James O'Neill's Blog

May 11, 2012

Lies, damn lies and public sector pensions

Filed under: Uncategorized — jamesone111 @ 9:08 am

Every time I hear that “public sector workers”  are protesting about government plans for their pensions –as happened yesterday – I think of two points I made to fellow school governors when the teachers took a day off (with the knock on cost to parents and the economy) these were

  • Does  classroom teachers understand their union wants them to subsidize the head’s pension from theirs ?  (Have the Unions explained to the classroom teachers that is what they are doing
  • Any teacher who is part of this protest has demonstrated they have insufficient grasp of maths to teach the subject (except, perhaps to the reception class.)

This second point is the easier of the two to explain: the pension paid for over your working life is a function of:

  • The salary you earned (which in turn depends on the rate at which your salary grew)
  • What fraction of your salary was paid in to your pension fund. It might be you gave up X% or your employer put in Y% that you never saw or a combination.   
  • How many years you paid in for (when you started paying in, and when you retire)
  • How well your pension fund grew before it paid out
  • How long the pension is expected to pay out for (how long you live after retirement)
  • Annuity rates – the interest earned on the pension fund as it pays out.

In addition, some people receive some pension which wasn’t paid for in this way; some employers (public or private sector) make guarantees to top up either the pension fund so it will buy a given level of annuity or to top-up  pension payments bought with the fund. The total you receive is the combination of what you have paid for directly and the top-up.
Change any factor – for example how long you expect to live – and either what you have paid for changes or the other factors have to change to compensate. Since earnings and rates of return aren’t something we control, living longer means either we have pay for a smaller pension, or we must pay in more, or retire later or some combination of all three. Demanding that the same amount will come out of a pension for longer, without paying more in is a demand for a guaranteed top-up in future – in the case of public sector employees that future top-up comes from future taxes, for private sector it comes from future profits.

It’s easy for those in Government to make pension promises because those promises don’t need to be met for 30 years or more. Teachers whose retirement is imminent would have come into the profession when Wilson, Heath or Callaghan was in Downing Street, and all 3 are dead and buried; so with the exception of Denis Healey are all the chancellors who set budgets while they were in office. It’s temping for governments to save on spending by under-contributing to pensions today, and leave future governments with the shortfall: taken to the extreme governments can turn pensions into a Ponzi scheme – this year’s “Teachers’/Police/whatever pay” bill covers what all current teachers/police officers / whoever are paid for doing the job and all pensions paid to retired ones for doing the job cheaply in the past. Since I am, more-or-less, accusing governments of all colours of committing fraud, I might as well add false accounting to the charge sheet. Let’s say the Government wants to buy a squadron of new aircraft but doesn’t want to raise taxes to pay for them all this year; it borrows money and the future liability that creates is accounted for. If the deal it makes with public sector workers is for a given amount to spend today, and a promise of a given standard of living in retirement ,does it record that promise – that future liability – as part of pay today? Take a wild guess.
This wouldn’t matter – outside accounting circles – if everything was constant. But the length of time between retirement and death has increased and keeps on increasing. For the sake of a simple example: lets assume someone born in 1920, joined the Police after world war II , served for 30 years and retired in 1975 at age 55 expecting to die at 70. Their retirement was half their length of service. Now consider someone born in 1955, who also joined the police at age 25, served for 30 years and retired 2010. Is any one making plans for their Pension to stop in 2025 ? We might reasonably expect this person to live well into their eighties – so we’ve moved from 1 retired officer for every 2 serving, to a 1:1 ratio. I’m not saying that in 1975 the ratio was 1:2 and in 2012 it is 1:1 but that’s the direction of travel. 

I’ve yet to hear a single teacher say their protests about pensions amount to a demand that they should under-fund their retirement as a matter of public policy and their pupils – who will then be tax payers – should make up difference. As one of those whose work generates the funds to pay for the public sector I must choose a combination of lower pension, later retirement, and higher contributions than I was led to expect when I started work 25 years or so ago. And there are people demanding my taxes insulate them from having to do the same; or (if you prefer) demanding a pay rise to cover the gap between what past governments have promised them and what they are actually paying for, or (and this becomes a bit uncomfortable) that government starts telling us what it really costs to have the teachers, nurses, police officers and so on we want. 

