Consultation on the discount rate used to set unfunded public service pension contributions

Transcription

1 Cnsultatin n the discunt rate used t set unfunded public service pensin cntributins December 2010

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3 Cnsultatin n the discunt rate used t set unfunded public service pensin cntributins December 2010

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5 Cntents Chapter 1 Intrductin and scpe f cnsultatin 3 Page Chapter 2 The SCAPE discunt rate and the current apprach t setting this rate 11 Chapter 3 Optins fr a new SCAPE discunt rate 15 Chapter 4 Summary f questins 19 Annex A The cnsultatin prcess 21 Annex B Schemes cvered by this cnsultatin 23 Annex C Public service pensin schemes: cnsultatin requirements 25 Annex D SCAPE: explanatin f methdlgy 27 Annex E Glssary 29 1

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7 1 Intrductin and scpe f cnsultatin Overview f chapter 1.1 This chapter intrduces discunt rates and their use in setting cntributin rates in unfunded public service pensin schemes. The scpe f the cnsultatin is explained and the implicatins f a lwer discunt rate are cnsidered. It then sets ut the questins n which respnses are requested. Discunt rates and their use in pensins The nature f pensins requires understanding f the value tday f future payments 1.2 Pensins are imprtant, cmplex and lng-term financial cmmitments, prviding peple with incme n which they rely during retirement. In rder that peple can make infrmed decisins and emplyers understand the implicatins f any pensin prvisin ffered, it is imprtant t be able t understand the value tday f future pensin payments. Discunt rates can prvide a value tday fr future expenditure cmmitments 1.3 In general, peple prefer t receive gds and services nw rather than later: this is knwn as time preference and is ften taken int accunt when cmparing csts and benefits that ccur in different time perids. Discunting is a technique that takes accunt f time preference by discunting (r reducing) the amunt f future payments, t express them in tday s terms. A cnsequence f time preference is that investrs demand a return n their investment, s that they will be able t cnsume a greater amunt f gds r services in the future as cmpensatin fr giving up cnsumptin tday. Discunt rates smetimes reflect the anticipated investment return n a prtfli f assets: the discunted value f future payments then represents the amunt f mney that needs t be invested tday in rder t meet thse future payments. Bx 1.A, taken frm the interim reprt f the Independent Public Service Pensins Cmmissin 1 (the Cmmissin), prvides a mre detailed discussin f discunt rates. 1 Independent Public Service Pensins Cmmissin: Interim Reprt, Octber

8 Bx 1.A: Discussin f discunt rates Pensins are lng-term cmmitments. An emplyee jining a public service pensin scheme at age 25 will prbably receive pensin payments between 40 and 70 years in the future. One methd used t understand the cst f pensin prmises made t date is t calculate the present value f expected pensin payments in the future using an apprpriate discunt rate. T explain discunt rates in mre detail, let us assume that a cmpany prmises an individual a payment f 100 in 10 years time. What is the cst f that prmise nw t the cmpany? The cst t the cmpany culd be cnsidered t be the amunt f mney needed nw in rder t pay 100 t this individual in 10 year s time. Let us assume that the cmpany decides that it will invest in gvernment bnds and it expects that these will give a return f 4 per cent (nminal) per year. The cst t the cmpany f prviding 100 in 10 year s time is therefre: = Effectively, the discunt rate used is 4 per cent a, which is equal t the expected return n gvernment bnds. Alternatively, the cmpany may decide t invest in equities, where it expects a return f 8 per cent b (nminal) per year. The cst t the cmpany f prviding 100 in 10 years time (using a discunt rate f 8 per cent) will then be: = S it may appear as thugh the cmpany shuld invest in equities. This isn t necessarily the case, because equities are mre risky than gvernment bnds and s if the cmpany invests in equities there is an increased chance that the they invest nw may be less than 100 in 10 years time and they may need t make up the difference. The cncept f a discunt rate becmes mre difficult with unfunded public service pensins as there are n assets t back the pensin prmises. A final pint t nte is that the individual may put an entirely different value n the 100 which may reflect hw much they value mney nw rather than later, hw much they think 100 will buy in 10 years and hw certain they think they are t get the 100. a 4 per cent nminal, s nt adjusted fr prices b 8 per cent nminal, s nt adjusted fr prices Surce: Independent Public Service Pensins Cmmissin: Interim Reprt, Octber

9 Rle f discunt rates in unfunded defined benefit public service pensin schemes Public service pensin schemes 1.4 The majrity f public services pensin schemes are unfunded defined benefit pensin schemes, including thse cvering the NHS, teachers, civil servants and armed frces In a defined benefit pensin scheme, the level f pensin benefit is defined, usually in relatin t the member s salary. If the eventual csts f these benefits are higher than anticipated, then additinal mney will be needed t meet the benefits. Fr private sectr schemes this additinal mney wuld generally cme frm the emplyer; fr public service schemes it wuld generally cme frm the taxpayer. S in defined benefit pensin schemes, the risk is with the emplyer r the taxpayer. 1.6 In cntrast, in defined cntributin pensin schemes the cntributins are defined and the accumulated cntributins are used t purchase benefits at retirement. If the csts f these benefits are higher than anticipated, the benefits that the member can purchase will be lwer than expected. S in defined cntributin pensin schemes, the risk is with the individual. Setting cntributin rates fr unfunded public service pensin schemes using the SCAPE discunt rate 1.7 In defined benefit pensin schemes, cntributins are set t meet the level f benefits thrugh a prcess called a scheme valuatin, which is utlined in paragraph Fr funded defined benefit schemes in the private sectr, cntributins are used t purchase assets that frm a fund frm which pensin benefits are paid. If investment returns prve t be lwer than anticipated and the fund f assets is insufficient t pay the benefits, then higher cntributins are necessary t make up the shrtfall. Cnversely, if investment returns prve t be higher than anticipated, the fund f assets wuld be mre than enugh t pay the benefits and it may be pssible t pay lwer cntributins in the future. 1.9 Unfunded public service pensin schemes d nt have a fund f assets frm which pensin benefits are paid. Instead the benefits are paid ut f tax revenue. The fact that the Exchequer ultimately stands behind these pensin prmises des nt change the imprtance f setting cntributins at a level which reflects expected benefits s that: the value f benefits being earned tday is recgnised and ttal cntributins reflect this; emplyers pay a charge that is apprpriate fr public service pensin schemes, just as private sectr emplyers must pay cntributins that are apprpriate fr funded pensin schemes; and tday s decisins by Gvernment and public service emplyers abut hw many peple t emply, as ppsed t ther frms f expenditure, take int accunt the full future cst f emplying peple tday The Gvernment has develped a methdlgy fr setting cntributins in the absence f a fund f assets and this is called the Superannuatin Cntributins Adjusted fr Past Experience (SCAPE) methdlgy and the discunt rate used in this valuatin methdlgy is called the SCAPE discunt rate. Chapter 2 sets ut hw the SCAPE discunt rate is used, with mre detail n the SCAPE methdlgy in Annex D. 2 There are als a few funded public service pensin schemes, f which the Lcal Gvernment Pensin Scheme is the largest. 5

