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Thursday, 18th April 2024 |
| Funding of public pensions - will the politicians leave the money alone |
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| The funding of public pensions has often be seen as a positive economic step by a government coming to terms with the financial reality of past promises made. However, as part of the euro zone, does this hold true, and, if so, does it matter? asks John Mannion |
There has been considerable publicity over the virtue of the Irish Government deciding to fund their pension obligations at a more rapid pace than the traditional pay-as-you-go approach. This approach has many economic arguments favouring it which have been widely commented upon. Such supporting arguments include:
•The financial discipline imposed on paying for promises decreases the likelihood of profligate promises being made.
•The establishment of a pool of investable assets with a long term horizon provides a boost to national capital markets that have numerous spin-off benefits.
•Future generations of taxpayers are spared what might become an unmanageable burden as the number of retirees increases.
•The pensioners receive better security as it is less likely that future Governments try to reduce benefits retrospectively (e.g. reduced indexation of pensions).
Overall, the concept of saving to meet for liabilities arising now and in the past has a simple and easy political message that is well understood by the electorate at large.
Leaving Pay-As-You-Go behind
In contrast the traditional approach of pay as you go when taken to the community could be viewed as saying "trust me I'm a politician". The basic tenet supporting pas-as-you-go could be expressed as follows:
With a responsible Government, long term infrastructure investment would be made rather than funding the pension obligations arising today. This infrastructure could be in a range of areas including health, education, transport etc. As these were wise investments the pay-off would be significant and future generations of taxpayers would on a net basis be better off. In addition, as a large part of value can not be captured in a commercial environment directly but falls into the community at large it is unlikely that a commercial enterprise would make such an investment.
The triggers for governments all over the world to move from pay-as-you-go included.
•Projections of the populations showing that there would be both an increasing number of pensioners but a declining relative number of workers. The pensioners were also expected to live for longer.
•Governments came under external; financial scrutiny with financial market globalisation and especially with the activity of rating agencies having a real impact on the Governments borrowing cost.
•Governments and the rating agencies were starting to get to grips with just how large some of these unfunded pension liabilities were. Even more interesting is just how large they were projected to become.
•The community acceptance through the privatisation programmes that there are a number of activities which are best handled outside of Government - especially the investment of money.
Does it matter?
On one hand we have the Government spending money on important services, on the other it is farmed out to investment managers who make it available for productive investment. In a closed national economy with effective governance processes the money would ultimately be highly productive.
To my mind there are three key areas where it does matter - and not just to the actuaries.
Almost all of the public commentary is based around whether a better process is available or not and mostly this revolves around the governance of the investment process. The clear experience is that unless the management is totally removed from political influence - including the appointment of politically motivated trustees - it is invested in a sub-optimal way in the commercial world. There can be no half-way house. The irony is that such a large amount of money will never be long removed from political influence - so the processes at least need to keep it as far away as possible.
Secondly under the control of the market a large part of it will be invested outside the national economy. It is sub-optimal to place restrictions on the extent to which it can be invested within or outside the Irish economy. Once there is a large fund to invest, it requires consideration of all global investment opportunities 99% of which exist outside of Ireland. This is not to say that a substantial level of investment within Ireland does not also make sense - but with the euro the currency risk card can not be played to keep the money on shore.
Thirdly, an important benefit in moving from pay as you go was that there was a good story to be told to the credit rating agencies. This story improved the credit rating agencies long term projections which potentially reduced sovereign borrowing costs. To the extent these were funded from offshore there would be a direct benefit. These savings paid for part of the funding. More importantly it normally stopped the unfunded liability expanding as a percentage of GDP which was often expected to happen if pay-as-you-go continued. This meant that it could be said to be "under control". Such an expansion would detract from the rating applied at a future date. To the extent that the Government's credit risk is assessed as strong there are flow on benefits in interest costs through the whole economy.
A question of trust
With the single currency the whole credit rating issue no longer appears to apply. So if the other countries in the euro zone are not also funding will Ireland (with less domestic infrastructure as it has been funding pensions) then also have to pay for the obligations of the other countries who have been less thrifty?
Perhaps the fundamental issue is one of trust. The driver for many other Governments around the worlds was one of trust (or lack of). Would future national Governments be able to:
•increase tax on a reducing number of taxpayers to support the past promises to
the increasing numbers of pensioners
•invest the money efficiently and without undue short term political influence
•balance the interests of competing generations.
Now we have a new area of trust around the fiscal reserve of other euro zone countries. Will the Irish leadership on this issue be rewarded by other countries following suit? It will be interesting to see - and not just for the actuaries - whether that trust was well placed in the areas of pensions. |
John Manion is an actuary and principal with Towers Perrin in London. He is Australian by nationality.
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| Article appeared in the December 1999 issue.
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