Put the Bank of England in charge of public sector pensions

Should the Bank of England be put in charge of putting our public sector pensions on a more rational, economic footing?

Having read today’s hard-hitting report from the Public Sector Pensions Commission (a joint effort between the Institute of Economic Affairs and Institute of Directors, not to be confused with the government commission to be chaired by John Hutton) I believe that case can be made.

One of the most shocking facts in the report is the way the government has hidden the true cost of public sector pensions. As Stephanie Flanders of the BBC explains, the government uses an inappropriately high discount rate to calculate the value of the liabilities building up in these schemes. The higher the discount rate you use the less it appears you have to set aside today.

Of course, the whole problem is that, with the exception of local government schemes, nothing is being set aside. Public sector pensions are unfunded schemes with payments to pensioners being met by the contributions of employees and – increasingly – taxpayers.

To make matters worse the government also uses the wrong discount rate when calculating workers’ contributions. As Ros Altmann, one of the panellists behind the report explains, ‘it assumes that the government can borrow at an interest rate of 3.5% above inflation, when the real yield on index-linked gilts [the asset that you would invest in to match the pension promises made to employees] is less than 1%.’

All of this means that the government misleads us by putting the value of these pensions at around 20% of workers’ salaries, when in reality it is worth at least double that. Damian Reece at the Daily Telegraph thinks this is a rip-off for tax payers. Certainly it means that the true worth of these pensions is hidden: stretching the pensions gap between private and public sectors to breaking point and concealing the true cost to the country. The most recent estimate by Towers Watson of outstanding public sector pension liabilities was over £1.1 trillion or £45,000 per household. The last official government estimate put the figure at £770 billion, itself equivalent to £30,000 per household.

What has the Bank of England got to do with this? Well the report says the Bank ‘offers its employees a non-contributory funded final salary scheme that is very similar to the unfunded public sector schemes.’ In 2005 it changed the discount rate used to calculate costs and contributions to the scheme and adopted the return on index-linked gilts as its benchmark. This immediately lifted the current service cost to 41.3% of salaries. Not only was this realistic, it was far more transparent.

The commission recommends that a new agency be created to manage public sector pension schemes and on the basis of the good work the Bank of England has done on its own scheme I would suggest that it look no further.

The commission wants the new agency to issue lots of index-linked gilts in which public sector schemes would invest, something that the Bank should be able to do. This would mean it overlapped with the Debt Management Office, an executive agency of the Treasury. But given that the Treasury is giving the Bank of England extra powers to regulate the City following the failure of the Financial Services Authority, perhaps it should get powers to sort out the economic mess behind public sector pensions.

As the report says a combination of raising the retirement age, increasing employee contributions and switching schemes from a final salary basis to a career average is the only way to make public sector pensions sustainable. Public sector workers will not benefit from locking the country into pension promises that it cannot afford.