10 Reasn fr reviewing the discunt rate 1.11 Initial wrk by the Cmmissin, as set ut in its interim reprt, suggests that the current discunt rate is at the high end f what is apprpriate and the Cmmissin recmmended that it shuld be reviewed. Scpe f this cnsultatin The SCAPE discunt rate 1.12 The fcus f this cnsultatin is the discunt rate used t set cntributin rates fr the unfunded public service pensin schemes thrugh valuatins fllwing the SCAPE methdlgy this is knwn as the SCAPE discunt rate This is a cnsultatin acrss the unfunded public service pensin schemes. Where there is a specific cnsultatin requirement within these schemes this cnsultatin cnstitutes the cnsultatin n the discunt rate fr the purpses f these scheme requirements. A list f the regulatins setting ut the cnsultatin requirements fr the largest schemes is prvided at Annex C Discunt rates are used in public service pensin schemes fr a variety f purpses ther than setting cntributins. The fllwing sectins set ut hw these relate t this cnsultatin. Other uses f discunt rates in public service pensin schemes 1.15 Public service pensin schemes als use discunt rates fr ther purpses such as: scheme annual resurce accunts; individual 3 and bulk transfers 4 int and ut f schemes 5 ; calculatin f the value f pensin benefits in divrce prceedings; and prductin f varius actuarial factrs fr member ptins, such as actuarially reduced early retirement benefits In sme, but nt all, f these calculatins the public service pensin schemes currently use the SCAPE discunt rate. Discunt rates that are currently related t SCAPE include thse used fr: individual transfers int and ut f schemes (Cash Equivalent Transfer Values); calculatin f the value f pensin benefits in divrce prceedings r the disslutin f civil partnerships; and fr sme cases, the prductin f varius actuarial factrs fr member ptins Shuld the SCAPE discunt rate change, the Gvernment will take advice frm actuaries abut whether it remains apprpriate t use the SCAPE discunt rate fr these purpses. 3 Individual transfers, knwn as Cash Equivalent Transfers (CETVs) are the amunt which can be taken t anther pensin scheme instead f a deferred pensin which the member hlds within their pensin scheme. A CETV includes an adjustment t allw fr the market cnditins at the time the transfer takes place. 4 Bulk transfers ccur when a grup f scheme members are transferred frm ne pensin scheme t anther. 5 In the cases where there are mvements f staff in and ut f schemes, the value f the pensin benefits earned is either transferred ut f a public service pensin scheme r transferred in t a public service pensin scheme. This is a chice pen t thse with ccupatinal pensin benefits. 6

11 The SCAPE discunt rate and cap and share refrms 1.18 The fur largest public service pensin schemes 6 have intrduced refrms which limit taxpayer expsure t the cst pressures assciated with the rising cst f prviding pensin scheme benefits (such as imprvements in life expectancy). The cap and share plicy is designed t ensure that these cst pressures are shared between emplyers and emplyees up t an agreed emplyer cntributin cap, beynd which all further increases will be the respnsibility f emplyees. This sets a maximum limit fr emplyer cntributins thus prtecting the public finances and the taxpayer The valuatins t implement these refrms use the SCAPE discunt rate. These valuatins have been suspended while this review is undertaken and while the Cmmissin cnsiders what risk-sharing arrangements might be apprpriate fr public service pensin schemes in the future. The rle f any new discunt rate in the cap and share plicy is therefre ut f the scpe f this cnsultatin. Balance f cntributins between emplyer and emplyee 1.20 In many public service pensin schemes, cntributins are paid by bth emplyers and emplyees. This cnsultatin seeks views n the discunt rate used t set the ttal cntributin rate that will be paid by emplyers and emplyees cmbined. The split in respect f hw these cntributins are shared between emplyers and emplyees is a questin f pensin scheme design that is beynd the scpe f this cnsultatin. Cnsultatin n Fair Deal plicy t be taken frward separately 1.21 At the Spending Review 8 the Gvernment annunced its intentin t undertake a review f the Fair Deal plicy 9, reprting by summer This will be taken frward separately frm this cnsultatin althugh it will be infrmed by this review f the discunt rate and the final reprt frm the Cmmissin. Pensin schemes cvered by this cnsultatin 1.22 The pensin schemes cvered by this cnsultatin are the unfunded public service pensin schemes. The largest schemes are Natinal Health Service Pensin Scheme, Teachers Pensin Scheme and the Principal Civil Service Pensin Scheme and a full list is prvided at Annex B The discunt rates used fr setting emplyer cntributins in the funded public service pensin schemes such as the Lcal Gvernment Pensin Scheme are utside the scpe f this cnsultatin. General impact f lwering the SCAPE discunt rate 1.24 In determining cntributin rates, scheme valuatins generally lk at tw srts f cst pressures. Firstly, the cst f future pensin benefits being earned by current emplyees (future service); and secndly whether further cntributins are required because past cntributins were insufficient t meet current estimates f the value f prmises already made (past service). 6 These are the Principal Civil Service Pensin Scheme, Teachers Pensin Scheme, Natinal Health Service Pensin Scheme and the Lcal Gvernment Pensin Scheme. 7 Lng Term Public Finance Reprt: An Analysis f Fiscal Sustainability, HM Treasury, December Spending Review 2010, HM Treasury, Octber This plicy requires that when public sectr wrkers are cmpulsrily transferred frm the public sectr under TUPE, the new emplyer is required t prvide bradly cmparable benefits t public service pensin schemes. Fr mre infrmatin g t 7

