Taming the Pensions Explosion

The last Pay Commission award increased the salaries of government staff by almost 2 per cent of GDP, a wage explosion that sent most states deep into the red. Yet a potentially greater problem is the explosive growth of pensions. The Pay Commission has greatly raised pension rates, and pensioners are living longer than ever. Pension payments are rising faster than salary payments. Some calculations suggest that pension payments could approach half of all salary payments in the foreseeable future. This will drain the Union and state governments of resources badly needed for essential services and infrastructure.

In some other countries, pensions are paid out of contributions from the monthly pay packets of employees. The provident fund scheme in India works exactly like this, and is a sustainable old-age provision. But government pensions are not funded by contributions from employees, and are paid out of the general tax pool. This is unsustainable. Sooner or later–and preferably sooner–the government must start deducting a sum from the monthly salary of all employees to provide for their pensions. Trade unions will protest, and may go on strike if the government attempts such a move. But the issue is so important that it cannot be swept under the carpet much longer.

It may prove politically impossible to make monthly deductions high enough to fully pay all pensions. Besides, the much-needed downsizing of government staff will steadily reduce the ratio of staff to pensioners, creating a steadily growing gap between what employees contribute and what pensioners get.

Some way is needed to plug this rising gap. What should this be? I think the best way is to take advantage of a phenomenon that is widely known yet not widely acted on. This is: Individuals attach a higher value to instant cash than governments. This is exhibited in the willingness of individuals to pay high rates of interest on all sorts of loans. Middle-class salary earners happily pay up to 20 per cent interest on car loans and credit card debt, and 15 per cent interest on housing loans. Many borrow on the unofficial money markets at 2-3 per cent per month (equal to 24-36 per cent per year) to finance expenses like weddings, emergency medical expenses, or foreign education for children.

Governments, on the other hand, can borrow at 8.5 per cent through tax-free bonds. So, there is a huge difference between the interest rates governments pay and individuals pay. What does this have to do with pensions? The answer is that governments can save a lot of money by using cheap loans to pay highly discounted lump- sums in lieu of pensions to retirees.

Government rules already allow retirees to commute pensions into a lump-sum, but this is optional, not mandatory. If it is made compulsory, it can greatly cut the government’s pension bill while possibly giving greater satisfaction to retirees.

How do you put a cash value on a future stream of pension benefits? Economists use something called a discount rate. This is most simply understood as the inverse of an interest rate. Suppose a lump-sum of Rs 10 lakh yields a steady return of 15 per cent per year over 30 years. That amounts to a return over three decades of Rs 45 lakh. We can put this another way: At a discount rate of 15 per cent, future payments of Rs 45 lakh over 30 years have the same value as Rs 10 lakh in cash today.

Every individual attaches a different value to instant cash, and so has a different discount rate. People urgently wanting cash have a high discount rate, those with no need for instant cash have a low discount rate. What is an average rate or fair rate?

This question was recently investigated by two economists, John Warner and Saul Peter, and their results published in the American Economic Review. The economists looked at retiring defence personnel in the US, who can opt for either a lump-sum discounted at 10 per cent or a pension. Three-quarters opted for the lump- sum. Now, the government can borrow at 5 per cent, just half the discount rate of defence personnel. So paying a lump-sum discounted at 10 per cent represents a huge financial saving for the government while meeting the cash needs of retirees.

The two economists looked at other separation packages accepted voluntarily by people in the US, and made the startling discovery that the discount rate varied from 17 per cent to 20 per cent. It seems that many individuals place an extraordinarily high value on cash in hand, and much less on steady monthly payments.

Inflation and interest rats are much higher in India than in the US. If discount rates of 17 to 20 per cent are acceptable in separation packages in the US, they are surely a bargain in India. On the other hand, some downward adjustment should be made if the discounting is mandatory and not optional. I think a discount rate of 15 per cent should be viewed as reasonable in Indian conditions. If the government can borrow at 8.5 per cent (through tax free bonds) to fund retirement lump- sums carrying an implicit rate of 15 per cent, it will save thousands of crores per year.

Can trade unions be persuaded to accept this discount rate? I think they can, provided the details are explained properly. The starting point for the discussion must be that pensions can no longer be paid out of general tax revenues, and something will have to be deducted from the monthly salaries of employees to foot the future pension bill. Now, the deductions will be smaller if retirees are paid lump-sums rather than pensions. The lump-sum option carries a double cash benefit. Employees will benefit from more cash in hand at salary time, and again from more cash in hand at retiring time. That sounds like an idea which trade unions will buy.

What do you think?