Affording pensions

"More of the workforce will be new entrants who, since 2005, will have to retire at a later age than 60."

Whenever unions offer cuts in benefits, it is always done at the expense of younger workers who will not retire for decades. I've always wondered why younger workers have any interest in joining a union and paying dues, when it always seems like their benefits are mere bargaining chips to be used at the expense of older workers to prop up a system that cannot survive long enough for them to benefit from it.

Living in France, I don't get a very full account of the proposed changes to British public-sector pensions. I have heard it said that the Govt proposes to change benefits from a multiple (rather, a fraction) of a worker's final salary to the same fraction of his/her average salary, the average being taken over the worker's lifetime.

Is that correct? It would seem to me that such a change would make a very large difference indeed to the expected pension of (for example) school teachers, whose salary rises appreciably with seniority. I could well understand that many workers would find such a change to be quite unacceptable and grounds for a strike.

As a "point of detail", I presume that the average salary calculated over one's working lifetime doesn't just take the raw salary one received year by year, but does have some adjustment for inflation? After all, even if inflation is "only" 2%, over a working lifetime of say 40 years that amounts to quite a change.

I know that private-sector pensions are generally based on a fraction of one's average salary, but for someone who started working as a teacher say 20 years ago, after several years of study, it's very hard indeed to accept big changes to the way one's future pension will be calculated.

A bit off topic but Bagehot opened his post today with the same view of the same helicopter.

doug374, the younger workeers don't have to "have any interest in joining a union and paying dues." The government union contracts generally only offer two options:
1) join the union,
2) don't join the union, but still pay the equivelent of dues for "representation" in salary negotiations while getting no say in who runs the union.
An option of "don't join and don't pay" is typically not on offer. Why the union negotiates that kind of agreement is pretty obvious.

UK public-sector workers are relatively over-pensioned. UK private-sector workers are under-pensioned. It is a mess.

@jouris

Look at the protests in Ohio and Wisconsin against collective bargaining. It's all college kids and young adults. They seem to think highly of union membership and benefits.

Life expectancy has increased and so have costs; its wishful thinking to expect that 60 is an affordable retirement age on a public pension. Unless of course you have a private pension and savings. Personally I think retirement age will be closer to 70 by the time its my turn.

It strikes me funny to compare pensions costs for a subset of workers to GDP. Wouldn't a better denominator be public sector revenue, expenditures, or payroll?

One of the standards of pension practice is disclosure of assumptions and methods. Another frequently applied standard is to value the current program and practices as continuing, at least as a starting point of reference. It sounds as if you are concerned these standards are not being met.

And since I don't think I'm able to comment directly on this week's column, I'll speak a bit out of place and say that Rauh & Novy-Marx (page 19, 2nd para under section header C) assume that "assets will grow at inflation plus 1.71% [per year]". It appears that 2% is their inflation estimate. Let's call it 3.75%.

Isn't that setting the bar a skosh low when setting aside cash for a 30+ year liability? Is there no merit to the taxpayer accepting a modest increase in risk, investing in high-grade corporate debt, and expecting even a still-modest 5.5% yield? Or even buying a few equities to back the promises made to those who won't even retire in the next 30 years?

Imagine the cash demands of public sector plans if we assume that gilts are not risk free(!), and we decided to invest in gold? Or just put the money in a vault to gather dust?

Several years ago a US actuary named Jeremy Gold made a name for himself by spreading a gospel that pension sponsors should invest in high-grade corporate bonds. Now Rauh is doing something of the same with gilts. Both have some worthy arguments, but neither is entirely compelling.

Getting some extra juice out of investments - even if the total asset allocation stays quite conservative - is arguably worth a lot more than forsaking all potential return for the certain doom of high cost.