12 1.25 Keeping all ther assumptins unchanged, a lwer discunt rate wuld result in higher cntributin rates at the next scheme valuatins. The effect f changing the discunt rate n cntributin rates will vary between different schemes due t the different genersity f scheme designs and the different prfiles f each wrkfrce It is imprtant t nte that sme ther changes t public service pensins wuld prvide ffsetting pressure n cntributin rates at the next scheme valuatins. The change in uprating f public service pensins frm RPI t CPI frm April will reduce cst pressures, reducing ttal cntributin rates. The increase in emplyee cntributin rates f an average f three percentage pints acrss the public service pensin schemes 11, t be phased in ver three years frm , will decrease emplyer cntributin rates in the absence f ther changes. Impact n cntributins fr future service 1.27 The Cmmissin have estimated that fr the unfunded schemes as a whle, the effect f reducing the discunt rate by 0.5 per cent per annum culd increase the calculated ttal cntributin required fr pensin benefits being earned by an average f abut 3 per cent f pay bill r 3 billin t 4 billin a year. Impact n cntributins fr past service 1.28 A change in discunt rate wuld als affect the value placed n the pensin benefits accrued relating t past service. The Gvernment has decided that it is nt apprpriate fr this t be reflected in future cntributin rates as a result f any change in the discunt rate fllwing this review. Impact n different types f emplyers 1.29 This sectin cnsiders the ptential impact f a lwer discunt rate n emplyers. Initial wrk by the Cmmissin, as set ut in its interim reprt, suggests that the current discunt rate is at the high end f what is apprpriate. This suggests that rganisatins that currently participate in the public service pensin schemes have access t public service pensin schemes at a lwer cntributin rate than wuld therwise be the case. A lwer discunt rate wuld, in the absence f ther changes, result in a higher level f cntributin rates being charged. The emplyers currently in unfunded public service pensin schemes are: Gvernment departments and ther public service emplyers such as the NHS, state schls and plice and fire services; independent prviders 12 that either have: right f access t public service pensin schemes, such as General Practitiner businesses 13, dental practices and independent schls; r staff wh retained access t their public service pensin scheme when they transferred int the rganisatin at its inceptin 14, as is the case fr sme scial enterprises. 10 Budget 2010, HM Treasury, June Spending Review 2010, HM Treasury, Octber This includes private sectr businesses and nn-prfit making rganisatins such as charitable bdies and scial enterprises. 13 Althugh General Practitiners prvide health services, they are nt emplyed as public sectr wrkers but have access t the Natinal Health Service Pensin Scheme. The same applies t dental practices. 14 In the NHS pensin scheme, it is pssible t allw staff transferring t an nn-prfit making external bdy t remain in the pensin scheme while undertaking the same duties; this is called a clsed directin. It des nt allw new staff in the external bdy t jin the scheme. 8

13 Independent prviders with access t public service schemes 1.30 In the absence f ther changes, a lwer discunt rate wuld increase the cntributin rate at which independent prviders have access t public service pensin schemes. This wuld mean increased cntributins fr such rganisatins as General Practitiner businesses, scial enterprises and independent schls. But as nted abve, ther changes t public service pensins, such as the change f indexatin and the increase in emplyee cntributins will prvide ffsetting pressure n cntributin rates at the next valuatins. Impact n emplyers within the public sectr 1.31 Any change in the discunt rate wuld have an impact n the cntributins paid by public service emplyers, but the Gvernment s intentin is that departmental budgets set in the Spending Review will nt cme under additinal pressure due t a change in the discunt rate. Impact n ptential new independent prviders f public services 1.32 The current level f emplyer cntributin rates in the unfunded public service pensin schemes is cited as a key barrier t greater plurality f public service prvisin, ptentially reducing efficiencies and innvatin in public service delivery frm independent prviders. A reductin in the discunt rate may, in the absence f ther changes, reduce the cst advantage f public service prviders when bidding against independent sectr rganisatins t prvide public services. As explained in paragraph 1.21, cnsultatin n the Fair Deal plicy will be taken frward separately. Impact n emplyees f changing the discunt rate Cntributins 1.33 As set ut in paragraph 1.20, the split in respect f hw much f these cntributins are paid by emplyers and hw much are paid by emplyees is a questin f pensin scheme design that is beynd the scpe f this cnsultatin. Other impacts 1.34 As nted in paragraphs 1.15 t 1.17, there are varius circumstances in which it has been the practice f the public service pensin schemes t use the SCAPE discunt rate fr ther purpses, sme f which directly affect individual scheme members (r ther beneficiaries). Any change t the discunt rate used will have an impact n these calculatins and, as explained, shuld the SCAPE discunt rate be changed the Gvernment wuld take advice frm actuaries n whether the SCAPE discunt rate remains apprpriate fr these ther purpses. Impact n future Gvernment expenditure 1.35 The discunt rate used t determine cntributin rates des nt have a material impact n the annual cst t the taxpayer 15 f unfunded public service pensin schemes. Timing and implementatin 1.36 Fllwing this review, any new SCAPE discunt rate wuld be used in upcming scheme valuatins, including thse currently n hld, fr the unfunded public service pensin schemes. The Gvernment will als review its guidance n individual transfers in and ut f schemes, such as Cash Equivalent Transfer Values. Implicatins fr ther activities (as discussed in paragraphs 1.15 t 1.17) will be assessed based n advice frm actuaries. 15 Annual taxpayer csts are the amunt f benefits paid t recipients by gvernment each year less cntributins received frm emplyees by Gvernment each year. 9

