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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is an FT contributing editor
At the last official reckoning in 2021, the value of UK public service pension scheme liabilities eclipsed 100 per cent of GDP. At the time, this was greater than the official estimate of the entire private sector pension system’s asset base. It was greater even than the stock of outstanding public debt. Since then, the scale of these liabilities against the benchmarks has receded thanks to higher bond yields and copious public debt issuance. But the liabilities are still huge.
Local government workers, MPs, and those working for the Bank of England see their monthly pension contributions invested in assets like equities, bonds and infrastructure. Almost all other government employees don’t. As such, the Treasury’s largest cohort of creditors include nurses, teachers, civil servants and soldiers.
In a new report from the capital markets think-tank New Financial, I argue that investing public employee pension contributions in assets could boost investment in the UK and generate for the exchequer tens or even hundreds of billions in fiscal savings.
Such a radical transition has precedent. At the end of the 1980s, some Canadian provincial public service occupational pensions, like the UK’s public service schemes, had only non-tradable government promises to their name before making a lengthy transition towards becoming fully-funded. Today schemes like the Ontario Teachers’ Pension Plan rank among the largest and most sophisticated institutional investors in the world. Their journey offers lessons as to how to integrate independent governance, professional in-house investment management, substantial scale, and asset diversification.
More than a decade ago when looking at the question of financing, the Independent Public Service Pensions Commission recommended that public service schemes should remain unfunded. Their rationale for favouring the status quo was based on the magnitude of the transition, potential investment risks, a lack of confidence in the associated economic benefits, and the needless management costs that asset-backed schemes would incur. These objections are worth revisiting.
First, public servants and their employers are sending £50bn into government coffers this year in the form of pension contributions. Diverting all of these towards productive finance would leave the Treasury with a not insubstantial funding hole. National accounts would see both debt-to-GDP and direct interest costs rise. Yet diverting even a portion of them would probably deliver substantial fiscal savings.
While on-balance sheet debt would rise, off-balance sheet liabilities would fall. And the cost of these off-balance sheet liabilities is substantial. Public sector pension contributions are a large and unscrutinised form of government finance. Since 2011, I estimate the effective interest rate on this financing has averaged around 3.7 percentage points more than the marginal costs of market-based borrowing. It beggars belief that this finance could not have been secured more cheaply in the bond market.
Second, asset-based schemes would expose the government to the risk of poor asset performance. These are risks that every private pension scheme and sovereign wealth fund faces today. But for these risks, such funds have been rewarded over long-term horizons. In fact, the UK already has in its Local Government Pension Scheme one of the largest asset-based public service pension schemes in the world. It has benefited from returns that have not only sustained its defined benefit promises, but left it handily overfunded.
Third, more investment means more jam tomorrow but less jam today. As has been argued by the Resolution Foundation’s 2030 Inquiry report as well as the IMF, rebalancing economic activity towards investment is what the UK needs to lift productivity growth.
Fourth, by increasing the stock of financial assets, this move could be seen as making hay for already wealthy bankers, lawyers and asset managers. But such concerns should not obstruct the path to a larger and more productive economy. If imperative, they should be addressed in the design of the tax system.
The contrast between the defined contribution schemes of private companies and the inflation-linked defined benefit schemes of the public sector has become increasingly stark. The latter are sometimes characterised as “gold-plated” — an unaffordable albatross around the necks of taxpayers. Reforms would shore up their ongoing political viability. They would also reduce their fiscal cost and create new investment powerhouses, helping to lift national investment and economic growth for the benefit of all.
