Published in the Wall Street Journal, 18 September 2011
Last week Britain’s public-sector unions announced that they would soon commence a “long, hard and dirty” dispute over proposed changes to their members’ pensions. Trades Union Congress Secretary General Brendan Barber says he is fully confident that the public will back the industrial action. Because this strike will cost the public a great deal of money and inconvenience, and because the unions have asked us to back them, it’s worth taking a non-partisan look at whether their cause is justified.
Pensions are a form of deferred compensation, so it clarifies matters to look at them as part of workers’ overall remuneration. On this basis, at first glance, the unions appear to have a reasonable case: The government’s proposed reforms would reduce the value of public-sector pensions and, hence, workers’ total remuneration. At the same time, the government is asking its workers to contribute more towards the cost of their pensions—effectively reducing their take-home pay. Furthermore, the unions claim, public-sector workers deserve better pension packages than their private-sector counterparts to make up for their supposedly lower salaries. The cost of these pensions to the government currently equals an apparently affordable 2% of GDP, and is projected to fall in the future.
However, if we take a more nuanced view, things look a bit different. The value and cost of public-sector pensions has consistently risen in recent decades. This is in part because life expectancies have improved dramatically: Today, a 60-year-old can expect to live and collect a pension for 28 years, whereas in the 1970s he would have expected to live another 18 years. This increase has been progressive, meaning that each generation of civil servants are effectively being remunerated more than their predecessors. They can expect to live longer and so their pensions are paid for a longer period.
Another factor affecting the cost of pension-provision is that real interest rates have progressively fallen over recent years, making pensions more expensive for employers. In this context think of the real interest rate as akin to the long-term exchange rate for converting pension costs into salaries. The combined effect of reduced real interest rates and increased life expectancy is that the costs of government pensions have approximately doubled in the last 20 years, in relation to public-sector workers’ other remuneration. Today, the value of civil servants’, teachers’ and health workers’ pensions is worth around 40% of their salary, and around 70% for firemen and members of the armed forces.
The actual value and cost of public-sector pensions is even bigger than that, because pensions are not taxed. For a private company, this makes pension sa good way of paying employees, because the money comes with a bonus tax break for the worker. But if you are the government, this is bad news: Giving your employees a bigger salary instead of a bigger pension would mean recuperating more of the cost as tax revenue. Likewise, paying more generous pensions is actually more expensive for state employers than paying more generous salaries.
So is the government justified in trying to reform pension benefits? If another benefit were to double in value—for example, imagine that an employer paid staff rents and these doubled over time—it would seem entirely reasonable for the employer to either seek to renegotiate the employees’ contracts and ask them to contribute more towards their housing costs, or to offer a valuable but cheaper form of compensation, such as a higher wage. Why should pensions be any different? The part of the Cameron government’s proposal that unions are making the biggest fuss over is an increase of 3% (or roughly 2.5% after taxes) to the amount that public-sector workers contribute to their pensions. Currently public workers contribute between 3.5% (for civil servants) and 11% (for police and firefighters) of their salaries to their pension plans. Union leaders are warning that the additional 2.5% would prompt many public workers to opt out of pensions entirely. But this only shows how little they understand the pensions’ true value: By opting out, workers would effectively be forgoing at least a third of their salary instead of paying an extra 2.5% of it.
The debate over public-sector pensions often centers around whether they are “affordable.” But affordability does not mean value for money. The government could probably “afford” to buy all its top employees Lamborghinis but that would hardly be a good use of taxpayers’ money. The government-commissioned Hutton report did recently project that the value of public-sector pensions would decline to 1.8% of GDP by 2030 from 2% today. But the devil is in the details. First, the Hutton report assumes that pension plans will be reformed in some of the ways that the unions are fighting against. Second—and I say this as an actuary—one must always ask what happens if things go wrong? What if, for instance, Britain is entering a Japanese-style “lost decade” of low growth and spiraling government debt? It is perfectly possible, given our country’s existing high debt levels and aging population. Under this scenario the cost of public pensions as a percentage of a shrinking GDP will increase, not decrease.
In my view, the unions’ looming strikes and protests are predictable, though not entirely justified. But the Cameron government is missing a trick here: It could offer employees a generous one-off salary increase—say, a 25% raise—in return for opting out of their pensions. That way everyone would be happy: public-sector workers would have an apparently bigger salary, taxpayers would be off the hook for some pension liabilities, and the government would receive extra tax revenue. Maybe this fall doesn’t have to be long, hard and dirty after all.
Nick Silver 