14 1.37 The Cmmissin expressed a preference fr a review f the SCAPE discunt rate in time fr the findings t infrm their final reprt. We wuld therefre like t share respnses t this cnsultatin with the Cmmissin as apprpriate. Questins fr this cnsultatin 1.38 This cnsultatin seeks views n the six questins belw. Questin 1: Chapter 1 sets ut the expected impacts f a lwer discunt rate. Are there any ther impacts arising frm a change in the discunt rate? Questin 2: Chapter 3 sets ut bjectives fr the Gvernment in setting the SCAPE discunt rate. Are there ther bjectives that shuld be taken int accunt? Questin 3: Chapter 3 sets ut fur ptins. What are the advantages and disadvantages f the fur ptins identified by the Cmmissin fr the apprach t setting the SCAPE discunt rate? Questin 4: Are there further appraches t setting the SCAPE discunt rate that the Gvernment culd cnsider? If s, what are their advantages and disadvantages? Questin 5: Which apprach t setting the SCAPE discunt rate d yu recmmend, and why? Fllwing yur preferred apprach, what actual discunt rate d yu cnsider wuld be apprpriate? Questin 6: D yu cnsider that there shuld be a regular review f the SCAPE discunt rate? If s, hw ften this shuld take place? 1.39 In prviding yur respnses t these questins, it wuld be helpful if yu culd: keep in mind the purpse f the discunt rate is t set cntributins in the unfunded public service pensin schemes and nte thse issues that are nt within the scpe f this cnsultatin as set ut in Chapter 1; explain yur ratinale fr favuring r rejecting ptins, with reference t the bjectives fr the discunt rate: fair reflectin f csts; reflect future risks t Gvernment incme; supprt plurality f prvisin f public services; transparent and simple; stability; and any ther bjective yu identify. specify whether the actual discunt rate yu cnsider wuld be apprpriate includes inflatin (i.e. whether the discunt rate is grss r net f inflatin), which measure f inflatin yu are using, and if it is grss f inflatin what yur crrespnding assumptin fr inflatin wuld be. If yur respnse des nt include a view n the assumed lng term average difference between CPI and RPI we will assume that discunt rates expressed in terms f RPI will be increased by 0.75 percentage pints t prduce discunt rates net f CPI; and include any analysis r evidence yu have t supprt yur prpsals, drawing n experience f ther sectrs r cuntries as apprpriate.. 10

15 2 The SCAPE discunt rate and the current apprach t setting this rate Overview f chapter 2.1 This chapter explains the apprach used fr chsing a discunt rate fr setting cntributins fr unfunded public service pensin schemes, which differs t the apprach taken by funded pensin schemes. It sets ut the ratinale fr the current discunt rate (called the Superannuatin Cntributins Adjusted fr Past Experience SCAPE discunt rate), which is based n the Gvernment s Scial Time Preference Rate. This is fllwed by a summary f the fur ptins fr alternative appraches t setting the SCAPE discunt rate identified by the Independent Public Service Pensins Cmmissin. The SCAPE discunt rate Apprach t chsing a discunt rate fr setting cntributin rates in unfunded public service schemes 2.2 As set ut in Chapter 1, it is imprtant t set unfunded public service pensin cntributins at a level which reflects expected benefits s that: the value f benefits being earned tday is recgnised and ttal cntributins reflect this; emplyers pay a charge that is apprpriate fr public service pensin schemes, just as private sectr emplyers must pay cntributins that are apprpriate fr funded pensin schemes; and tday s decisins by Gvernment and public service emplyers abut hw many peple t emply, as ppsed t ther frms f expenditure, take int accunt the full future cst f emplying peple tday. 2.3 Fr funded pensin schemes in the private sectr the discunt rate used t set cntributin rates fr pensin accrual is nrmally set equal t the discunt rate used t value existing pensin liabilities 1. The discunt rate is generally set with reference t the return expected frm the assets held by the pensin scheme, adjusted t allw fr the emplyer s financial strength and lng term cmmitment t the scheme (this is knwn as the emplyer s cvenant). Given its imprtance, the prcess used t set the discunt rate fr technical prvisins is gverned by funding legislatin Unfunded public service pensin schemes d nt hld assets, therefre the discunt rate cannt be based n investment returns. Furthermre, the prcess fr setting the discunt rate differs frm the private sectr funded schemes because: the Gvernment has a unique risk-bearing prfile cmpared t private sectr emplyers because f its ability t raise funds frm future taxpayers; and 1 This is knwn as technical prvisins. 2 Part III f the Pensin Act

