The truly shocking cost of State pensions

[elacsaplau]

Hi Paid,

Can you answer just one question please? (Note: I asked a very similar question to noproblem, 3 times in a row, and he refused to answer!!)

If I was in a private DC plan and am at the point of retirement at age 60 and have a fund of €1.5m and want to use this fund to buy myself a pension with the same terms and conditions as a civil servant's pension (i.e. spouse's pension, escalation, etc.).....how much income could I receive if I wanted to convert my fund into a guaranteed income for life?

 

[Páid]

I'm not a pension expert (far from it). Someone else may be able to answer.

 

[Cervelo]

Hi Paid,

Can you answer just one question please? (Note: I asked a very similar question to noproblem, 3 times in a row, and he refused to answer!!)

If I was in a private DC plan and am at the point of retirement at age 60 and have a fund of €1.5m and want to use this fund to buy myself a pension with the same terms and conditions as a civil servant's pension (i.e. spouse's pension, escalation, etc.).....how much income could I receive if I wanted to convert my fund into a guaranteed income for life?

From Irish Life (pensionplanetinteractive.ie)
Annuity Details
Quote Basis: Standard
Quote Date: 12/10/2016
Interest Rate: 0.2%
Payment Frequency: Monthly
Currency: Euro
Pension Type: Compulsory Purchase
Pension Details
Available fund: €1,500,000.00
First Life Pension Amount: €24,817.20
Second Life Pension Amount: €12,408.60
Escalation Type: Inflation - Annual Cap
Inflation Cap: 5%
Investment Protection: No
Guarantee Period: 5 years
Commencement Date: 12/10/2016
Commission: 2%
Reversion %: 50.0
Overlap Indicator: No
Beneficiary Details
First Life: Ringo Star
DOB: 12/10/1956
Gender: Male
Second Life: R Star
DOB: 12/10/1956
Gender: Female

 

[elacsaplau]

Thanks Paid,

Your honesty is appreciated.

And thanks Cervelo!

What Cervelo has shown is the annuity cost!

That is just a fact. That was the point of the article.

Two key reasons annuities are so expensive are:
- long-term high-grade European bonds yielding c. 0.60 p.a.
- actual and anticipated increases to life expectancy

Sarenco has already shown that annuities are not especially profitable from the perspective of the insurer.

I get the idea that the capital value appears enormous - again the point of the article was simply to illustrate just how valuable these benefits are. As another poster put it so well recently - a nickel ain't worth a dime anymore!

************

For what it's worth, and this is related but separate but the point of the article, if I had a DC fund of €1.5m, I would find it difficult to hand-over €1.5m in return for the guaranteed annuity of €24k p.a. This question is probably worth a separate thread that would have the potential to run as long any Big Short thread....

 

[Sarenco]

That €98bn represents the cost of pensions for what must be at least 400,000 public service workers and pensioners.

No, the figure of €98bn represents the present value of all expected future superannuation payments to current public sector staff and their spouses in respect of service to December 2012, plus the liability for all future payments to current and preserved pensioners and to their spouses.

That group would include individuals as diverse as newly qualified nurses and 95 year old widows. It would also include individuals that only worked for a short time in the public service.

Both you and the author are playing with words to make it look like civil servants are millionaires because of their pensions, citing how much it would cost in the marketplace and not stating how much those pensions actually cost the State.

No, I'm not playing with words. The fact that you either cannot understand what the article is saying or that you are uncomfortable with the implications of what is being stated does not mean that anybody is playing with words.

You can only tell the actual cost of a pension with the benefit of hindsight. At the time that an individual starts drawing a pension you do not know how long that individual (or his spouse) will live, the future cost of living, etc.

 

[Páid]

No, the figure of €98bn represents the present value of all expected future superannuation payments to current public sector staff and their spouses in respect of service to December 2012, plus the liability for all future payments to current and preserved pensioners and to their spouses.

That group would include individuals as diverse as newly qualified nurses and 95 year old widows. It would also include individuals that only worked for a short time in the public service.

How is that different than what I said? There were about 300,000 public service workers and 90,000 retirees at the end of 2012. It's the total projected pension liability of the State for the next 70 years for all of those people.

No, I'm not playing with words. The fact that you either cannot understand what the article is saying or that you are uncomfortable with the implications of what is being stated does not mean that anybody is playing with words.

You can only tell the actual cost of a pension with the benefit of hindsight. At the time that an individual starts drawing a pension you do not know how long that individual (or his spouse) will live, the future cost of living, etc.

The article is claiming that civil servants could be millionaires based on their pensions. That is a direct quote from the title of the article. How is that not playing with words? The Government will never be going to the marketplace for an annuity for any of the people mentioned in the article. It seems to be ok to assess how much the fund would cost in the marketplace but not how much it could cost the State for those pensions.

 

[Sarenco]

It's the total projected pension liability of the State for the next 70 years for all of those people.

That's correct but in your previous post you said "€98bn represents the cost of pensions", which is incorrect.

