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Public sector pension reform could slaughter high earners

Retirement | Occupational Pension

By Justin Modray, published 10 March 2011.
Helpful? 23

More news today on how the Government might tackle the problem of rising public sector pension costs. And it's generally not good news, especially for high earners.

Public sector pensions are an increasing drain on public finances - a trend that can't continue, especially in these austere times (to see why this is a problem read my earlier article).

Lord Hutton has published his final report after 9 months of study into how the Government might solve this problem.

The report makes a number of recommendations, as follows:

Replace final salary pensions with a career average revalued earnings (CARE) scheme

Under final salary schemes retirement income is calculated based on the number of years' service and salary at retirement. For example, someone with 30 years of service in a 1/60th scheme earning £40,000 at retirement would enjoy a pension of £20,000 a year (calculated as 30 x 1/60 x 40,000).

A CARE scheme instead calculates pension income based on average earnings over that period of service and the number of years' service. The report's favoured option seems to be taking each year's salary and increasing that in-line with average national earnings up until retirement, at which point it's multiplied by 1/61 to get retirement income, which will increase by inflation (not earnings) when in payment.

So in our above example, if the person's salary had increased by average earnings each year the only change would be the 'accrual' rate of 1/60th falling to 1/61th, so income would be 30 x 1/61 x 40,000 = £19,672.

The proposed CARE scheme would most penalise those whose earnings have increased faster than the average during their career - a group the report refers to as 'high flyers'. They could lose out significantly as the below example shows:

Salary change over 30 years of serviceFinal Salary (1/60 accrual rate)CARE (1/61 accrual rate)
£15,000 to £40,000
(in-line with average earnings)
£20,000 £19,672
£15,000 to £80,000
(rises faster than average earnings)
£40,000 £29,859
Assumes average earnings rise by 3.5% a year.

Adopt a single benefit scheme with tiered contribution rates

This means all employees should be able to accrue the same benefits regardless of salary, but might have to pay differing levels of contributions to enjoy them. The report favours this approach over a 'salary cap' on pension benefits for higher earners.

Align public sector retirement age with the state pension retirement age

The normal retirement age (NRA) for public sector pensions should increase to be in-line with the state pension (it's not uncommon for longer serving members to have a NRA of 60). There should also be flexibility to retire either side of this, subject to a fair pension adjustment (i.e. reflecting life expectancy).

Existing final salary benefits should be protected

New rules should only affect future service, not existing benefits built up under final salary rules.

Introduce a fixed cost ceiling for taxpayers

This is perhaps the most sensible recommendation from taxpayers' point of view and the most worrying if you have a public sector pension. Fixing the proportion of public sector pensionable pay that taxpayers effectively fund leaves the door firmly open for further public sector pension cuts if any initial changes don't save the required amount of money.

How do public sector pension contributions compare to the private sector?

If you're curious, the table below (taken from the report) sheds some light. It doesn't cover the benefits received for those contributions (preventing accurate comparison), but does help paint a picture of the extent taxpayers ae funding public sector pensions (via employer contributions).

SchemeEmployee contributionEmployer contribution
Teachers 6.4% 14.1%
NHS 5.5% - 8.5% 14%
Civil Service 1.5% or 3.5% 19%
Police (1987 scheme) 11% 24.2%
Police (2006 scheme) 9.5% 24.2%
Fire (1992 scheme) 11% 26.5%
Fire (2006 scheme) 8.5% 14.2%
Armed Forces (officers) 0% 37.3%
Armed Forces (others) 0% 21.4%
Local Government (LGPS) 5.5% - 7.5% 14% - 25%
Private Sector (average final salary*) 5.4% 14.9%
Private Sector (average money purchase*) 3% 6.4%
Source: IPSPC. * open schemes only.

Are the Hutton Report recommendations a good thing?

Probably not if you work in the public sector, especially if you are, or expect to be, a high earner over the course of your career.

But from a taxpayer's point of view putting a lid on public sector pensions expenditure is necessary and the only way to practically achieve this is to reduce average benefits, whichever way that might be implemented.

However, while there's little choice but to cut public sector pensions, I do have sympathy for those affected. Let's not forget they're already going to be hit from this April by switching annual pension inflation-linking from RPI to CPI. CPI tends to be lower as it doesn't include housing costs - the Pensions Policy Institute predicts this move will reduce the average public sector employee benefit rate from 24% to 20% (ok, still high, but a significant reduction nevertheless).

The report urges the Government to introduce any changes during the current parliament, that is by 2015. So, as seems to be case with most pension proposals these days, we'll have to continue watching this space...

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Readers' Comments (4) - To post a comment please register or login .

Comment by davidt38 at 9:06am on 14 Mar 2011:

The cost of NHS pensions varies with the scheme - this is not clear from this article, The 2008 scheme vastly reduced the cost to the NHS employers, when it increased retirement to 65 (rather than at 60) and gave no automatic lump sum (subsidy cut from 22% to 14% roughly).
This was on top of the discontinuation of the pre 1995 scheme benefits.Where for example, pre- 1995 scheme Mental Health nurses benefited from doubling of a year's membership after 20 years. This meant under the 1995 scheme if you worked 30 years you would get 40 years membership, under the 1/80 scheme so get the maximum pension (50% of the final salary). To get the same benefit new members after 1995 nursing staff would have to work another 10 years in an extremely stressful environment.

Comment by pvcdoc at 4:51pm on 14 Mar 2011:

Also concerning the NHS scheme, whilst hospital doctors have a "final salary" system, GPs have always had a "career average" arrangement.

Comment by amc630 at 3:06pm on 24 May 2011:

As a retired RAF Officer I can assure you that I "paid" an employee contribution for my pension. However, it was not reflected in my monthly pay slip or P60. Instead the Armed Forces Pay Revue Body deducted the pension contribution for the final salary agreed with the Government and paid me the net sum as my publicly recorded salary. The same rule pertained to other rank's salaries and pensions, and to the other Services.

Comment by justin at 3:37pm on 24 May 2011:

Hi amc630, thanks for clarifying that - very helpful.