Careful what you wish for

8 Jun 09
Public sector pensions are the focus of efficiency plans for all the major political parties. But any change to schemes could have knock-on effects that would be detrimental to short-term and long-term public finances

by Nigel Keogh

05 June 2009

Public sector pensions are the focus of efficiency plans for all the major political parties. But any change to schemes could have knock-on effects that would be detrimental to short-term and long-term public finances

The momentous changes needed to boost the public finances have again turned policy-makers’ attention on to the cost of public sector pensions. The question is how these costs are to be reined in to help reduce government borrowing or fix the ‘black hole’ in the public finances – which is £90bn, according to the Institute for Fiscal Studies.

The opposition parties have been outlining their thoughts on the future of public sector pensions in recent weeks. The Liberal Democrats have reiterated their calls for an independent review, a line that has been taken up by the Conservatives, who have proposed a royal commission to look into the matter. The Tories’ earlier pronouncements had seemed to suggest that they had already decided to scrap defined benefit schemes in favour of defined contribution schemes for the public services, mirroring their pledge to do that for MPs’ pensions.

Whatever the outcome, it seems that, somewhere along the line, public sector workers face the prospect of having their pensions arrangements raided to make good the severe dent in the public finances. In the current climate, closing these schemes might appear an attractive option. But just how much would this contribute to cutting costs in the public sector?

The unfunded central government pension schemes, such as those for the NHS, civil service, armed forces and teachers, operate on a ‘pay as you go basis’. In practice, this means that current employers’ and employees’ contributions are used to pay the pensions of those who have already retired, with the shortfall being funded by the Treasury.

In 2007/08, the total amount of pensions paid was approximately £20bn, of which £2.3bn was met directly by the Treasury. The remainder was funded from pension scheme contributions, of which £4.1bn came from scheme members. The net cost to the taxpayer was therefore around £16bn, comprising the Treasury-funded element and the employer contribution.

So what would happen if these schemes were to be closed to future accrual? The current pensions bill of around £20bn would remain unchanged as this relates to pensions already in payment. However, all contributions into the schemes would cease. Therefore, the £4.1bn contribution currently made by scheme members towards the cost of existing pensions would have to be replaced by funding from the Treasury. This would have the effect of increasing the cost to the taxpayer by £4.1bn overnight. So while closing the schemes would effectively freeze liabilities at current levels (future longevity improvements notwithstanding), the cost to government of making payments would clearly increase.

Another option that would ensure that the flow of employee contributions continues would be to allow existing employees to retain membership of the defined benefit pension scheme but to close the scheme to new members. This would, however, raise other issues.

Setting aside for one moment the questionable short-term financial benefits of curtailing the current public sector pensions arrangements, another noticeable common factor in all of the recent pronouncements is that public service pensions are referred to as an homogeneous whole. This ignores the often vastly different occupational nature of the schemes and their memberships. For example, retirement ages, accrual rates, contributions structures and benefit entitlements vary from scheme to scheme.

It also overlooks the practical problems of dealing with the large number of quite diverse employee representative groups and those responsible for bringing about change to public sector pensions arrangements. These are important distinctions, particularly when one considers the role pensions play in the ability of public sector organisations to recruit and retain skilled staff.

Many might think that recruitment is not difficult, particularly today. Historically, during times of rising private sector unemployment, the public sector has been seen as an attractive option. The education sector in particular looks set to benefit from the current downturn, with interest in teaching vacancies up by 45% on last year. However, public sector roles are not homogeneous and it is certainly not the case that all sectors will benefit. For example, many social care vacancies remain hard to fill. It should also be borne in mind that, however difficult the outlook is now, things will get better and those who have sought refuge in public sector employment might leave to take advantage of new opportunities as they arise in the private sector.

Whether the attraction of a public sector pension scheme is sufficient to make these individuals stay is hard to say. Private sector employers no longer see the provision of a defined benefit occupational pension scheme as important to being competitive in the employment market place – except, perhaps, when it comes to recruiting senior executives. After years of scheme closures in the private sector, membership has fallen to fewer than 3 million, from a membership peak of more than 8 million in the 1960s. Of these 3 million, barely more than 1 million are continuing to accrue benefits in these schemes.

That is not to say that all employers take the view that defined benefit pensions no longer have a part to play in modern day remuneration. Some believe that high quality occupational pensions provision is part and parcel of being a responsible employer. The John Lewis Partnership is a case in point. Their non-contributory final salary scheme continues to grow, with 11,000 new members joining last year following the company’s decision to reduce the waiting period for membership from five years to three.

Indeed, despite the many obituaries we have seen marking the demise of the defined benefit pension scheme, there are those that find it hard to accept that the pensions industry has moved so swiftly from defined benefit to defined contribution schemes without exploring the many compromises that can be found along the way. Writing recently, Duncan Howarth, president of the Society of Pensions Consultants, pointed out that options that allow greater risk sharing between employer and employee might yet permit defined benefit schemes to survive.

The public sector has already embraced this principle to a degree. The wide-ranging reviews of public sector pension schemes that took place earlier this decade resulted in cost-sharing/cost-capping arrangements being introduced in the local government, NHS, teachers and civil service schemes. These agreements are intended to share the costs of unanticipated increases in costs (primarily those associated with improving longevity) between employer and employee.

More recently, local government minister John Healey, speaking at the National Association of Pension Funds local authority pensions conference, took time to reaffirm that the principles that underpinned the creation of the Local Government Pension Scheme remain the same today. However, in so doing he acknowledged that schemes must continue to adapt to changing circumstances in society, and in the workforce itself, to maintain their long-term financial sustainability.

This acceptance of – and commitment to respond to – the need for change demonstrates a continuing appetite for quality pensions provision in the public sector. We know from the way in which public service employee representatives have defended pensions entitlements in the past that employees hold their pensions arrangements dear.

What we do not know is the effect that any kneejerk responses, such as reducing or removing pensions benefits, will have on the career decisions of the prospective men and women needed to defend our shores, fight our fires, police our streets, educate our children, nurse our sick and care for our elderly people.

Any decisions about the future of public sector pensions will need to bear in mind that any degradation could have knock-on consequences elsewhere in the public finances. And, of course, any review would need to consider the ability of public sector organisations to recruit and retain the necessary skilled, experienced and committed individuals to provide public services, often to the most vulnerable in our society.

Nigel Keogh is technical manager at CIPFA. A session on pensions — All our futures: the pensions challenge — will be held at the CIPFA annual conference on Wednesday, June 24


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