I might owe somebody an apple in 10 years' time but I don't know what that apple is going to cost in 10 years' time - hence the projection.

The article is claiming that civil servants could be millionaires based on their pensions.

Broadly, a millionaire is a person whose assets are worth one million euro or more. A pension is an asset - it is the right to receive a stream of income. Cervelo's post shows what a particular pension (an asset) is worth in the marketplace.

Again, the cost of purchasing an annuity that provides a comparable benefit to an individual State pension is a good, if imperfect, way of estimating the actuarial value of that pension. The actuarial value is the anticipated total of cost of the benefit provided by the pension.

 

[Páid]

Broadly, a millionaire is a person whose assets are worth one million euro or more. A pension is an asset - it is the right to receive a stream of income. Cervelo's post shows what a particular pension (an asset) is worth in the marketplace.

Public servants don't own annuity pensions hence it cannot be one of their assets.

Again, the cost of purchasing an annuity that provides a comparable benefit to an individual State pension is a good, if imperfect, way of estimating the actuarial value of that pension. The actuarial value is the anticipated total of cost of the benefit provided by the pension.....

....in the marketplace. Is it not possible to assess how much an average public service pension will cost the State in the future?

 

[Sarenco]

Public servants don't own annuity pensions hence it cannot be one of their assets.

Sigh.

Once more, nobody is suggesting that the State buys annuities to make PS pension payments. However, a retiring PS employee (and his/her surviving spouse) will have a claim on the State in respect of those pension payments that is comparable to the claim that an annuitant will have on a life company for a similar stream of income.

The right to a stream of income from a PS pension is an asset that has a value. That value is comparable to the value of a comparable annuity.

Is it not possible to assess how much an average public service pension will cost the State in the future?

Yes, that's called an actuarial valuation. The actuarial value is the anticipated total of cost of the benefit provided by the pension.

The cost of an annuity that provides a comparable benefit to an individual State pension is a good, if imperfect, way of estimating the actuarial value of that pension.

 

[mtk]

The cost of unemployment assistance paid to those who have never worked over their lifetime is an even bigger number ! Pensioners deserve their state pension

 

[invest101]

Annuities are probably not attractive for anybody to buy right now. Most with a choice should stay out of that market until prices improve and look to alternatives.

The cost of providing a retirement benefit to a state employee is not the today open market annuity cost.

The State has an advantage today - is a seller, not a buyer of government bonds.

Perhaps when comparing benefits to the private sector the value to the state employee needs to be approximated using open market cost for the same benefit. It is a bit opportunistic to use the today value when the market isn't offering any value to anyone. We should use a longer term average of that cost.

 

[Sarenco]

The State has an advantage today - is a seller, not a buyer of government bonds.

The State issued 30-years bonds last year at a coupon of 2% and those long-term bonds would have been purchased, inter alia, by life assurance companies that write annuities.

So the State borrows money at long term rates of ~2% to put itself in funds to make PS pension payments (amongst other things), whereas life companies lend money to the State at a rate of ~2% to fund annuity payments (amongst other things). The State is effectively securitising a future income stream (tax) whereas the life company is buying an income stream (the bond coupon).

In other words, the State and the life company are simply on opposite sides of the trade - one does not have an inherent advantage over the other.

 

[invest101]

The State issued 30-years bonds last year at a coupon of 2% and those long-term bonds would have been purchased, inter alia, by life assurance companies that write annuities.

So the State borrows money at long term rates of ~2% to put itself in funds to make PS pension payments (amongst other things), whereas life companies lend money to the State at a rate of ~2% to fund annuity payments (amongst other things). The State is effectively securitising a future income stream (tax) whereas the life company is buying an income stream (the bond coupon).

In other words, the State and the life company are simply on opposite sides of the trade - one does not have an inherent advantage over the other.

Yes I agree.

The point is that the current rate is way below the long term average because of an unusually large gang of motivated buyers. Including the European Central Bank as a major player. These buyers are not mostly motivated to generate a future income stream but to provide liquidity to markets, counter deflation and others motivated by general risk aversion with memories of 2008/9.

Those looking for annuity type income streams are caught up in this and are are offered very poor value compared to the average long term rate. Those forced to buy also added, further reduces the rate. Perhaps it could be argued that today's rate is not the one to generally value the yes very significant value of the income stream of a public service pension, but rather the longer term average rate in a more normal market which is higher.

On the other side if this higher long term average rate reduces the approximated value of a state pension then not included and what would increase increase the value, is the risk in accumulation phase for DC pensions e.g. Volatility, Investment returns, charges, job security, USC on entry and drawdown, political risk and uncertainty around changing maximum contribution limits, risk of levies and maximum fund thresholds etc.

My point regarding the states advantage in the current market is on the cost side not the value side. People are perhaps trying to equate the value to the person between the public and private sectors using annuity rates, which I agree with, just not today's rate it should be a longer term average rate. Hopefully we will get back there again and the annuity market will reopen for private sector retirees. They are also perhaps assuming the costs to the state and the costs to the private buyers of annuities using today's annuity rates, which I also don't agree with. The original article was perhaps simplistically saying the cost to both is the same using today's rate. The state is actually now borrowing at a very low rate to pay annuities and other things reducing the cost, while DC annuity buyers are only getting that low rate. In a sense debt buyers - central banks and annuity buyers are subsidising the state, that is to the states current advantage. You can't say the cost to both is the same at this moment.