16 the Gvernment s chices abut whether t make cmmitments n public service pensins require cmparisns with ther frms f future public, rather than private, spending. 2.5 A different apprach is therefre needed t chse a discunt rate fr the unfunded public service pensin schemes. A different methdlgy is als needed t calculate cntributin rates fr unfunded public service pensin schemes. The current methdlgy, intrduced in the late 1990s, is called the Superannuatin Cntributins Adjusted fr Past Experience (SCAPE) methdlgy and the discunt rate fr setting cntributins is therefre knwn as the SCAPE discunt rate. This methdlgy is explained at Annex D. The current value f the SCAPE discunt rate 3.5 per cent abve RPI inflatin 2.6 The Gvernment is respnsible fr setting the assumptins used in unfunded public service pensin schemes valuatins, including the discunt rate. 2.7 The SCAPE discunt rate has been a cnstant 3.5 per cent abve inflatin - as measured by the Retail Prices Index (RPI) - since the intrductin f the SCAPE methdlgy. Treatment f inflatin 2.8 The SCAPE discunt rate is expressed net f inflatin. As annunced at the Emergency Budget, frm April 2011 public service pensin increases will be set by reference t CPI inflatin. Ging frward, the discunt rate will therefre be expressed in terms f CPI inflatin. Hwever, this cnsultatin dcument expresses discunt rates net f RPI inflatin t aid cmparisn with the current rate. Ratinale fr the current SCAPE discunt rate fllwing the Scial Time Preference Rate 2.9 The discunt rate was set at 3.5 per cent plus RPI inflatin t be in line with the Gvernment s Scial Time Preference Rate (STPR). This is an estimatin f sciety's preference fr cnsumptin sner rather than later, used in the Gvernment's investment appraisals f different prjects that invlve spending mney in the shrt term t deliver future welfare benefit. Fr example, building a new schl r hspital has upfrnt csts but will prvide future welfare benefit t sciety. The use f the STPR in the appraisal and evaluatin f all plicies, prgrammes and prjects by Gvernment is set ut in guidance The current STPR f 3.5 per cent per annum net f price inflatin is bradly made up f three cmpnents: Catastrphe risk: 1.0 per cent - the likelihd that there will be sme event s devastating that all returns frm plicies, prgrammes r prjects are eliminated r at least radically and unpredictably altered; Pure time preference: 0.5 per cent - this reflects the preference f individuals fr cnsumptin nw, rather than later, assuming an unchanging level f cnsumptin per capita ver time; and Grwth in per capita cnsumptin: 2.0 per cent - this reflects an assumptin that future cnsumptin will be plentiful cmpared t the current psitin with crrespnding lwer marginal utility Using a discunt rate in line with the STPR reflects the unfunded nature f public service 3 The Green Bk: Appraisal and Evaluatin in Central Gvernment, HM Treasury,

17 pensin schemes by treating the schemes as inter-tempral transfers within the public sectr, in line with ther public investment prjects. It reflects the delay between the pensin prmises being made tday and the actual pensins expenditure required by the taxpayer. Using the same discunt rate the STPR gives cnsistency with ther decisins abut the csts and benefits ver time cnsidered by Gvernment It als has the benefit f being stable, rather than referenced t a specific set f investments. This means that cntributin rates nly increase due t actual effects n scheme csts (such as pay and wrkfrce restructuring, r changes in life expectancy) withut subjecting cntributins t effects such as fluctuatins in market rates, which wuld nt affect the actual cst f pensin benefits. A stable discunt rate als reduces administratin csts fr public service schemes. Pssible appraches fr setting the discunt rate 2.13 The Cmmissin has identified fur alternative appraches t setting the discunt rate: a rate cnsistent with private sectr and ther funded schemes: a rate based n the yield n index-linked gilts; a rate in line with expected GDP grwth; and a Scial Time Preference Rate that makes allwances fr the particular cntext f pensin prvisin. These fur ptins and their implicatins are discussed in the next chapter. 13

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19 3 Optins fr a new SCAPE discunt rate Overview f chapter 3.1 This chapter sets ut bjectives against which different appraches t setting the SCAPE discunt rate can be evaluated, and presents fur alternative appraches fr setting the discunt rate identified by the Independent Public Service Pensins Cmmissin. Objectives fr the SCAPE discunt rate 3.2 In cnsidering the different appraches t setting the SCAPE discunt rate it is useful t evaluate them against bjectives. Five ptential bjectives fr the SCAPE discunt rate are suggested belw. Respndents are invited t ffer additins r cmment n their relative imprtance. There are tensins between these bjectives and it is unlikely that any ne apprach will satisfy all f them. Fair reflectin f csts this is relevant s that: the value f benefits being earned tday is recgnised and ttal cntributins reflect this; emplyers pay a charge that is apprpriate fr public service pensin schemes, just as private sectr emplyers must pay cntributins that are apprpriate fr funded pensin schemes; and tday s decisins by Gvernment and public service emplyers abut hw many peple t emply, as ppsed t ther frms f expenditure, take int accunt the full future cst f emplying peple tday. When cmparing with ther frms f expenditure, cnsistency with ther lng-term spending may be desirable. Reflect future risks t Gvernment incme unfunded public service pensins are paid frm future tax revenues, which may turn ut t be different t what is expected. It may be apprpriate fr the discunt rate t reflect this risk. Supprt plurality f prvisin f public services the level f emplyer cntributin rates, calculated using the current discunt rate, is cited as a barrier t greater plurality f public service prvisin. A discunt rate mre in line with thse used in funded schemes culd prmte a mre level playing field fr independent sectr rganisatins when bidding t prvide public services. Transparent and simple a transparent and simple apprach t setting the discunt rate wuld assist with wider understanding f the mechanism fr budgeting fr public service pensins. 15

