Public sector pensions: sow as you shall reap?

Or perhaps not. With the pensions landscape in a state of flux, and the Hutton commission likely to recommend major changes, many public sector pension rewards might soon be blown away

This could prove to be a landmark year for public sector pensions, with the Hutton Commission’s findings due to be published in time to inform the March Budget.

There has already been a fundamental shift in ­attitudes since the new government came in – with the default starting position now that public sector schemes are unaffordable in their current form, that change is inevitable, and that immediate savings can be made to contribute to the government’s austerity measures.

This reshaping of the landscape of public sector ­pensions began even before the May 2010 election, by both Conservative and Liberal Democrat politicians, journalists, the business community, ­pensions ­commentators and various Right-wing think tanks.

However, the chief catalyst for this new orthodoxy has been the work of the Independent Public Service Pensions Commission. The commission, chaired by former Labour work and pensions secretary Lord Hutton, was set up last June by the Con-Lib coalition. Its task is to fundamentally review current pension ­provision and to recommend changes that are ­sustainable and affordable in the long term, while remaining fair to both the public service workforce and the taxpayer. All the major public service pension schemes in the UK are covered by the review.

The commission published its interim report on October 7, 2010 after taking evidence from more than 100 organisations and individuals. Perhaps drawing on ­lessons from Lord Turner’s Pensions ­Commission, which reported on private sector pensions and long-term saving in 2006, a good deal of the interim report is given over to establishing a comprehensive fact base upon which credible conclusions can be drawn.

Judging by the general response to the interim report, this approach was successful. The report’s findings were largely welcomed by those from all sides of the debate, with little challenge to the stated facts and conclusions. This might be because there was something in the interim report for everyone.

Employees and their representatives will have ­welcomed Hutton’s ­conclusions that ‘gold-plated public sector pensions’ are a myth and that the downward drift of pensions in the private sector is not justification for public sector pensions to follow the same course – that is, that there should be no ‘race to the bottom’ in terms of pensions provision.

On the other hand, those looking for reform will note the firm commitment to move away from final salary pensions and the recommendation that employee contributions should rise. They might also welcome the proposals to look closely at the Fair Deal policy on ­pensions equivalence during outsourcing before the summer and the consultation on the public sector ­pensions discount rate (used in calculating pension liabilities), which was launched in December 2010.

Perhaps most importantly the interim report found favour with Chancellor George Osborne. Referring to it in the October Comprehensive Spending Review, he said: ‘The report highlights the importance of providing good quality pensions to public servants, rejects a race to the bottom in pension provision, but concludes that there is a clear rationale for public servants to make a greater contribution if their pensions are to remain fair to taxpayers and employees, and affordable for the country. The government accepts these conclusions.’

The interim report also set out the principles that the commission would be basing its final recommendations on: affordability and sustainability; adequacy and fairness; supporting productivity; and transparency and simplicity. It added that the current two extremes of the pensions spectrum (final salary defined benefit versus individual defined contribution) would not meet these basic design criteria – final salary on the grounds of fairness; individual defined contribution on the grounds of adequacy.

The challenge of devising a solution that meets all these criteria considerably narrows the options available and will require careful navigation. ­Submissions from stakeholders have begun to coalesce around one particular way forward – a ‘career average defined ­benefit’ model. It is also likely that the new arrangements will feature a later retirement age, in common with the plans for the state pension.

Beyond these broad design features, stakeholders would generally like other details to be tailored to individual schemes, to meet the requirements of a diverse range of employment types and cost envelopes. Such details include the normal pension age, the accrual rate and the precise composition of the ­benefits package. Judging by the commission’s interim report and the questions posed in its second consultation round, which clearly recognise the difficulties of a ‘one-size-fits-all’ approach, the stakeholders might well get their wish.

However, despite the positive signs that have emerged so far, there are still a number of obstacles on the path to reform that will need to be reconciled with the ­commission’s final recommendations.

First of these is that the commission was specifically tasked at the outset to find short-term cost-cutting measures to contribute to the government’s deficit reduction plans in time for the Spending Review. Of the alternatives suggested by respondents during the first consultation, it was immediately clear that only one option could generate the savings sought within the period covered by the Spending Review (to 2014/15) – and that was increasing employee contributions.

This conclusion was duly reported by the commission in its interim report and the chancellor announced in the Spending Review that employee contributions would rise by around 3% on average by 2014/15. This would increase the yield from employee ­contributions by £1.8bn in the unfunded public sector schemes and by £900m in the Local Government Pension Scheme (increasing the average contribution rate from 6.6% to around 10%).

At the same time, the government expressed the wish that lower-paid staff should be protected from the worst effects of the rate hike and that the increased contributions yield should be implemented in such a way as to minimise scheme ­opt-out rates.

This might prove to be a difficult balancing act. As CIPFA set out in its latest submission to the ­commission, in a typical local government pension fund, 75% to 80% of members will earn less than the national average wage. If this group is to be protected, the demand for increased contributions will fall upon a relatively small section of the scheme membership. This could result in disproportionate rises in contribution rates for some members. There might be similar issues for the tiered contribution rates in the NHS, while teachers could face contribution rates approaching 10%.

