Big challenges- for the next government

Teachers pensions first in the frame, but little transparency overall


The Chancellor in 2009 told Britain’s 5.8m public-sector workers that pay rises would be capped at just 1% and that their generous pension benefits could not last much longer. He  said “Public pensions need to be broadly in line with those offered in the private sector. By 2012 contributions by the state to public-service pensions for teachers, local government, NHS and the civil service will be capped – saving around £1bn a year.” Public-sector workers earning more than £100,000 a year will be the hardest hit, and are expected to pay the most in additional contributions. But some economists and pensions experts believe that this is not sufficient and the growing structural imbalances must be addressed with more draconian reforms.

Public sector workers monthly deduction on their pay slips entitled “pension contribution”, doesn’t cover the actual cost of their retirement. Many, unsurprisingly, think it does. Unlike most private sector pension schemes, public sector pensions are mostly unfunded:  so that pension contributions paid by today’s workers are used to pay pensions to today’s pensioners, while tomorrow’s pensioners will be paid out of pension contributions paid by tomorrow’s workers. The cost of supporting the growing number of public sector workers may be great now, but it will be even greater in future thanks to the millstone of public sector pensions.

Policy Exchange in its report ‘The Renewal of Government’ (2010) found that at the moment the Government  ‘asks NHS employees and teachers for a contribution  which averages around 6% of pay and  employers  deliver an additional 14%, in order to help meet the pension promises it has made, i.e. 20% of total employee pay. But over 40 years a typical public sector worker would have needed to have paid 48% of his salary into his scheme, in every year of his career in order to pay for the pension payouts at the end of it. The Treasury (ie the taxpayer) of course currently covers this annual 28% gap.’ Policy Exchange has pointed out that  of  the six largest public sector pension schemes, only one (the Local Government Pension Scheme) is funded (though centrally guaranteed); the other five (those for the NHS, teachers, the civil service, the police and the armed forces) are not.

Britain’s teachers as it happens may be first in the firing line in the chancellor’s squeeze on public-sector pensions as the teachers scheme is  in the process of being revalued .A £9.5bn loss in 2007 in the teachers’ scheme was due to an increase in life expectancy that experts said should be included in the current  revaluation, and this it is estimated   could lead to a  one percentage point rise in contributions to 7.4%, cutting £300 from the take-home pay of a teacher. Teachers contribute to their pension of course (6.4%)  but there is still this yawning gap between their contributions and the payments they get when they retire.

By 2003 the net public liability caused overall by the pensions shortfall was £560billion. At that point the Government considered, but thanks to pressure from trade unions, ultimately failed to reform public sector pensions. It wasn’t Alan Johnson’s finest hour .

A report this month  from pension experts Towers Watson said that  the  real the cost of public sector pensions is  £1,200billion, which is about 80 per cent of the country’s total economic output.

To make matters worse, although their figure includes most public sector workers, it does not include all of them – for instance local government staff. Towers Watson said its figure for liabilities to retired state workers and those currently in employment is far higher than the Government’s estimate because the company used a realistic calculation rather than an optimistic one.

It also not unnaturally upsetting many in the private sector who have to make their own pension arrangements which they have seen significantly reduced in value over the last few years and who are expected in turn to subsidize gold plated public service pensions which have no risks attached to them and which have not suffered in the downturn.

In contrast to the private sector, where the vast majority of workers will retire on pensions determined by the size of the pooled funds in which their pension contributions have been invested, most public sector workers can still look forward to final salary pensions. So in retirement they will receive an income based on their salary at the time they retired – often two-thirds – index-linked for life. A report from AXA has warned that about 60 per cent of voters say it is unfair that public sector workers get a better deal than their private counterparts.

According to research by the Pensions Policy Institute, the average public sector pension is worth three times as much as the typical scheme still open to workers in the private sector. And, just 4.6% of private sector employees are in defined benefit schemes that are open, compared to 82% of public sector workers. In the Private sector many, now most, defined benefit schemes – which promise a pension related to earnings and years of service – have closed to new entrants. In their place are defined contribution schemes, which have been designed to be, on average, less generous and which leave employees formally bearing more risk, for example that investments under perform. Defined benefit pensions in the public sector are worth more as a share of the total remuneration package than they are in the private sector.  And most public sector workers are able to claim their pensions at an earlier date than workers in the private sector, which means that the accrual of extra pension rights is worth more to public sector workers.