But what of my claim that Unions get low paid staff to subsidize the pensions of higher paid colleagues. Lets take two teachers; I’ll call them Alice and Bob, and since this is a simplified example they’ll fit two stereotypes: Alice sticks to working in the class room; and gets a 2% cost of living rise every year. Bob competes for every possible promotion, and gets promoted in alternate years, so he gets a 2% cost of living rise alternating with a 10% rise. Although they both started on the same salary after 9 end-of-year rises, Alice’s pay has gone up by 19.5% and Bob – who must be a head by now – has seen his rise by 74%  
Throughout the 10 years they pay 10% of their salary into their pension fund – to make the sums easy we’ll assume they pay the whole 10% on the last day of the year, and each year their pension fund manager earns them 10% of what was in their pension pot at the end of the previous year. After 10 years Alice has £17,184 in her pension pot, and Bob has £20,390 in his.

Alice (and her fellow class room teachers) are told by the Union Rep that any attempt to change from final salary as the calculation mechanism is an attack on your pension, for her, this is factually wrong. If you are ever told this you need to ask if you are a high flier like Bob or if your career is more like Alice’s. To see why it is wrong (and lets put it down to the Union rep being innumerate , rather than dishonest), lets pretend the pension scheme only has Alice and Bob in it. So the total pot is £37,574 – Alice put in 46% of that money, but of it is shared in the ratio of the final salaries 11,950 : 17,432 ,Alice gets 41% of the pay out. 
You can argue it doesn’t work like that because Alice’s pot (at 1.44 times her final salary) might just cover the percentage of her final salary she has been promised: Bob’s pension pot is only 1.17 times his final salary which will give him a smaller percentage so the government steps in and boosts his pot to be 1.44 time his  final salary just like Alice’s. So Bob gets a golden handshake of nearly £4700 and Alice gets nothing.
Suppose 1.44 years is nowhere near enough and Alice and Bob need 3 years salary to buy a large enough annuity; the government needs to find £18,668 for Alice (108% of her pot), and 31,907 for Bob (156% of his pot). Whichever way you cut and slice if your salary grows quicker than your colleagues you will do better out of final salary than they do. If it grows more slowly you will fare worse.  

Alice Bob
Salary Increase Pension Payment Pension Pot Salary Increase Pension Payment Pension Pot
Year 1   10,000.00 2%               1,000.00     1,000.00   10,000.00 10%               1,000.00     1,000.00
Year 2   10,200.00 2%               1,020.00     2,120.00   11,000.00 2%               1,100.00     2,200.00
Year 3   10,404.00 2%               1,040.40     3,372.40   11,220.00 10%               1,122.00     3,542.00
Year 4   10,612.08 2%               1,061.21     4,770.85   12,342.00 2%               1,234.20     5,130.40
Year 5   10,824.32 2%               1,082.43     6,330.36   12,588.84 10%               1,258.88     6,902.32
Year 6   11,040.81 2%               1,104.08     8,067.48   13,847.72 2%               1,384.77     8,977.33
Year 7   11,261.62 2%               1,126.16   10,000.39   14,124.68 10%               1,412.47   11,287.53
Year 8   11,486.86 2%               1,148.69   12,149.12   15,537.15 2%               1,553.71   13,970.00
Year 9   11,716.59 2%               1,171.66   14,535.69   15,847.89 10%               1,584.79   16,951.79
Year 10   11,950.93               1,195.09  17,184.35   17,432.68               1,743.27   20,390.23
Average Salary   10,949.72   13,394.10
Combined Final Salary   29,383.60 Total Pot  37,574.58
Alice’s share   15,282.37
Bob’s Share   22,292.21
Combined Average Salary   24,343.82 Total Pot   37,574.58
Alice’s share   16,900.85
Bob’s Share   20,673.73

What if the mechanism for calculating were Average salary , not final salary? It doesn’t quite remove gap but gets very close. Instead of £2,000 of Alice’s money going to Bob it’s less than £300. 
A better way to look at this is to say if the amount of money in the combined Pension pot pays £5000 a year in Pensions, do we split it as roughly £2000 to Alice and £3000 to Bob (the rough ratio of their final salaries – each gets about 1/6th of their final salary) or £2250 to Alice and £2750 to Bob (the ratio of their average salaries and each gets about 1/5th of their average).
Whenever average salary is suggested as a basis, union leaders will say that pensions are calculated from a smaller number as if it reduces the amount paid. If the government wanted to take money that way it would be simpler to say “a full pension will in future be a smaller percentage of final salary”. Changing to average-based implies an increase in the percentage paid. 

That perhaps is the final irony. Rank and file Police officers – whose career pay is like Alice’s in the example – marched through London yesterday demanding that their pensions be left alone; you do not need to spend long reading “Inspector Gadget” to realise when you remove the problems created for the Police by politicians most of the problems that are left are created by senior officers whose career pay follows the “Bob” path. Yet the “many” marching were demanding that they continue to subsidize these “few”. As Gadget himself likes to say : you couldn’t make it up.

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