 

[PMU]

Except that a PS pension is not a series of known payments to be made in future over time. PS pensions payments are linked to PS salaries that increase over time.

Well, as very few people live beyond 90, I think 25 years is a reasonable duration to estimate the capital value of a pension.

In the case in question, a pension of 24,000 pa equates to the pension payable to a person who retires on the max of the executive officer scale (currently 47,379 pa). 25 years ago, in 1991 the same salary point was, as far as I can determine, 22,862 IEP, equivalent to 29,029 EUR. So the salary increase over 25 years is equivalent to a CAGR of 1.98%, which by any standard is a very modest increase. Note also that civil service salaries do not increase linearly but in steps due to national wage agreements etc. typically with a duration of 4 years.
So, if we assume that these type of increases will apply in the future, discounted at the ECB's inflation rate target of 2%, the NPV of the pension of a civil servant retiring on final salary of 48,000 (i.e. pension of 24,000) over 25 years is about 646,243, let's say 650,000. This is its a actuarial value. It's nowhere near 1.5ml. Benefits paid to a surviving spouse will reduce this figure.

The comparison made by the IT with a annuity is bogus. Only a real fool would pay 1.5 ml for a series of future payments with a capital value of 672,000. The annuity value does not represent the potential call on the state / taxpayer to pay the pension – the capital sum does. Civil servants, particularly those who retire on modest incomes, are not the equivalent of millionaires and do not have 1.5 ml pension pots.

 

[Sarenco]

I wonder is it the title of the thread that's causing confusion?

If so...

Perhaps I should have titled this thread:-

"The truly shocking cost for somebody in the private sector to buy an annuity that provides an income comparable to the pension currently payable to an average civil service pensioner".

By way of a reminder, the contentious statement in IT article was simply that the pension paid to the average civil servant that retires at 60, with 40 years service, would cost €1.5m if bought in the marketplace and the assumptions underlying that statement were explicitly set out in the article.

After a lengthy discussion, I think (hope?) that everybody now accepts that this statement is entirely reasonable.

I went on to suggest that the cost of purchasing an annuity that provides a comparable benefit to a State pension is a good, if imperfect, way of estimating the actuarial value of that pension benefit. I would still maintain that this is the case although I appreciate that this is contentious.

That is different from estimating the net present value (PV) of the cash payments that the State will need to make to discharge its obligation to that pensioner. As invest101 correctly points out above, the PV of the State's liability is likely to be materially lower than the market value of the pension benefit in this era of financial repression.

In other words, the actuarial value of the State's liability in respect of a particular pension will be lower than the actuarial value of the benefit of that pension due to generationally low bond yields.

So, if we assume that these type of increases will apply in the future, discounted at the ECB's inflation rate target of 2%, the NPV of the pension of a civil servant retiring on final salary of 48,000 (i.e. pension of 24,000) over 25 years is about 646,243, let's say 650,000. This is its a actuarial value. It's nowhere near 1.5ml. Benefits paid to a surviving spouse will reduce this figure.

I would quibble with some of those assumptions.

• Firstly, the C&AG assumes that PS pensions will increase by 1.75% above cost of living increases;
• Secondly, the Irish 30-year bond is currently trading at a YTM of 1.36% and I would suggest that is a more appropriate discount rate than the target inflation rate; and
• Thirdly, the accrued benefits of the (57 year-old, female) spouse would increase, not decrease, your PV figure.

Only a real fool would pay 1.5 ml for a series of future payments with a capital value of 672,000.

And yet somebody in the circumstances described above that is retiring with a DC pension will have to pay ~€1.5m to purchase a guaranteed income of €24k pa. Perhaps you are right and anybody who finds themselves in these circumstances must feel like a fool for not taking a job in the PS.

Civil servants...do not have 1.5 ml pension pots.

I don't believe anybody suggested that they did.

What has been suggested is that the average civil servant will retire today with pension benefits that would cost €1.5m if bought in the open market.

 

[orka]

Well, as very few people live beyond 90, I think 25 years is a reasonable duration to estimate the capital value of a pension.

Not true.



US figures - can't find Irish ones but I doubt they are vastly different (Ireland actually has a slightly higher life expectancy than the US). A man aged 65 has a 20% chance of reaching 90, a woman of 65 has a 32% of reaching 90 and a couple both aged 65 have a 42% of at least one of them reaching 90.

Using the calculator on the website above, our 65/62 couple have a 55% chance of one of them surviving your 25 years...

 

[Sarenco]

It's also important to allow for future increases in longevity - life expectancy in Ireland has increased by two and a half years since 2004!

Another nuance is that Irish public servants have been found to have lower mortality rates than those experienced by the general population - on average they live longer.