Thanks, in response to the various comments. An average salary scheme takes each year's earnings and upgrades it for inflation so it doesn't penalise poor workers; the main effect is on senior staff. But remember that none of this affected accrued rights; it's only for pensions going forward
re pensions actuary, you could make the same argument to say that a state should invest iun equities to finance future highways development. But in terms of the cost, you can say that the state is handing over to employees a long-term put option on the stock market (since it is guaranteeing a pension whatever the market outcome). long-term options are actually more expensive than short-term ones even though people think the market "must" go up over the long term. If you took the cost of the option away from the expected equity return, you would probably end up with the risk-free rate (otherwise arbitage would take place). Better to account for the risk-free rate; if excess profits from equities are earned later, contributions can always be adjusted at that point

I think a lot of the gripes are about the changing goalposts.

As most people in the UK know, the traditional narrative has been about public sector workers accepting lower wages in return for stabler jobs and better pensions. The state of the country's finances has meant the former is no longer tenable and the latter has been and continues to be chipped away slowly, starting from the reforms of the previous government.

Although I personally think the proposed changes are as fair as can be possible, it is noticeable that a certain cohort of public workers are not having their pensions slashed - granted MPs are underpaid, but in these tough times aren't we meant to be 'in it together'? It would be a symbolic gesture, but not touching them would be a slap in the face for public sector workers.

I am really surprised that Buttonwood hasn't bothered to include the fact that more employees means more money circulating in the economy and the higher the pensions.
But even if employment levels go down due to automation, as productivity increases, (due to automation) then pensions will remain affordable too.
This is all linked to policies of wealth redistribution: but this appears to be taboo for fear that the rich will run away to countries like Botswana.

Buttonwood wrote: "An average salary scheme takes each year's earnings and upgrades it for inflation".

That was my original understanding but, from what I've read about Hutton's report, he appears to be proposing that accrued pension be upgraded in line with average earnings. (And I think Osborne said he would not cherry-pick.)

http://cdn.hm-treasury.gov.uk/hutton_final_100311.pdf states: "pensions in payment should be indexed by inflation, while accrued benefits should be revalued by earnings for active members".

Jouris sorry but you are simply wrong, in the UK there is no compulsion to pay into either a union or into some other fund for representation and never has been. There used to be the situation where some employment was a 'closed shop' and you had to be a union member to gain employment. That situation was abolished in the early 1980's.

In terms of younger members joining well pensions are not the only issue that faces negotiations, representation also invoves dealing with issues around disciplinary hearings, or changes in working practice, acess to training.

There are several reasons why the cost starts to come down, one of the biggest as discussed is the change to CPI from RPI which the government has imposed and Hutton takes as a given. The unions are objecting, and some are taking a court case to say that the change can not be made unilaterally but it seems at present that on that one the government will win.

Then base age on retirement, was changed for new starters from 40 years service and minimum 60 to 40 years service and minimum 65. In some areas I.e.teaching and healthcare these people are increasingly graduates so would not have started by 20 so were not accruing 40 years service till 62 or 63 anyway.

Increased contributions by existing employees, the various schemes have a different history and different contribution rates by employees, e.g. Armed forces pay zero, civil servants 3%, teachers 6.5% NHS 7.5% etc and the employers pay in a % which over the years has increased more than that of employees. An example quoted a lot by Government Ministers is the teaching scheme which started as 5% from employee and employer and now is 6.5% employee and 14% employer. The change in 2005-7 for the various schemes was that if there was a need for increased contribution rates in future, as everyone accepts ther will be due to demographic changes the increased contributions would fall on the employee.

So the no change position would be a review every 3 to 5 years and on most occasions some increase in contribution rates from the employees. In the NHS the revaluation has just happened, and was likely to lead to an increase in contribution rates of around 1% from 2013.

The argument is over the fact that the government wants a increase in contribution rates of 3.2% because it says so, not based on revaluation of the various individual schemes but just because! They want it from 2012 in the middle of a public sector pay freeze.

The unions are not saying there will be no increase in contributions ever, but they not unreasonably want to minimise it and delay it, and will have to justify it to their membership so that means details of different demographic and age profiles in different individual schemes.

