic] and both are inflation-linked (subject to the differential between RPI and CPI indexation in public sector pensions)."
Let's examine this proposition in some detail. Index-linked gilts are fully negotiable and traded in active markets. But public sector pensions, in common with pensions more generally, are not negotiable. There are sound public policy reasons for this - if a pension beneficiary can freely sell his pension rights, he may subsequently become indigent and dependent upon the state. A pension is a non-negotiable asset of its owner, the beneficiary. A consequence of this is that a pension should, for the valuation purposes of a beneficiary, carry a liquidity penalty - somewhat confusingly, this is known as a 'liquidity premium'.
Public sector schemes are subject to 'cap-and-share' arrangements. These limit the amount of pension cost payable by the government employers. This is in stark contrast to private sector schemes, where the employer sponsor is the balance of cost underwriter of the scheme, liable for all increases. It means the public schemes have acquired the characteristics of member mutual insurance societies - clearly, it is inappropriate for a beneficiary to value his asset on the basis on government obligations when they are clearly not fully that. This implies that these pensions carry a level of credit risk, associated with the (potential future) unwillingness of the members of a scheme to pay increased contributions to meet costs in excess of those covered by the capped contributions of their government employers. This warrants a credit risk discount in the evaluation of the asset by its beneficiary owner.
Gilts are liquid assets that are fully negotiable and carry little or no credit risk. They trade in markets for liquidity - real liquidity in the case of ILGs and nominal liquidity for all other government securities. The defining characteristic of a liquid instrument is that it is price-insensitive to information. Any store of liquidity that is highly price volatile is of little use to its owner. Far from all financial markets function as markets for liquidity.
Let's indulge in a simple thought experiment. What price would these contracts trade at in a market if the beneficiary owner were free to sell them? The buyer would certainly notice that not all of the benefits were guaranteed by the government employer and discount the pension asset for that. This would be just the beginning of the discounting process - the buyer would also ask why the pensioner beneficiary now wants to sell this asset. There is significant information asymmetry between the buyer and the seller. The seller knows far better than the buyer his state of health and expectation of lifetime in retirement. This is the prime determinant of the total amount of pension that will be paid, the asset's ultimate value. The buyer should assume that, today, the seller wishes to cash future pensions payments he does not expect to survive long enough to collect. This problem is known in the economics literature as 'Akerlof's lemons', and the prices that result are low (and implicit discount rates high), a further and substantial discount.
So even if this market existed, its prices would be of no value in valuing the liabilities of the sponsor employer. The discount rate required by the Treasury consultation and discussed by John Ralfe is precisely this, the discount rate applicable to the employer sponsor's liabilities.
In general, markets do not exist for liabilities, as these liabilities are the property of their owners, their assets, and the owners have property rights over them. The issuer of an equity security or a bond does not have the unconditional unilateral right to substitute some other name for its own in these securities, no matter how much it might be offered or paid to do so - the owner's property rights will require their consent to such modifications of their assets.
The accounting and regulatory standard of valuing pension scheme solvency using discounted present values for liabilities and market prices for assets, which is known as 'mixed attribute' accounting, is most illuminating in this regard. An asset exchanged in a market is sold finally, there is no further recourse. It raises cash liquidity unconditionally.
The discount function used in present value calculations sets a schedule for the recognition of the amount of a liability over its entire lifetime. It can be thought of as an amortisation function. It sets the present value and also the higher values at all times until its final discharge. Two consequences follow from this simple observation.
First, that the transfer or sale of a liability would depend upon both the current present value and also upon the future performance of the 'buyer'. The pension beneficiary has rights with respect to this future performance. Unconditional sale or transfer by the obligor is not feasible. This limits the transferability of liabilities and thus constitutes a barrier to exit for the sponsor employer. This problem is well understood in the private equity market, where the subscribers to funds may not sell their paid-up investments without also making provision to discharge their obligation to make payments on future calls on their undrawn commitments.
Second, using asset market based discounted present values for liabilities and market values for assets means any profit recognition prior to the full discharge of the liability is arbitrary. This mixed attribute accounting regime is time inconsistent - it is comparing unconditional cash today with (some) cash today and further future cash amounts from the obligor. This is a truly fundamental flaw in the accounting and regulatory regime.
The school of John Ralfe labours under another accounting misconception, that the accounting identity that asset equals liability applies. This is true within the books of a firm, in an inside sense, but it is not applicable to the assets and liabilities of any firm in any external sense. If it were to be true in this external sense, then no firm could create any profits ever.
Some of this school would have us believe this relation is merely some form of replication of the liability. It is true that in complete and efficient markets we can expect, in general, to be able to replicate one asset's performance with some other assets and a trading strategy. However, even though the relation between an asset and its corresponding liability is one of rigid rotation about zero, or multiplication by minus 1, this is not true when the relation is between disparate assets and liabilities. If it were, we would have no need for pensions institutions and they would not exist. At the least, we would see some adopting this replication process, and they don't exist.
The issue for the sponsor employer is the cost of a pension award and when it should be recognised. This is a question of the sponsor employer's cost of production. It is not the social time preference rate or SCAPE methodology applied by the Treasury - that is applicable to the evaluation of the benefits arising from putative projects.
The schemes covered by the Treasury consultation were the unfunded public sector schemes, such as the Armed Forces and National Health Service schemes. These are known as pay-as-you-go (PAYG) schemes. Both employers and employees contribute to them. Though the employees' contributions are used to pay current pensions, this is not the true application of these funds or, for that matter, of employer contributions. In particular, it should be noted that then employee contributions accrue some implicit investment returns - the system is not PAYG in the sense that total contributions are expected to equal total pensions paid currently or over time. There is an ongoing role for central government in this regard. The implicit rate of investment return is the discount rate applied to the pension ultimately payable.
The true use of funds recognises that these contributions lower the need for higher current government expenditures and, thereby, the need to raise higher taxes today. This leaves all taxpayers with higher current disposable income to consume or invest as is their wont - it raises both current and future real GDP. This is the productive output resulting from the unfunded scheme and is, incidentally, far more efficient than any funded arrangement. Recall that a pension is, economically, merely a claim on future production.
It is also true that GDP represents the potential tax base of the economy, but that is incidental to the use of the rate of GDP growth as the discount function. Of course, GDP growth is not entirely due to the consumption and investment resulting from these absent taxes - that is determined by both public and private sectors. However, it is socially equitable in the sense that this is the average return available to both sectors.
It appears that only too much of the debate on public sector pensions - and, unfortunately, the Hutton Report - is based upon misconceptions and the politics of envy. The reality is that if we remove these schemes, the only substitutes available are far less efficient and therefore costly. Concerned taxpayers, such as John Ralfe, should be very careful of what they wish for.
Con Keating is head of research at Brighton Rock Group
Those wishing to see a fuller discussion of the issues raised and alternatives proposed in the Treasury consultation can read the European Federation of Financial Analysts' submission here.