Comment

Generation gap

It is the discount rate that matters in calculating future pension liabilities argues Lindsay Tomlinson, NAPF chairman

As we all know only too well, the government's primary economic task is to manage the fallout from the 2008 financial crisis. This remains urgent. It will continue to remain the chief preoccupation for some time to come.

But alongside this urgent task there is an equally important longer term problem to resolve – this is to achieve a sustainable intergenerational settlement in our ageing society. If each generation does not feel that it has received its fair share of the national income over its lifetime, intergenerational conflict will produce big problems. And that is the current position, with the baby boom generation having staked a claim on national resources which succeeding generations will regard as inequitable.

Symptoms of this problem can be seen in the current heated discussion of public sector pensions, in the debate about pension scheme deficits and in the effects on corporations of the Pensions Regulator's activities. Further symptoms are also going to be seen in arguments about long term care and NHS funding.

A fair and rational solution

To make any progress towards a fair and rational solution, we need to understand the likely costs of future benefits. There is one fundamentally important variable in arriving at cost estimates. That is the discount rate that is to be used.

All arguments about intergenerational issues hinge on the discount rate used. For example, the Stern Review on the “Economics of Climate Change” considered the costs of taking action now in comparison to future costs if action were not taken. The discount rate is the critical factor. The same is true when seeking to include decommissioning costs when considering plans to build a nuclear power station. And it is equally true when considering public sector pensions in particular, or pension costs in general.

Don't panic

Given the critical nature of the decision on the discount rate, how should we make it?

When I took my actuarial exams, the view was that a long term real rate of return of 3% pa could reasonably be expected. Since the early 1980s, we have index linked gilts giving a market measure of long term real returns. These stocks were originally introduced on a real yield of 2% pa, but in the 1980s this yield was considered inadequate. Real yields went up to nearly 4% pa. In recent years the real yield on long dated index linked stocks has fallen significantly, to around 1% pa.

Which of these discount rates should we now use? This depends on a host of considerations. What does one think of market based valuation methodologies? Are interest rates currently distorted by quantitative easing and the dearth of long dated index linked stocks? What is the likely growth rate of the economy etc? And, for the hardened cynic, what result does one wish to achieve?

It seems to me that a long term discount rate of around 2.5% pa real might be a reasonable basis for policy decisions. To be absolutely clear, this is a strictly personal view. If one uses such a rate, pension liabilities shrink and we avoid frightening ourselves into panic measures, in both private and public sectors.

Fulfilling promises

The NAPF is conducting a review of the current accounting standards for pensions. Discount rates are a crucial part of the exercise. One of the factors we must take into account is the way in which current market based measures of liabilities are not helping us to have a considered political debate.

To summarise, it is the discount rate that matters. Current market interest rates are too low and overstate future liabilities. And if I am wrong, we should be worrying even more about the 2008 financial crisis and the immediate economic outlook, not about our ability to fulfil promises in 30 years' time.

Lindsay Tomlinson is chairman of the National Association of Pension Funds; lindsay.tomlinson@blackrock.com