Liam Halligan: Public Sector Pensions: The UK’s Hidden National Debt

With even sober commentators claiming that more than 10% of British government taxes will be used just to pay British government debt interest in four years’ time, we could be heading into interesting times. However, if the government’s planned austerity programme becomes window dressing and bureaucratic obfuscation rather than warm bodies out of the door, or if HM Treasury has been too optimistic on its growth estimates, or if the Debt Management Office gets hit by much higher interest rates to attract gilts buyers, then this percentage figure could go a lot higher still.

That’s an awful lot of hurdles to avoid. Or if the British state were an aeroplane, then that would be a particularly small runway to land upon. With no more parachutes to go round, let us hope that its pilots stay strong enough to remain at the controls rather than standing on the wings and praying.

To make things even more interesting, what these sober commentators usually fail to take into account is the amount of tax which the private citizen will also be coerced to hand over to pay most British government employee pensions. Currently, very few of these pensions are funded through investment and returns, which some might say leads to the moral hazard of civil servants failing to care about nurturing the business prospects and long-term financial health of the rest of the country. Most government pensions are funded on the hope that future British government taxpayers will accept increasing retirement ages and will remain happy to fork over increasing amounts of cash from their own dwindling private pension pots to ensure that most British government employees can continue to retire at 60 with comfortable index-linked pensions.

Add this to the debt interest payments coming from future taxation and the question the British government has to ask itself is will the taxpayer wear it? Will we be happy to work at 75 and pay 50% taxes to see most of this swallowed up to pay for the fiscal mistakes and the retirement comfort of the same British government civil servants who sleepwalked us into this gigantic financial mess in the first place? While pondering that, the first port of call they ought to visit for answers is the bubbling magma chamber underlying all of this potential calamity, which is centred on the question of these unfunded public sector pension liabilities. And who better to be our guide into this usually undiscussed inferno, than Liam Halligan of The Daily Telegraph, who wrote the following superb piece in his most recent Economics Agenda column:

Public Sector Pensions: The UK’s Hidden National Debt
Telegraph Media Group (London), Sunday 11 July 2010, City, Page 4

By Liam Halligan

For many years, this column has highlighted the spiraling cost of the UK’s unfunded public sector pensions. Others are now joining the fray. This vital issue is bubbling close to the top of the political agenda and there it should stay, until a solution is found. The taxpayer liability involved is the same size, or even bigger, than the UK’s official national debt.

Last week saw the publication of a compelling report by the Institute of Directors and the Institute of Economic Affairs – laying out a series of measures that would help rein-in the potentially disastrous costs of a pension scheme that caters to only a fifth of the UK workforce.

The word “scheme” flatters what actually goes on. Incredibly, the vast majority of UK public sector pensions aren’t funded by contributions that have been invested and, over many years, benefited from returns and compound interest. If only.

So chaotic is the UK system that most state workers receive occupational pensions paid for directly from current taxation. That’s why our public sector pension system is so vulnerable to changing demography, with the number of retirees growing and the tax base shrinking as the baby-boomers quit work. It is, in the words of this IOD/IEA report, an “unstable Ponzi scheme”.

It is disgraceful that, in one of the world’s most sophisticated countries, arguably the centre of the global asset management industry, years of Whitehall buck-passing and obfuscation have resulted in us running a public sector pension scheme that is almost entirely unfunded. As long as the civil servants involved clung on to their public sector pension entitlements, why should they care?

The same goes for successive government. Politicians have repeatedly ducked this issue – at least those from the main parties. As recently as March 2009, Lord Oakeshott, a Liberal Democrat peer widely admired for this financial acumen, led attempts to set up “Turner II” – an official inquiry into public sector pension costs, something that Lord Turner’s five-year “root and branch” commission singularly failed to do. Yet Oakeshott’s proposals were voted down, not just by the then Labour government, but the Tories too.

Unsurprisingly, the IOD/IEA document sparked knee-jerk condemnation from some of the union leaders who profess to represent Britain’s public sector workers. Ministers, apparently, “won’t know what has hit them” if they dare to modify schemes designed 50 years ago and barely changed since even though life expectancy has risen by almost two decades.

