Will public pensions cost £40,000 each?

Analysis
By Ian Pollock
BBC personal finance reporter

Public pensions may be very expensive to fund

Let me make a prediction.

When you open your newspaper, you may read some screaming headlines.

They will suggest that every household in the country will have to set aside £40,000 to fund the pensions of public employees such as NHS staff, civil servants and teachers.

This rather alarming suggestion has been drawn from an analysis by the very large actuarial firm, Watson Wyatt.

They have been making some interesting calculations.

They have looked at how much money the government would have to put aside if unfunded state pension schemes were paid for out of an investment fund rather than, as at present, out of taxation.

False assumptions?

Last week the government said such a fund would need assets worth £530bn.

Watsons argues that this involves a false investment assumption; that the fund would earn a return of 3.5% above inflation every year.

The actuaries go on to argue that the government should assume such a fund would earn no more than the current return on inflation-proofed government bonds.

Currently, these give investors a very safe but very meagre return of around 1% over inflation.

So with a much smaller inflow of cash for every pound held, the government fund would need to be bigger to meet its future payments.

Much, much bigger in fact.

Top up the fund by an extra 3% to account for people living longer and Watsons come up with a figure of £960bn, not far off the total stock of private debt owed by people in the UK.

Divide this by the number of households in the country and you get £40,000 each!

Apples and pears

So, should we all die of fright at the thought of this financial Armageddon?

It is a measure of the extent of the promises that have been made Stephen Yeo, Watson Wyatt

Actually, no.

The Watson Wyatt analysis is really a comparison of apples with pears.

The first point is that the government has absolutely no plans to create a national pension fund to pay for the retirement income of civil servants, nurses, teachers etc.

And even if it did, there wouldn't be nearly enough inflation-proofed bonds in circulation left to buy up.

Any such fund would be forced to put much of its money in a much wider spread of investments such as shares, bonds issued by companies and foreign governments, and property.

In other words, it would have to act rather like a real investment fund, such as the ones that underlie most private sector pension schemes.

Almost by default then, it would probably earn a higher real rate of return than just 1%.

Lord Turner's Pensions Commission warned about the rising cost of pensions

In fact, if the real rate of return was 3.5%, the sort commonly assumed for funded pension schemes, then the size of the government's non-existent pension fund could shrink closer to the estimate it published last week of £530bn.

That, of course, is still a lot of money, even if it is not going to be crystallised into a cash sum that all tax payers have to stump up right now.

As the author of the Watson Wyatt research, Stephen Yeo, points out, "It is a measure of the extent of the promises that have been made."

Real costs

There is no doubt that the pensions promised to public sector staff certainly do carry a real and increasing cash cost

In 2002, according to Lord Turner's Pensions Commission, the unfunded public sector schemes paid out 1.5% of the country's total economic output (GDP).

That amounted to about £15bn.

The government has since estimated that figure will rise over the next 30 years to 2.1% of GDP.

So the pensions certainly have to be paid, and by the taxpayer and council tax payer directly.

And as that is a 40% increase, they will absorb a lot of extra cash.

So looking at just how much, and how it might be paid for, is a very sensible thing to do.

That is why the government has been so keen to make public servants work longer before retiring, so that the financing of the schemes won't balloon out of control.

But you won't have reach for your cheque book and write out a cheque for £40,000.