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Why public sector pensions are a problem

Retirement | Occupational Pension

By Justin Modray, published 09 July 2010.
Helpful? 32

One of the most unpopular, but essential, cuts the coalition Government will probably make is trimming back public sector pensions to an affordable level.

If you work in the public sector you have my sympathy if your pension benefits end up being cut, but the harsh reality is that without action the cost to taxpayers will continue soaring to unsustainable levels.

Why is the cost of public sector pensions rising?

It’s a combination of demographics and pension schemes being too generous to employees.

Public sector pensions paid to retired workers are funded by those still working, just like the state pension. That means public sector employee and employer pension contributions go straight towards paying someone else’s pension now, rather than being tucked away for the future.

This approach is fine if the number of workers and retirees is constant, but it’s not. The proportion of workers to pensioners is shrinking - projections suggest that while there are currently four workers to support every person over age 65, this could shrink to two workers by 2050 (because we’re generally having fewer children). With fewer workers to support those in retirement the shortfall will grow, costing taxpayers more and more.

Public sector pensions are also too generous. A typical civil servant has a total employer/employee pension contribution of about 20% of salary, yet receives benefits equal to around 40% of salary according to a report this week by the Public Sector Pensions Committee. This difference must be funded by taxpayers and/or government borrowing – neither an attractive option at present.

The table below, taken from the report, shows contribution levels and estimated benefits as a percentage of salary.

Worker TypeEmployee ContributionEmployer ContributionTotal ContributionEstimated Value
Civil Service 3.5% 17.1-26.5% 20.6-30.0% 41%
Teachers 6.4% 14.1% 20.5% 41%
NHS 5.0-8.5% 14.0% 19.0-22.5% 41%
Police 9.5% 24.2% 33.7% 71%
Firefighters 8.5% 14.2% 22.7% 71%
Note: the Public Sector Pensions Committee figures differ from government figures due to a lower, more realistic, ‘discount rate’ being used. The discount rate is an assumed annual growth rate used to work out the value of a future pension in today’s terms.

What is the cost?

Figures from the recent emergency Budget estimate net public sector pension costs to be £4 billion for 2010/11, rising to £10.3 billion by 2015/16. However, these don’t tell the full story because employer pension contributions are excluded – and being public employers their bill is ultimately footed by taxpayers.

Adding in employer contributions the Public Sector Pensions Committee report estimates the total cost at £17.9 billion for this year, equal to about £700 per household. Factor in the above Budget estimates and the bill could well hit £25 billion by 2015/16 – a 40% increase.

What can be done?

There are a number of viable options to put a lid on costs to taxpayers (all estimates taken from the Public Sector Pensions Committee report).

  • Increase the retirement age
    Increasing the retirement age from 65 to 70 would reduce the value of a typical pension from about 40% of salary to 34%. Clearly this helps, but still leaves a big funding gap as this figure needs to be nearer 20% (before we even take the ageing population into account).
  • Move the pensionable salary calculation to a career average
    Rather than base a pension on salary at retirement it could be based on a career average. This could reduce a typical pension to 29% of salary. Again, not enough on its own, but it would make a significant difference.
  • Introduce salary ceilings
    Placing a cap on the amount of salary that can be eligible for pension benefits would be politically popular as it targets the rich. But in practice it would make very little difference – a £50,000 cap would only reduce costs by 2.3%.
  • Reduce accrual rates
    Final salary pensions are calculated as a percentage of salary at retiement, typically 1/60th or 1/80th, for each year worked. Increasing this 'accrual' rate to 1/100th could reduce the typical pension to around 22% of salary at retirement.
  • Remove index-linking
    This could save a lot of money longer term, but would probably be too unpopular to ever implement. Although the Government has announced that rises will be linked to the CPI measure of inflation, rather than RPI from next April (CPI tends to lower than RPI as it excludes housing costs).
  • Increase employee contributions
    An obvious solution would be to require employees to put their hands in their pockets to make good the shortfall. But then asking public workers to contribute an extra 20% of their salary into their pension is probably a non-starter.
  • Move to defined contribution pensions
    The best long term solution would be to close final salary pensions for public sector workers and replace with money purchase pensions – just as is happening in the private sector. This removes the problem of funding shortfalls in one fell swoop. However, it would be a massively unpopular move, hence difficult to implement.

What Next?

The Government has asked John Hutton, the former Secretary for Work & Pensions, to study the options and come up with recommendations for the 2011 Budget next March. I suspect they’ll include a combination of increased retirement age, salary ceilings, higher accrual rates and possibly a move to career average salary calculations.

Whatever ultimately happens, public sector workers will undoubtedly be worse off, which I doubt they’ll take lying down. So expect protests and strikes...

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Readers' Comments (1) - To post a comment please register or login .

Comment by Mickey at 2:17pm on 17 Jul 2010:

Interesting although I have worked in two of those highlighted areas during the last 5 years and each time I have paid higher pension contributions than listed in the article. This constant bashing of the public sector is topical and probably designed to attract attention, however many of these articles are not that well informed.
P.S. can you tell me where to get those 'Estimated Value' rates, a pension I get is less than 50% of that quoted :-), amazing tricks can be played with stats :-)