Comparing the private and public sectors overall remuneration is difficult but certainly in relation to pensions there is a growing perception of structural imbalances between the two respective sectors.  These imbalances are drawing more and more of our best graduates into the public sector. This in one significant sense is a good thing.  We obviously need good quality people in public service but it is, self-evidently, also at the expense of the wealth creating, entrepreneurial  private sector. So there is a big downside. It limits our capacity to generate wealth, to deliver sustained economic growth and to increase the size of the tax base. As the private sector has contracted, the public sector has continued to expanded even throughout the recession and credit crunch and along with it the public sector pension liabilities.

There is a huge risk in this arrangement: the Government does not know for sure how many public sector workers there will be to pay for future pensions, neither does it know what rate of inflation will prevail over the coming decades nor how long its pensioners will live. It was precisely this kind of miscalculation which brought down the Equitable Life insurance company. If the public sector’s pension scheme was offered by a private company then it would have gone bust years ago; but instead the taxpayer simply picks up the tab for this growing, yawning gap between pension contributions and payments. Some experts say  that pensions are only “affordable” today because there are four workers for each retired person. In 20 years the ratio sinks to two per person. In effect, the burden of pension payments is at its largest at the point where there are fewer taxpayers to pay the bill.

The Government is keen that more private sector and not for profits deliver public services But there is this pension sword of Damocles hanging over all public enterprises. The CBI says that businesses are often prevented from bidding for public service contracts by their inability to pay a premium – of between 25% and 50% – to match the pension entitlements of formerly public sector staff. It also means that it is more difficult for the private sector to compete with the public sector – further reducing competition and innovation in the public sector.

But there is another problem too. Public Sector workers can, like anyone else, become disillusioned and de-motivated in their jobs but have a huge incentive to stay on in their jobs. A public sector worker might be able to increase his or her salary by moving to a private sector job, but it would, more often than not probably, compromise the value of  their  pension. So they have an incentive to stay on and become an underperforming time-server. This is known to be a problem in the teaching profession where more flexible pension arrangements have been called for in a recent think tank report for precisely this reason.

There is a strong case, of course, for honouring existing  pension obligations but at least for new entrants significant reforms to public sector pensions are essential. Politicians themselves benefit from attractive pension arrangements and both they and public servants  more generally are very coy about  telling us the nature and scale of the problems we, and lets face it, our children  are facing. This is particularly the case in the wake of the expenses scandal and in the run up to the next election where promises of future austerity are probably not on the face of it vote winners.

Experts including at the IFS believe that the Governments  is understating, significantly, the true cost of their employees’ pension costs in terms of both the liabilities already incurred and the annual cost of running the  public sector schemes. The government actuary’s department is entrusted with estimating the cost of pensions for the Treasury. However, experts say it uses out-of-date figures for life expectancy and overly generous interest rates and inflation and have called for an independent review.

The Taxpayers Alliance (TPA) has issued a report on public sector pension schemes in the UK with local government pension funding alone estimated to have a shortfall of around £53 billion. The figure for the 2008/09 tax year sees more than 15 councils with a deficit of over £500 million each which will be funded by UK taxpayers in due course. The figure of £53 billion is an increase of £9 billion on the previous tax year after investments fell by £21 billion during the 12 month period, with additional contributions making up some of the shortfall. The Alliance claims that Taxpayers do not seem to realise that these gold-plated local council pension schemes, which are final salary based, continue to grow in size and continue to place more pressure on the tax liabilities of UK consumers and UK businesses.

The first step must be to reveal the size of the problem, and prevent the Government from running up further off-the-books debt. The Government lambasts banks over the size of their hidden debts and pushes private pension funds to be more transparent but hides the level of its own liabilities. Companies have to include pension liabilities as a debt in their accounts. The Government should be held to similar standards. It makes sense that Public sector employers must make pension provision for their current staff each year, equivalent to the full market value of the pension benefits they have given out

The Government should focus on ensuring that the overall remuneration package, including   pensions offered to public sector workers serves to attract and retains suitable employees at the lowest cost to the taxpayer. And, is it really  too much to ask that they are more transparent about the challenges we face and  that we have a mature debate about how to deal with it, not least for our children’s sake.

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