As the report shows, many state workers who retire at 60 years of age – as the vast majority still do – will draw a final salary pension, paid out of current taxation, for longer than they actually worked. Any trade unionist who doesn’t accept that this is financially insane is either innumerate or incredibly selfish.

So I say the coalition government should be bold. In these tough times, the general public is increasingly miffed at shelling-out ever more tax to pay for state workers’ guaranteed pensions at 60, while having to work longer before receiving their pension, the size of which has been slashed. Once the facts come to light, and the extent of the costs is more widely understood, I reckon recalcitrant trade union leaders will be blown away by a barrage of public disdain.

So I say bring on a fully-blown battle over public sector pensions. Because of all the excessive government spending that goes on, the huge bill for these gold-plated, index-linked, final salary schemes for state workers is among the most difficult to swallow.

For one thing, as the IOD/IEA report makes clear, the disparity between occupational pensions in the public and the private sector is vast – and getting wider all the time. As general pension provision crumbles, only 11pc of private sector workers now enjoy the relative security of contributing to an employer pension scheme that will provide them with a retirement income proportionate to their final salary.

This expensive privilege is, meanwhile, still bestowed on 94pc of state workers – the vast majority of whom can draw their pension from 60 years of age or even younger, even though private sector pension ages now average over 65 and are rapidly heading towards 70.

Union leaders claim that generous public sector pensions are “compensation for lower public sector wages”. As the IOD/IEA report says, “this cannot now be argued with any degree of credibility”. That’s because state sector wages are, on average, considerably higher these days than those in the private sector – especially outside London and the South East. On top of that, public sector employees work fewer hours, get more holiday and have much more job security than the rest of us. And far, far better pensions on top of that.

The unions like to cite that annual public sector pension payouts average just £6,000 in the civil service and £7,000 in the NHS. But the average doesn’t tell the whole story – seeing as it includes pensions paid to part-time workers and those who only held their state jobs temporarily. Many former state workers command annual pensions exceeding £20,000 – or even £100,000 in the top echelons of the civil service – and are set to draw such pensions for more than 20 years, paid for out of current taxation. That simply cannot be sustained.

Along with the huge discrepancy between public and private sector pensions, the IOD/IEA report highlights the lack of transparency in how the public scheme is run. People are now spending at least twice as long in retirement as previous generations. The cost implications of this have been very visible for funded private sector schemes – as annual pensions have fallen and pension ages have been pushed into the future.

The financial implications of our changing demography on public sector schemes has been deliberately hidden, though, allowing such schemes to remain largely unaltered. In short, Whitehall rigs the underlying assumptions to minimize future costs and then buries the entire liability off-balance sheet. Anyone running a business this way would be accused – and convicted – of fraud.

The government says total outstanding public sector pensions liabilities are equivalent to 53pc of national income. The IEA/IOD puts the true cost at 74pc of GDP. Towers Watson, a highly-respected group of actuaries, calculates total liabilities as no less than 83pc of national income – more than our national debt.

Remember, this liability must all be met out of current taxation and pays for the pensions of just a fifth of the workforce. And having attempted to hide the bill, Whitehall is increasingly trying to fund public sector pensions via council tax – paid by all retirees, of course, many of whom are struggling on denuded private sector pensions.

Our public sector pension system is imposing a massive burden on former and existing private sector workers – to say nothing of our children and grandchildren. And every additional worker the state employs increases that burden even more.

Coalition ministers tell me they now “get” the problem. An official commission has finally been set up – and will publish an interim report in September. I urge those involved to take note of the IOD/IEA recommendations – a minimum 2pc increase public sector pension contributions and reduced entitlements for each year of service, along with a “hybrid” scheme giving state workers some guaranteed occupational pension benefit with a money purchase scheme on top.

No-one wants to deny public sector workers a decent pension. But our shifting demography cannot be avoided and the burden must be shared by all.

Liam Halligan is Chief Economist at Prosperity Capital Management