The lives of everyone in society are divided into three distinct periods ,Education, Work and Retirement.The minority who are not involved in any or all of these activities is small enough to be ignored . Let us look at each one of these periods in turn.
Education
From there being none to speak of ,the period of Education has now reached a minimum of 13 years in most countries, which means that for most youngsters work commences at 18.

Work
Whether there are enough jobs to do is another matter ! In many Countries there are not! So the youngsters who cannot get work add to the rising level of unemployment .Governments are fond of the term Job Creation as the solution. But automation steadily erodes the need for labour,and technological advances raise the rate of erosion. so increasing the length of working life is pointless
.There will come a time when there will be no work,especially when employers areable to dispense altogether with tiresome and unreasonable humans! Could be sooner than you think

Retirment
An increasing life expectation raises the cost of pensions overall
and cost of living increases require to be neutralized by raising the levels of pensions

So what is the solution to be gentlemen? Is it to be any or all of those solutions currently under discussion? Or is it to be a years retirement, all costs paid for by the State, followed by Euthanasia , It may well come to that you know !

Buttonwood,

On the hopes you'll receive this after enjoying a nice vacation:

"re pensions actuary, you could make the same argument to say that a state should invest iun equities to finance future highways development. "

In finance, I understand it is common to match the benefit with the obligation. Large capital projects such as highways are often funded with debt at the time of construction. The stakeholders then benefit from the improvement while they pay off the bond through future tolls or taxes.

Your argument sounds like saving in advance for highway construction so as to bequeath a free highway to the next generation. Most governments I know have run up substantial debts, not saved for future generations.

Pensions work somewhat in reverse of highway bond financing. An employee provides services in 2011 and earns a benefit payable in 2040 - 2070. Presumably we can agree that it would be better to fund that benefit in 2011 rather than stick the next generation with the tab. Given that, how best to fund it? If the goal is to avoid risk, an annuity purchase seems the best tool. (Yes, a defined contribution plan would also eliminate the investment risk.) However, a downside to annuity purchases is that the annual purchase cost for each year of a worker's service will rise considerably as the worker ages.

I hope I am not beating this point to death, but purchasing a 30-year gilt for a person who will not retire for approximately 30 years is not risk free. Even assuming timely return of interest and principal, there is considerable reinvestment when the person retires 30 years hence and gilts are yielding [your guess here].

"Better to account for the risk-free rate; if excess profits from equities are earned later, contributions can always be adjusted at that point"

If Rauh and Novy-Marx were making the point in their latest work that pension plans will definitely have severe cash flow issues if public pensions move all their investments to gilts, then consider the point granted. :D

I am however sympathetic to your point that risk premiums should not be recognized prior to their realization. (Indeed, I recall that to be part of Jeremy Gold's case for why corporate bonds should be held by pension sponsors.) However, I would not budget for my own retirement, for example, by assuming I will earn only the risk free rate. Would you? I might instead assume a below median realization of the risk premium.

So if the public (or a company or a union) is willing to sponsor a defined benefit plan, and willing to accept some risk in its funding, it would be fair to assume at least some of that risk will bear out. The alternatives appear to be using the risk free rate, in which case pension contributions will start very high, and would be likely to come down in future years - or - using an aggressive assumed rate of return, in which pension contributions will start quite low, and would be fairly likely to rise in future years.

Pension plans that older workers signed up for should be honoured without question or debate. Otherwise it's tantamount to a sovereign breach of promise.

Having said that, I gotta admit, the way the moribund British economy is spiralling downwards so precipitously, the pension promises will become unsustainable & be broken, sooner than later.

Austerity Days loom menacingly over Brit skies. Steel yourselves folks. The good times are over..

Today we can see that Imperialist governments has been able to find money to wage overt and covert Wars overseas.

But when coming to paying decent pension to a growing underclass of people, they suddenly run out of money. One one hand, People are now living much longer and other hand, prices are steadily being pushed ever higher by various Ponzi scheme to rob people of their savings like printing money out of thin air. It is easy to see why the great disconnect between the ruling elites and ordinary people.