In the policy costings that accompanied the 2010 Spending Review, the Treasury took the view that: ‘It is possible that a small number of individuals will choose to leave their pension scheme as a result of these changes, though given the generosity of the schemes there is little economic rationale to do so, and policy will be designed to mitigate these impacts.’ ­Consequently, the costings assumed that opt-out rates would increase ‘equal to 1% of the total pay bill’.

In isolation, this assumption might have held. ­However, in view of the other pressures on personal incomes in the public sector (pay restraint, benefit reductions, tax and National Insurance increases, inflation approaching 5% and the prospect of interest rate rises before the end of 2011), many public sector employees, particularly the low-paid, might already be considering whether they can afford pension scheme membership at the current contribution rates.

The prospective increases are likely to widen these concerns to those higher up the income scale. Indeed, recent surveys suggest that opt-out rates could exceed 50% if contribution rates were to double, with a further 30% undecided. With the  first details of the new contribution tariffs likely to be published in the summer, we might not have to wait too long to see how the ‘squeezed middle’ will react to the planned rises.

The consultation on the discount rate, which Hutton believes may be too high, could also lead to an increase in employee contributions. Any lowering of the rate will have consequences for contribution rates but employers are protected from any rise during the Spending Review period. However, the consultation document does not offer the same assurance on employee contributions. As a consequence, employee contribution rates at these levels (potentially up to 15% for high earners in the LGPS), with the threat of further increases, have the potential to create further restrictions on the future shape of public sector pensions and on the breadth of recommendations that the ­commission might be considering.

In order to maintain membership with such high employee contribution rates, the benefits package will need to be commensurate and at a level that members will still believe represents value for money.

In 2008/09, UK public sector employees contributed more than £6bn into the unfunded public sector ­pensions arrangements across the UK. These contributions were used to defray the £22.5bn cost of paying today’s public sector pensioners – around 27% of the total cost. By the time we reach 2014/15, this will have risen to approximately £8.4bn, based on the latest Spending Review figures.

These spending forecasts place a great deal of ­emphasis on the employee contribution remaining intact throughout the course of this Parliament to avoid the contributions/expenditure gap widening further and therefore placing greater strain on the public finances. If pension scheme membership were to reduce ­substantially, and beyond that already assumed in the Spending Review forecasts, the current sizeable contribution from employees – which supports the cost of today’s public ­service ­pension payments – could be reduced, potentially quite significantly.

Reductions in public sector pension scheme ­membership could also have adverse longer-term consequences for the public finances. Employees might judge that their contributions are unaffordable or that their schemes no longer offer value for money. If so, they might abandon ­pension saving altogether, as many in the private sector have done in the past 15 years. This presents the risk that many more pensioners will depend on a greater amount of state support in retirement.

Widening rates of employee contributions might also affect the ability of the different sectors to attract the necessary talent. While a 3% or 4% differential might not be an important factor in choosing an employer; an 8% or 9% difference might.

Other developments in pension policy could also affect the long-term affordability of public sector ­pensions, for both employer and employee. In ­February, the government announced that the National Insurance rebates in contracted-out defined benefit pension schemes would be cut. Under current arrangements, employees pay 1.6% less and employers 3.7% less than the standard rates. From April 2012, these discounts will be cut back, increasing NI contributions by 0.2% for employees and 0.3% for employers.

But the changes might not rest there. The government’s ambition to bring in a ‘universal’ state pension of £140 per week will combine the basic and second state pension, with the aim of reducing reliance on top-up benefits. Such a move might also bring with it the complete abolition of the contracting out of the second state pension and associated rebates. In 2009/10, these rebates cost the government an estimated £9.5bn – a sum that would go some way to meeting the cost of the new, enhanced basic state pension.

This would have major implications for public sector pension scheme members who would consequently face an additional and significant de facto NI increase at the same time as rising employee contribution rates and other scheme changes.

Elsewhere, the Independent Review of Police ­Officers’ and Staff Remuneration and Conditions (the Winsor Review), might also have an impact on the final shape of police pensions. Launched in October 2010, the first stage of the review was due to report in February, with a second later in the year. Unsurprisingly, the police ­pension arrangements feature heavily in the review.

Questions also remain as to how the final Hutton report will address the widening gap in occupational pensions provision between the public and private sectors, and in particular the pressing need to encourage adequate saving for retirement in the private sector. The interim report placed a great deal of reliance on the success of the soon-to-be launched National Endowment Savings Trust and the associated auto-enrolment process as the catalyst to reinvigorate workplace-based pensions.

It was also hoped that the new public sector pension arrangements (whatever they might eventually be) would act as a benchmark for the private sector.

Whether these measures will be enough to reverse the years of decline in private sector pensions remains to be seen. It is to be hoped that the review does not miss the opportunity to make the case for measures to improve private sector pensions. In doing so, it should contribute to the work of the recently launched Workplace Retirement Income Commission, chaired by Lord McFall, which is looking at  how the UK can radically change its approach to retirement saving.

The final Hutton report is due to be published in the next week or so, and the government is expected to respond in its March 23 Budget statement.

Both the report and the government’s response will emerge into a pensions landscape that is complex and in a state of flux. As such, the report will merely signify the end of the beginning. Much more lies ahead before public sector pensions reach a new steady state but, on the evidence to date, it is likely to be quite different from anything public servants have known in the past.