20 Stability an apprach t setting the discunt rate that avids fluctuatins in emplyer charges that d nt reflect actual changes in the expected future cash csts culd be better fr Gvernment in taking lng term expenditure decisins. Minimising unnecessary changes wuld reduce administratin csts fr the public sectr. Fur ptins fr a new apprach t setting the discunt rate 3.3 The Cmmissin identified fur alternative appraches t setting the SCAPE discunt rate: a rate cnsistent with private sectr and ther funded schemes; a rate based n the yield n index-linked gilts; a rate in line with expected GDP grwth; and a Scial Time Preference Rate (STPR) that makes allwances fr the particular cntext f pensin prvisin. Optin (a) a discunt rate cnsistent with private sectr and ther funded schemes 3.4 As explained in Chapter 2, the discunt rate used fr setting cntributins in private sectr schemes is typically set with reference t the assets held and their expected returns and the strength f an emplyer s cvenant (the ability and willingness f the emplyer t supprt the pensin scheme in the lng term). 3.5 Unfunded schemes d nt hld assets. Nnetheless, the Cmmissin highlights that ne apprach t setting the discunt rate culd be t cnsider the discunt rates used by a private emplyer f the strngest cvenant (thugh it shuld be nted that the Gvernment s ability t bear risk cannt be replicated in the private sectr) r a Lcal Gvernment emplyer. 3.6 Using the mst recent data published by the Pensins Regulatr and analysis f the 31 March 2007 English Lcal Gvernment Pensin Scheme valuatins, the Cmmissin estimates a discunt rate based n this apprach 1 culd be in the regin f 2.5 per cent t 3.0 per cent abve RPI inflatin. Optin (b) a discunt rate based n the yield n index-linked gilts 3.7 It is smetimes argued that as pensin cntributins are being used t finance current Gvernment spending, pensin liabilities shuld be discunted at the market rate f Gvernment brrwing, as measured by the yield n index-linked gilts. 3.8 The Cmmissin in their interim reprt suggest a discunt rate based n the current yield n index-linked gilts wuld be arund 0.8 per cent abve RPI inflatin. Optin (c) a discunt rate in line with expected GDP grwth 3.9 Setting the discunt rate in line with GDP grwth wuld reflect the fact that pensins frm the unfunded public service pensin schemes will be paid fr ut f future tax revenues, as ppsed t a fund f assets. Pensins culd therefre be valued by discunting at the rate at which tax revenue is expected t grw. Over the lng term, an apprpriate guide t the grwth rate f tax revenues is the lng-term future rate f GDP grwth The Cmmissin suggested that a discunt rate based n this apprach might be arund 2 per cent t 2.5 per cent abve RPI inflatin, based n recent frecasts. 1 Scheme Funding Analysis 2008, The Pensins Regulatr, 16

21 Optin (d) a Scial Time Preference Rate 3.11 As explained in Chapter 2, the ratinale fr setting the discunt rate in line with the Gvernment s STPR is that it represents the alternative public investment pprtunities fr the funds used t pay fr public service pensins. This is the current apprach and s cntinuing with this apprach is ne pssible ptin Hwever, the Cmmissin questined whether sme f the elements that make up the current rate are suitable fr public service pensins. In particular, the Cmmissin has questined the applicatin f catastrphe risk and the relevance f pure time preference. The Cmmissin als nted it might be apprpriate fr public service pensins t have a lwer discunt rate due t their very lng-term nature Taking int accunt the elements which the Cmmissin have questined abve, a discunt rate based n adjustment t the STPR wuld be arund 2 t 3 per cent abve RPI inflatin. Reviewing the SCAPE discunt rate 3.14 There is currently n mechanism fr regular reviews f the SCAPE discunt rate. This cnsultatin seeks views n whether this wuld be apprpriate and, if s, hw ften this shuld be undertaken. 17

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23 4 Summary f questins 4.1 This cnsultatin seeks views n the fllwing questins in rder t infrm the Gvernment s apprach t setting the discunt rate used t determine cntributin rates fr the unfunded public service pensin schemes. Questin 1: Chapter 1 sets ut the expected impacts f a lwer discunt rate. Are there any ther impacts arising frm a change in the discunt rate? Questin 2: Chapter 3 sets ut bjectives fr the Gvernment in setting the SCAPE discunt rate. Are there ther bjectives that shuld be taken int accunt? Questin 3: Chapter 3 sets ut fur ptins. What are the advantages and disadvantages f the fur ptins identified by the Cmmissin fr the apprach t setting the SCAPE discunt rate? Questin 4: Are there further appraches t setting the SCAPE discunt rate that the Gvernment culd cnsider? If s, what are their advantages and disadvantages? Questin 5: Which apprach t setting the SCAPE discunt rate d yu recmmend, and why? Fllwing yur preferred apprach, what actual discunt rate d yu cnsider wuld be apprpriate? Questin 6: D yu cnsider that there shuld be a regular review f the SCAPE discunt rate? If s, hw ften this shuld take place? 4.2 In prviding yur respnses t these questins, it wuld be helpful if yu culd: keep in mind the purpse f the discunt rate is t set cntributins in the unfunded public service pensin schemes and nte thse issues that are nt within the scpe f this cnsultatin as set ut in Chapter 1; explain yur ratinale fr favuring r rejecting ptins, with reference t the bjectives fr the discunt rate: fair reflectin f csts; reflect future risks t Gvernment incme; supprt plurality f prvisin f public services; transparent and simple; stability; and any ther bjective yu identify. 19

24 specify whether the actual discunt rate yu cnsider wuld be apprpriate includes inflatin (i.e. whether the discunt rate is grss r net f inflatin), which measure f inflatin yu are using, and if it is grss f inflatin what yur crrespnding assumptin fr inflatin wuld be. If yur respnse des nt include a view n the assumed lng term average difference between CPI and RPI we will assume that discunt rates expressed in terms f RPI will be increased by 0.75 percentage pints t prduce discunt rates net f CPI; and include any analysis r evidence yu have t supprt yur prpsals, drawing n experience f ther sectrs r cuntries as apprpriate. 20

