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The pay deficit: measuring the effect of pension deficit payments on workers’ wages

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This paper is the sixth report for the Intergenerational Commission, which was launched in the summer of 2016 to explore questions of intergenerational fairness that are currently rising up the agenda. Previous work has shown that younger cohorts have been particularly badly affected by recent trends in pay growth. Far from enjoying the generation-on-generation gains in pay that characterised much of the 20th century, the oldest millennials (born 1981-85) are earning £40 a week less around the age of 30 than those born 10 years earlier earned at the same age. And the next group of millennials (born 1986-90) have had the same levels of weekly pay in their early- and mid-20s as those born 15 years before them did.

These outcomes owe much to the long post-financial crisis wage squeeze. Even after two years of wage recovery – driven by ultra-low inflation – average earnings remain around £15 a week below peak. With a fresh pay squeeze now hitting and likely to grow over the course of 2017 as inflation picks up, pre-crisis pay levels are unlikely to be restored until 2022.

Yet, while this disappointing pay performance can be attributed in part to the unusual circumstances of a financial crisis in the first instance and a sterling depreciation sparked by the vote for Brexit in the second, the fact that pay growth had already slowed markedly in the pre-crisis period provides cause for longer-term concern. Average weekly earnings grew by just 0.6 per cent a year between 2004 and 2008, compared with an annual average of 2.5 per cent between 1996 and 2004. Identifying what contributed to this slowdown – and whether it represents a new benchmark for ‘normal’ wage growth or simply a blip – is key to understanding the pay prospects facing younger workers.

Several factors appear relevant to this pre-crisis wage disappointment – not least a slowdown in productivity growth and reductions in working hours – but this paper focuses specifically on what appears to have been an important shift in the nature of employee compensation from the turn of the century. Between 2000 and 2016, non-wage employer social contributions comprised a growing share of total employee compensation – generating an increased ‘wedge’ between overall remuneration and workers’ pay packets.

Before 2000, non-wage elements accounted for 13 per cent of compensation on average; but this share increased sharply thereafter, reaching more than 18 per cent in 2012. While it has fallen a little since, it remained just under 17 per cent in 2016. Relative to the pre-2000 average,  this elevated share of compensation accounted for by non-wage employer contributions was equivalent to around £37 billion. Non-wage compensation includes employer National Insurance contributions as well as maternity and sickness pay. But by far the biggest driver of the increase in non-wage payments over the post-2000 period – accounting for £26 billion of the overall £37 billion increase in 2016 – was employer pension contributions.

This increase is somewhat surprising given the shift in workplace pensions that has taken place in recent years. Overall employee coverage in occupational pension schemes fell over the course of the 2000s, as increasing numbers of defined benefit (DB) schemes closed to new members. It then picked up strongly from 2012 as the policy of auto-enrolment increased access to defined contribution (DC) pension schemes. Given the much lower employer contribution rates typically associated with DC pensions however, the shift away from DB might have been expected to lower overall employer contributions.

That employer pension contributions instead rose as a share of overall compensation after 2000 flows from the fact that improvements in longevity, weak asset returns and a reduced discount rate significantly increased the cost of funding a given DB pension. This raised the employer (and employee in some cases) contributions required to meet both pre-existing and new DB commitments. On the employer side this manifested itself in steep increases in both ‘normal’ DB payments (covering new pension entitlements accrued) and ‘special’ (or deficit-funding) payments. Having accounted for an average 0.5 per cent of total employee compensation before 2000, the latter made up 3.3 per cent of the total by 2012 – remaining at 2.5 per cent in 2016. Increased deficit-funding contributions therefore accounted for around £19 billion of the overall £37 billion elevation in non-wage employer contributions in 2016.

Faced with a cost pressure associated with meeting a schedule of pension deficit payments that applies to some but not all firms, businesses might be expected to respond in a range of ways. In perfectly competitive labour and product markets – where employers are price takers – this would primarily take the form of lower profits, while some business groups have argued that investment spending has been reduced.  Another hypothesis is that, due to either imperfect competition or the fact that some employees benefit from the plugging of DB deficits, there might also be a wage effect. With the time-periods in question neatly aligned, the suggestion has been that this wage effect might go some way to explaining the pre-crisis slowdown in pay growth and therefore represent an important consideration for future living standards prospects.

