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Rt Hon George Osborne MP
Chancellor of the Exchequer
HM Treasury
Horse Guards Road
London SW1A 2HQ
Dear Mr Osborne,
You announced in the Budget that the annual cost of new public sector pension promises would be calculated using a discount rate of expected GDP growth above inflation and the formal reasons for this were published on April 6th.
We are writing to ask that you re-consider this decision which we believe fundamentally misrepresents the economics of public sector pensions and has serious pernicious consequences.
In our view the correct discount rate should be based on the yield on long-dated index-linked gilts, (adjusted for the difference between consumer price inflation and retail price inflation), since public sector pensions and index-linked gilts share similar characteristics. Both are obligations of the UK government, both are contractually committed, legally-binding and both are inflation-linked.
The Consultation suggests the argument for using expected GDP growth is that pensions are "paid for out of future tax revenues".
But gilt interest and principal payments are also paid for out of future tax revenues. This clearly does not mean that new gilt issues should be valued by discounting payments in line with expected GDP growth, rather than the market gilt rate.
In using expected GDP growth, the Treasury has not explained how an obligation to pay a public sector pension differs from an obligation to pay gilts. If there is no difference, then pensions should be discounted at the gilt rate. The other possibility, that gilt payments should be discounted at the expected GDP growth rate, is immediately contradicted by the market.
The government's approach implies that 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.
By overstating the discount rate we understate both the current economic cost of public sector pensions and the real economic savings from the Hutton Report's recommendations. It also means that the efficiency of individual public sector bodies is overstated, as employment costs are understated and at the macro-level, the current generation of taxpayers is passing on an economic cost to be paid by future generations.
We must be clear that public sector pensions are not discretionary government spending, like health or education, which, subject to the ballot box, can be reduced to maintain affordability. They are deferred pay earned as part of a legally binding contract of employment, the equivalent of giving gilts to be redeemed at retirement and we believe their true cost should be properly measured. In light of this we ask you to re-consider this decision.
Yours sincerely,
[This letter is signed in a personal capacity and any institutional affiliation does not imply endorsement by that institution]
Lawrence Bader
Fellow of the Society of Actuaries
Andrew G. Biggs
Resident Scholar
The American Enterprise Institute
Zvi Bodie
Professor of Management, Finance and Economics
Boston University School of Management
Jeffrey R. Brown
William G. Karnes Professor of Finance and
Director of the Center for Business & Public Policy
University of Illinois
Jeremy I. Bulow
Richard Stepp Professor of Economics
Graduate School of Business
Stanford University
Wayne Cannon
Fellow of the Institute of Actuaries of Australia
Bernard Casey
Principal Research Fellow
Warwick Institute for Employment Research
Daniel Clarke
Departmental Lecturer in Actuarial Science
Department of Statistics
University of Oxford
Tony Day
Founder
Scarce Capital
Jon Exley
Fellow of The Institute of Actuaries
Thornton Steward
Jeremy Gold
Jeremy Gold Pensions
Philip Lawlor
David A. Love
Assistant Professor of Economics
Williams College
Jon Palin
Fellow of The Institute of Actuaries
George G. Pennacchi
Professor of Finance
University of Illinois
John Ralfe
John Ralfe Consulting
Neil Record
Institute of Economic Affairs
Ronald J. Ryan, CFA
Chief Executive Officer
Ryan ALM, Inc.
Crispin Southgate
55 Calton Avenue
London, SE21 7DF
Cliff Speed
Fellow of the Faculty of Actuaries
David Starkie
Senior Associate
Case Associates
Ian Sykes
Fellow of The Institute of Actuaries
Peter Tompkins
Fellow of the Institute and Faculty of Actuaries
Simon Scarpa