25 A The cnsultatin prcess Hw t respnd A.1 This cnsultatin dcument is available n the Treasury website at A.2 Respnses are requested by 3 March Please ensure that respnses are sent in befre the clsing date. The Gvernment will als engage directly with interested grups. A.3 Respnses can be sent by t: discuntratecnsultatin@hmtreasury.gsi.gv.uk. Alternatively, they can be psted t: Public Service Pensins Discunt Rate Cnsultatin Wrkfrce, Pay and Pensins Team Public Services and Grwth Directrate HM Treasury 1 Hrse Guards Rad Lndn SW1A 2HQ A.4 When respnding, please state whether yu are ding s as an individual r n behalf f an rganisatin. Cnfidentiality A.5 Infrmatin prvided in respnse t this cnsultatin, including persnal infrmatin, may be published r disclsed in accrdance with the access t infrmatin regimes (these are primarily the Freedm f Infrmatin Act 2000 (FOIA), the Data Prtectin Act 1998 (DPA) and the Envirnmental Infrmatin Regulatins 2004). A.6 If yu want the infrmatin that yu prvide t be treated as cnfidential, please be aware that, under the FOIA, there is a statutry Cde f Practice with which public authrities must cmply and which deals, amngst ther things, with bligatins f cnfidence. In view f this it wuld be helpful if yu culd explain t us why yu regard the infrmatin yu have prvided as cnfidential. If we receive a request fr disclsure f the infrmatin we will take full accunt f yur explanatin, but we cannt give an assurance that cnfidentiality can be maintained in all circumstances. An autmatic cnfidentiality disclaimer generated by yur IT system will nt, f itself, be regarded as binding n HM Treasury. A.7 HM Treasury will prcess yur persnal data in accrdance with the DPA and in the majrity f circumstances; this will mean that yur persnal data will nt be disclsed t third parties. A.8 In additin t ur bligatins under FOIA and DAP, we wuld like t share respnses t this cnsultatin with the Independent Public Service Pensins Cmmissin as apprpriate. Where yu have asked that yur respnse is treated as cnfidential, please indicate whether yu are willing fr it t be shwn t the Cmmissin. 21

26 The Gvernment s Cnsultatin Cde f Practice A.9 This cnsultatin is being cnducted in accrdance with the Gvernment s Cde f Practice n Cnsultatin. A cpy f the Cde f Practice can be fund n the Business Innvatin and Skills website: The cnsultatin criteria 1 When t cnsult - Frmal cnsultatin shuld take place at a stage when there is scpe t influence the plicy utcme. 2 Duratin f cnsultatin exercises - Cnsultatins shuld nrmally last fr at least 12 weeks with cnsideratin given t lnger timescales where feasible and sensible. 3 Clarity f scpe and impact - Cnsultatin dcuments shuld be clear abut the cnsultatin prcess, what is being prpsed, the scpe t influence and the expected csts and benefits f the prpsals. 4 Accessibility f cnsultatin exercise - Cnsultatin exercises shuld be designed t be accessible t, and clearly targeted at, thse peple the exercise is intended t reach. 5 The burden f cnsultatin - Keeping the burden f cnsultatin t a minimum is essential if cnsultatins are t be effective and if cnsultees buy-in t the prcess is t be btained. 6 Respnsiveness f cnsultatin exercises - Cnsultatin respnses shuld be analysed carefully and clear feedback shuld be prvided t participants fllwing the cnsultatin. 7 Capacity t cnsult - Officials running cnsultatins shuld seek guidance in hw t run an effective cnsultatin exercise and share what they have learned frm the experience. A.10 If yu feel that this cnsultatin des nt satisfy these criteria, r if yu have any cmplaints r cmments abut the prcess, please cntact: Better Regulatin Unit at HM Treasury /

27 B Schemes cvered by this cnsultatin Scheme cverage B.1 This cnsultatin seeks t establish the apprpriate discunt rate (i.e. the SCAPE discunt rate) t use in actuarial valuatins fr setting cntributin rates under SCAPE methdlgy fr the unfunded public service pensin schemes. B.2 The unfunded public service pensin schemes cvered by this cnsultatin include: Fr civil servants: Principal Civil Service Pensin Scheme Principal Civil Service Pensin Scheme (Nrthern Ireland) Armed Frces Pensin Scheme Fr NHS emplyees: NHS Pensin Scheme NHS Superannuatin Scheme (Sctland) Health and Persnal Scial Services Nrthern Ireland Superannuatin Scheme Fr teachers: Teachers Pensin Scheme (England and Wales) Scttish Teachers Superannuatin Scheme Nrthern Ireland Teachers Superannuatin Scheme Plice Pensin Scheme (administered lcally) Firefighters Pensin Scheme (administered lcally) United Kingdm Atmic Energy Authrity Pensin Schemes Judicial Pensins Scheme Research Cuncils Pensin Schemes In additin t the schemes mentined abve, there are a number f smaller schemes and many established t cver nly ne senir appintment which d nt specifically need t frm part f the review but which will be required t act n the recmmendatins. 23