To date there has been little research to distinguish between these different possibilities, each of which has potentially important distributional – including intergenerational – implications. With 85 per cent of DB schemes closed to new members and 35 per cent also closed to future accrual, the population with most to gain from closing scheme deficits is likely to have limited overlap with the population affected by any reduction in dividend payments, investment or pay. Of the 10.9 million members of DB schemes, 40 per cent are already in retirement and just 1.6 per cent are under-30 and actively contributing.

To help inform debate in this area, this note presents the first empirical testing of the impact of deficit payments on pay levels, based on more than 180,000 observations across around 400 firms between 2002 and 2015. The approach takes advantage of the exogenous nature of the deficit payments to present regression analysis that compares the pay of similar-looking workers in similar-looking firms where only the level of deficit payment made by the firms varies. In doing so it provides an opportunity to consider whether the micro deficit payments issue links back to the macro wage slowdown phenomenon.

The analysis identifies a strongly significant negative effect on hourly pay at the level of the individual firm. For every increase in deficit payment equivalent to 1 per cent of the firm’s total wage bill, the hourly pay of its workers is lowered by roughly 0.1 per cent. With the £19 billion relative increase in DB deficit payments that we have identified in 2016 being roughly equivalent to 2.5 per cent of the UK’s total wage bill, the implication is that such employer contributions are lowering average employee pay by between 0.2 per cent and 0.3 per cent. Converting that hourly pay effect into an aggregate annual figure suggests that DB deficit payments are directly lowering employee pay by between £1.4 billion and £2.2 billion a year.

This means that in the region of 10 per cent of the £19 billion elevation in special payments can be directly associated with lower hourly pay. The remaining 90 per cent is likely to be spread across a combination of wider wage spillover effects that include non-pension deficit firms, reductions in profits, or lower investment. Understanding how this remaining burden has been distributed across groups should form an important next step in unpicking the impact of elevated DB deficit payments.

A direct wage drag of the magnitude identified in this research can only explain a small part of the aggregate pre-crisis pay slowdown. However, it must be remembered that the £1.4 billion to £2.2 billion figure relates entirely to employees in DB-deficit firms rather than the entire working population. With roughly half of private sector employees working in firms with DB schemes, the average annual pay effect within this group rises to somewhere in the range £145-£225. And this average is likely to mask still more sizeable effects for some: looking across the firms in the sample used in the research, the average deficit payment relative to wage bill is 6 per cent, with a standard deviation of 9 per cent.

The regression also shows that the wage effect is stronger on those employees who remain active members of the DB scheme. For such workers, an increase in deficit payments equivalent to 1 per cent of a firm’s wage bill is associated with a pay reduction of between 0.12 per cent and 0.18 per cent. The magnitude of impact is lower for deferred DB pension members (those in schemes which are closed to future accrual) and across all firms is not statistically significant for employees who have never been members of the pension scheme.

However, there is a significant negative effect (with a coefficient of 0.22 per cent) for those who have never been members when we concentrate on employees in the bottom quarter of the pay distribution. This group is younger than any other considered in the research, implying that the UK’s youngest and lowest earners are suffering an additional pay penalty as a result of DB deficit payments that have no benefit to them. The fact that higher earners who have never been members of their firm’s DB schemes do not appear to have been affected implies that relative labour strength may form part of the story too.

This analysis tells us about what the specific relationship between deficit payments and pay has been in the past, describing which groups have felt wage effects and which haven’t. It doesn’t tell us anything either about what firms should have done when faced with these increased costs, or about wider employer and employee attitudes to pay and reward that might affect the impact of future deficit payments on pay. Nor can we confidently predict how the scale of DB deficits will alter in the coming years. Forward-looking scheme valuations are inevitably subject to significant uncertainty and will depend in part on the future path of interest rates.

Nevertheless, the current scale of deficits and the tendency of longevity to surprise on the upside implies that we might expect contributions to drag on pay for the foreseeable future. With this in mind, the new evidence reported in this paper highlights the need to look beyond questions relating to the sustainability of deficit schedules. Policy makers should also seek to better understand how the DB deficit burden is being distributed across different groups and different cohorts, with our findings providing added urgency to the need to tackle the UK’s ongoing pay and productivity problems.