As arguments rage over the best way to finance major public sector infrastructure projects, Anthony Sperryn argues that one potential source of investment remains unrecognised – the state pension fund.

London’s mayoral contest has brought the financing of the capital’s Underground system to the fore. But the current arguments of bonds versus public-private partnerships miss an important aspect of what public finance is about and what it ought to be about. Capital investments in major infrastructure items, which are normally in the public sector and are of a monopoly nature, are considered by many to belong to the people as a whole. ‘It’s our London Underground,’ they say.

But the assets can be allowed to be run down, creating periodic crises when funding is needed. The problem lies in the funding mechanism and the lack of inflation-related accounting treatment in the public sector until the recent introduction of resource accounting. One way this could be solved without losing public ownership is through ‘pay-as-you-go’ pension schemes.

My National Insurance contributions, which are to a large extent my contributions to my old-age pension, ought to be invested in something, just as if I made contributions to a private pension scheme. Why not into vital state infrastructure projects, like new Underground lines, just as the contributions of past National Insurance payers went into the existing Underground system and roads, schools and hospitals?

On this concept can be built a new, transparent way of financing – a supplement, if you like, to the Private Finance Initiative, public-private partnerships etc – but one that bridges the generation gap. And what would be the rate of return on my contributions? Index-linked of course – at least, the index-linked gilt yield plus capital protection. And that means index-linked-plus pensions for all.

If you take London Underground, there is a whole spectrum of infrastructure capital items of different lengths of useful life. The unequipped, excavated tunnel costs money to dig but will last a very long time. The lining of the tunnel will last a long time, too, but will need maintenance from time to time and, perhaps, renewal, if and when the steel rusts. The track, the signal and the other static equipment may not last as long but ought to be maintained and depreciated (through sinking funds set up for the purpose) over their lives so that when they need replacing, the money is there.

All that is common sense in the private sector, but the current run-down state of the London Underground reflects the fact that proper and necessary accounting procedures and provisions for replacement were either not set up or not applied in years gone by. The trains similarly would have been treated for accounting purposes as items whose replacement, ultimately, was a necessary evil, rather than a properly planned process.

Roads, schools, hospitals, government offices, land, equipment and even open spaces are capable of proper inflation-related accounting treatment, as items owned by the nation, if that form of ownership is what the public wants. It is possible to distinguish between the various categories of capital asset, perhaps depending on the expected life of the asset.

This article does not go into whether or not an operator needs to own the assets involved in a public service, nor the arguments about bonds versus public-private partnerships. A PPP operator does not need to own a train, nor does the public body. But the public body probably needs to own the hole in the ground through which the train runs because that is a monopoly asset – you couldn’t have half a dozen parallel tube lines in competition with each other in a place like London.

As a starting point, the unequipped tunnel, valued at current replacement cost, or indexed original cost, is the sort of asset that ought to be considered as suitable for the state pension fund. The operator of the Underground train service would pay for maintenance and depreciation plus an index-linked user charge related to current valuation – this user charge being the investment income attached to that asset of the state pension fund.

The public body itself doesn’t need to dig the hole in the ground for a new line. That is what contractors can do but the public body ought to be competent to choose the contractor that will dig the cheapest and best hole in the ground. There is no need to be dogmatic about what is in the public sector or what is done by the public sector. However, when the crunch comes, some areas are sacrosanct. For example, the public as a whole wants a National Health Service.

Empirically, it is clear that social exclusion issues require the state to assist quite a large proportion of the population to achieve access to the relevant services. The bedrock of its capacity to do that will probably turn out to be its collection of infrastructure assets (some of which will be in the state pension fund) for which the totality of taxpayers pays a proper user charge. That mechanism for payment is likely to be more effective than one that subsidises individuals, however much free marketers would wish otherwise.

Who pays for the capital investment? The simple answer is that we do. The real question is how. If it is public funding, it is out of the current year’s taxation or borrowing. If it is PFI, it is through the current taxation in future years, and the residual asset may or may not have value, and may or may not belong to the state.

The cost of finance built into the PFI calculation will be a private sector one. The risk has been transferred to the private sector (until a crisis occurs) but in the meantime the contracted income for the operator carries the higher nominal finance cost on assets, some of which are actually inflation-proof. This raises the question of whether the state is getting best value.

It may well be reasonable for the capital costs of a new hospital to be paid for over future years. The question it raises is whether we have yet hit on the best method of doing so. At present, there is a squeeze on the supply of gilt-edged stocks in the markets. Gilt yields are low, whether index-linked at under 2% real, or conventional at under 5% to redemption. Purchasers of annuities may moan but those are secure yields at a time when asset inflation may spill over into general inflation and when stock markets are high.

Meanwhile, although price-earnings ratios of the share indexes are over 20, the private sector looks for rates of return on investment of 10%, 20% or even 30% per annum. It is not difficult to see who pays for the capital investment and who gains. Perhaps it is time to have another look at how the investment is paid for.

It is interesting to see that index-linked financing is emerging in the financing of PFI projects – for example, the Greenwich Hospital project. This could lead to a further variant for my proposal to have the state pension given an asset backing. Cost variations will need very careful scrutiny of where real risk lies.

Turning to the assets themselves – as Harold Macmillan said: ‘The family silver has been sold off.’ We can’t turn the clock back on what was the public sector, so the question is whether there is still enough to have a suitably sized asset backing for the state pension fund.

Last year, the new National Asset Register totted up to some £200bn but that doesn’t include such things as roads – which at £1m per mile could add up to quite a lot.

Looked at from the other angle, what are the accumulated contributions for the British workforce? Twenty-three million people working for 40 years – earning, on a revalued basis, an average of £250 a week for 52 weeks of the year and setting aside 10% of pay – would be saving £29.9bn per annum.

Taking the average length of service of the workforce at 18 years at any one time means that the accumulated contributions of the current workforce amount to some £538bn (not so different from what the nation owns).

Actual values could be debated but rules can be made. It would not be unreasonable to define existing assets of around £500bn to constitute the assets of the state pension fund. This would just involve extending the registers already made, relabelling, installing proper financial controls and moving forward from there.

Those assets at 2% real yield would produce an investment income of £10bn per annum for the state pension fund. With the contributions of £29.9bn as above, there would be a total of £39.9bn available to pay current pensioners (static population basis). The estimated 9.4 million people over 65 years (1996 figure) would thus be entitled to a flat rate pension of £81.60 a week.

There is scope for adjustment, refinement of calculation and so on. My calculations, based on life expectancy tables and the assumptions stated, show that a man on £10,000 pa, saving £1,000 pa from age 20 to age 65 invested at 2.5% real (which is historically a more appropriate long-term yield than the present one) would accumulate funds to provide him with a pension of about £7,500 indexed and upgraded at 2.5% per annum real.

This would be his of right (if the state paid his contributions when he was unemployed or incapacitated). This is a financial mechanism to back the minimum pension guarantee that would also not discourage saving, and which would bring in an approximation to the earnings link. As asset depreciation money flowed into the state pension fund, the economy grew and people took out Additional Voluntary Contributions, there would be a supply of funds for new investment to supplement any PFI/PPP scheme.

Basically, this way of looking at the state pension fund offers a third way mechanism for reconciling the state and the private sector and the competing demands of successive generations.

The new approach to the financing of the state pension would bring greater transparency to that area of the public finances, could ensure that subsidies to the poor do not mean that the poor find it counter-productive to save for their own old age, and could ensure a steady stream of investment to supplement PFI/PP from those who would not want the bulk of their savings to be dependent on the vagaries of the stock market.