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29 C Public service pensin schemes: cnsultatin requirements C.1 The fllwing statutry prvisins set ut the cnsultatin requirements fr individual public service pensin schemes: Firefighters Pensin Scheme 1992/New Firefighters Pensin Scheme 2006 (England & Wales, Sctland): Sectin 34 f Fire and Rescue Services Act 2004 Firefighters Pensin Scheme (Nrthern Ireland) Fire and Rescue Services (Nrthern Ireland) Order 2006 Health and Persnal Scial Services Superannuatin Scheme (Nrthern Ireland) Article 12(4) f the Superannuatin (Nrthern Ireland) Order 1972 NHS Pensin Scheme 1995/2008 (England & Wales): U3 Accunts and Actuarial Reprts f the NHS Pensin Scheme Regulatins B.1 Actuarial Reprts and Accunts f the NHS Pensin Scheme Regulatins 2008 Superannuatin Act 1972 Sectin 10 NHS Pensin Scheme (Sctland): Regulatin U3 f the Natinal Health Service Superannuatin Scheme (Sctland Regulatins) 1995 Regulatin 1.B.1 f the Natinal Health Service Pensin Scheme (Sctland) Regulatins 2008 Superannuatin Act 1972 Sectin 10 Nrthern Ireland Teachers Superannuatin Scheme Superannuatin (Nrthern Ireland) Order 1972 Article 11(5) Plice Pensin Scheme (England & Wales, Sctland): Plice Pensins Act (1) Plice Pensin Scheme (Nrthern Ireland) Plice Nrthern Ireland Act 1998 Sectin 33 Principal Civil Service Pensin Scheme Sectin IV f the PCSPS(NI) rules: the 2008 Sectin Sectin 1(3) f the Superannuatin Act 1972 Principal Civil Service Pensin Scheme (Nrthern Ireland) Article 2(2) f the Superannuatin (Nrthern Ireland) Order 1972 Teachers Pensin Scheme (England & Wales, Sctland) Superannuatin Act 1972 Sectin 9(5) Teachers Pensins Regulatins Schedule 3 Reg 5 Teachers Pensins Regulatins 2010 Regulatin

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31 D SCAPE: explanatin f methdlgy D.1 In Chapter 2, the use f the Superannuatin Cntributins Adjusted fr Experience (SCAPE) discunt rate and the current apprach t setting this discunt rate was discussed. This annex explains the SCAPE methdlgy and hw it is used t set the cntributin rates required fr the unfunded public service pensin schemes. D.2 Regular scheme valuatins f the unfunded public service schemes are carried ut in rder t set cntributin levels. The prcess differs frm that fr private sectr funded schemes because the unfunded public service schemes d nt actually hld a fund f assets. An alternative apprach t setting cntributin levels must therefre be fund. This is achieved thrugh the cnstructin and tracking f a ntinal fund. The methdlgy is called SCAPE and was intrduced in the late 1990 s. D.3 The SCAPE methdlgy creates the cncept f a ntinal fund the SCAPE fund in which the scheme assets prvide a guaranteed rate f return in line with the SCAPE discunt rate. In the absence f real assets the SCAPE fund: increases in line with the nminal amunt f cntributins made; increases with ntinal returns, in line with the current discunt rate, at 3.5% per annum plus inflatin; and decreases when pensin benefit payments are paid. D.4 The additin f actual experienced inflatin t the ntinal returns has the effect that cntributins are nt affected by inflatin being higher r lwer than expected. D.5 The SCAPE methdlgy can then ensure that cntributins reflect the cst f nging pensin prmises plus any csts caused by past experience differing frm that which was assumed at previus SCAPE valuatins (fr example peple living lnger than previusly assumed). D.6 When SCAPE was intrduced each unfunded public service pensin scheme was assumed t hld a SCAPE fund f ntinal assets that exactly matched the scheme s liabilities. Ging frward, t evaluate whether a shrtfall r verpayment has been made in respect f past prmises, subsequent SCAPE valuatins then estimate the present value f all the pensin prmises that have been made by the scheme the scheme s liabilities up t the date f the valuatin and seek t cmpare that with the assets f the scheme. If any shrtfall emerges between the value f assets and the calculated liabilities, cntributins will be increased such that the shrtfall is remved ver a number f years. Similarly, if the calculatins shw that verpayments have been made in the past, cntributins will be reduced. 27

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33 E Glssary Glssary f terms E.1 Active members: These are current emplyees wh are cntributing (r have cntributins made n their behalf) t an rganisatin s ccupatinal pensin scheme. They are distinct frm deferred members and pensiners. E.2 Accrued liabilities: A measure f the value, in tday s mney, f all pensin entitlements t be paid in the future that have been earned t date. E.3 Actuarial valuatin: A reprt f the financial psitin f a defined benefit pensin scheme usually carried ut by an actuary every three r fur years. The reprt typically sets ut the scheme s assets and liabilities as at the date f the valuatin; the rate at which the spnsring emplyer must cntribute t meet the liabilities accruing as they becme due; and the additinal rate at which the emplyer must cntribute t eradicate any deficit (the excess f liabilities ver assets) within a stated time perid. E.4 Cap and share: This is an arrangement applying t the pensin schemes fr the NHS, Teachers, Civil Service and Lcal Gvernment, whereby increases r reductins in the csts f a scheme identified in a pensin scheme actuarial valuatin are shared between emplyees and emplyers up t the value f the cap. Abve the cap the increases r reductins are brne by emplyees, either by changing emplyee cntributins r future benefits r bth. E.5 Cash Equivalent Transfer Value (CETV): The value f accrued pensin rights when any wrker ceases t be an active member f a scheme befre pensin is payable. These are used fr transfers in t and ut f defined benefit pensin schemes. E.6 Deferred members: Deferred members are scheme members wh have left emplyment, r ceased t be an active member f the scheme whilst remaining in emplyment, but retain an entitlement t a pensin frm the scheme which has nt yet cme int payment. E.7 Defined benefit (DB) pensin scheme: A pensin scheme where the pensin is related t the member s salary r sme ther value fixed in advance. E.8 Discunt rate: A discunt rate is the rate at which a future payment r stream f payments is cnverted int a single value tday. E.9 Emplyee cntributin rates: The percentage f their pensinable salary that emplyees pay as a cntributin twards their benefits frm a pensin scheme. E.10 Emplyer cntributin rates: The percentage f the salary f emplyees that emplyers pay as a cntributin twards the emplyees pensin. E.11 Fair Deal: A nn-statutry cde f practice intrduced in 1999 that prtects the pensin prvisins f public sectr wrkers wh have their emplyment cmpulsrily transferred ut f the public sectr. In such a situatin the transferring rganisatin is required t ensure that the pensin prvisin fr future service is bradly cmparable after the transfer. 29