Don't write off the public sector
There is a widespread view of the job market which goes something like this. Tech, finance and other blue-chip industries pay such lucrative salaries that qualified graduates seeking a lifetime of high earnings wouldn't think of looking anywhere else. Especially not the government.
The latest example of this mantra comes from the journalist Robert Peston, who yesterday pointed to the gap between public sector salaries and those from the most prestigious private sector employers, as part of an argument about the career path to becoming a diplomat:
The argument that “rational” graduates concerned with financial security would automatically aim for these sectors, rather than the public sector, has a few things going for it, especially when it comes to the housing ladder. But it misses one crucial detail.
That detail is pensions.
Facebook and Google both offer their employees defined contribution pension schemes in the UK. For those unfamiliar with the terminology, schemes of this kind are simply savings from earnings, topped up by employer contributions, and invested in some mixture of equities, bonds and other asset classes.
These schemes contrast with defined benefit pension schemes, where payments are made in return for a guaranteed lifetime income in retirement. In the UK over the past few decades, these schemes have been mostly phased out of the private sector due to their costs (except for legacy members). But not the public sector.
If you start working at the civil service today, you get a defined benefit pension. According to the current scheme, Alpha, your retirement income increases by 2.32 per cent of your pensionable earnings each year. The contributions vary depending on salary, but they are all below 10 per cent of annual income. You have access to the pension you have built up at whichever is older - 65, or the state pension age.
It's worth going over some back of the envelope calculations showing just how generous this retirement income is.
Let's assume that a civil servant earns £40,000 every year over 40 years. For the moment, we'll ignore inflation and pay rises over the working period (obviously earnings would be lower earlier on, and higher later on). Upon retirement, he or she would have accrued an annual income of £37,120, which would rise with inflation thereafter.
To come close to this kind of retirement income, savings in a defined pension contribution scheme would need to be enormous — a significant proportion of overall earnings — even without the inflation linking. The contributions from a salary of £100,000 (assuming 5 per cent contributions matched by the employer, for a total of 10 per cent), over the same period, would not come close.
It is true that defined contribution savings would be invested in financial markets, and if markets provided significant returns above inflation, then the size of the private retirement income would increase. But this is not a good argument in favour of the attractiveness of defined benefit contribution pensions. It simply illustrates their high level of dependency on market performance. Confidence in the vast uncertainties around this performance tend to be unjustifiably based on postwar historical trends, rather than meaningful estimations about the future state of the world.
The civil service pension is not directly exposed to markets. Instead, the savers' exposure is to the UK government; the risks are sovereign default, or extraordinary retrospective legislative shifts that would necessitate a broader repudiation of legal norms. It's worth asking yourself which exposure you'd prefer — this, or a diversified basket of financial securities — if push came to shove.
The final thing to consider is the duration risk of employment. There is clearly some threshold at which private sector earnings more than compensate for the absence of a defined benefit pension. Once pension pots are factored in, employees at prestigious firms are probably still significantly ahead, especially if stock options or bonuses are included.
However, the long-term viability of a lucrative salary at a private sector company is exposed to more risks than the long-term viability of employment in the civil service. It is easier to imagine any number of prestigious private sector companies going out of existence, as they already have done, than it is the civil service.
While it might in many cases seem true that a lucrative private sector job implies higher lifetime earnings including pensions, this is likely to bring with it additional risk. On a risk-adjusted basis, it is not clear cut which sectors' earnings are more lucrative. If working hours, rather than years, are used to make the comparison, that will tend to weaken the private sector's claim further.
Taken all together, the widespread practice of comparing private and public labour markets on the basis of present-day salaries, with minimal attention to either the duration risk of employment or the post-employment generosity of pension benefits, is misleading. The power of a defined benefit pension is common knowledge for anyone above a certain age, and barely acknowledged by anyone below a certain age.
This informational deficit gives rise to a kind of generational arbitrage opportunity. The most astute graduates would seek to exploit that, rather than blindly follow the crowd.
Related links:The post-crisis generation game - FT Alphaville
Saving for old age: the global story (part I) - FT Alphaville
Saving for old age: the global story (part II) - FT Alphaville
Saving for old age: the global story (part I) - FT Alphaville
Saving for old age: the global story (part II) - FT Alphaville
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