A Look At Defined Benefit Pension Costs

The Economist:

FRESH from a duel with Free Exchange, I now find myself compelled to add some context to a Democracy in America post on the Wisconsin situation.
The problem with public sector/private sector pay comparisons is that pay comes in two forms; current and deferred (ie pensions). A pension promise from the government is a very valuable thing indeed; some states have made it constitutionally protected. So, unlike the typical private sector employee who is now in a DC scheme, the public sector employee has certainty about his or her pension entitlement. If the equity market falters, the DC plan member will suffer; the employer of the DB member will make up the shortfall. In effect, the employer has written the employee a put option on the market.
How valuable is this option? We can make a judgment by looking at the Bank of England scheme. It avoids all equity risk by buying index-linked bonds to cover its pension liability. This costs it 55% of payroll in the current year (the ratio varies with the level of real yields). The average contribution into a DC scheme (employer and employee) is 10%, in both Britain and America. In a room full of actuaries last week, I asked whether this was a fair basis of pay comparsion and the answer was yes.