Public Sector Pensions

28 Nov 2008, by Nigel Stanley in Pensions & Investment, Politics, Public services

There has been a sustained campaign by the Taxpayers’ Alliance and rightwing newspapers against public sector pensions. Public servants are featherbedded they say, and the future cost of providing pensions are of telephone number proportions.

They seem to have made a convert in David Cameron. This is what he said in answer to questions at a Manchester Chamber of Commerce meeting last Monday (first revealed by the FT’s estimable Nick Timmins):

“We have got to end the apartheid. We are getting into a situation now where pretty much everyone in the private sector has gone to defined contributions and the final salary schemes are closed. In the public sector you have still got a lot of people on final salary schemes including members of parliament.

“MPs are going to have to lead by example. We have got to close the MP’s final salary scheme because we have got to be able to turn around to the rest of the public sector and say that over time it does makes sense to move towards defined contribution.

“There is an issue of fairness between the private sector and the public sector but there is also an issue of economic efficiency. We do not want to make it so hard for people to move from the public sector to the private sector or from the private sector to the public sector.

“My vision over time is to move increasingly towards defined contribution rather than final salary schemes. This is something (sic) where the government has been remarkably feeble partly because they are in hock to the public sector unions”.

It is only fair to report that today the Tories’ Chris Grayling has attempted to row back. The FT again:

“That is not a decision we have taken,” he said. “That is not a decision we have even discussed. There is no hidden plan to make radical changes in one particular direction or another.”

Mr Grayling said it was “irresponsible” for opposition politicians to “grandstand” about the issue without having proper access to assessments of the costs.

“It is an issue that no future government will be able to ignore but we’re just not willing to get involved in a detailed discussion about the future of public sector pensions from a position of substantial ignorance in opposition,” he said.

But this is a slightly odd response. First he seems to be accusing his leader of grandstanding – as there is no doubt that he did say all of this in Manchester. Secondly it is simply not the case that there are lots of secrets about public sector pensions hidden away in Whitehall. Public sector pensions info is in the public domain. The Pensions Policy Institute has indeed just published a very useful summary of the situation.

It would not be surprising if public sector workers concluded that Mr Cameron’s words were an accurate statement of intent, even if the TUC’s rather obvious point that there are lots of potential losers in every marginal seat caused a rapid public retreat.

Mr Grayling as the DWP shadow may also realise that what Mr Cameron said is extremely hard to achieve for many public servants. To see why, you first have to understand the different ways that pensions are funded.

In the private sector there are two basic models of pension provided by employers:

Defined benefit (DB) pensions make a pensions promise to their members. Usually this is that every member will get a pension in retirement that is related to their salary when they leave their job and the number of years they contributed to the pension scheme. It is up the employer to make sure than the pension scheme is well enough funded to pay out the pensions that are promised.

pensions make a pensions promise to their members. Usually this is that every member will get a pension in retirement that is related to their salary when they leave their job and the number of years they contributed to the pension scheme. It is up the employer to make sure than the pension scheme is well enough funded to pay out the pensions that are promised. Defined contribution (DC) pensions do not make any kind of promise about the pension a member will receive. They are simply a savings scheme. The member and employer contribute to the pension. It is then invested on the members behalf, and the pension the member gets depends on the size of this savings pot when they retire and turn it into a regular pension income by buying an annuity.

There is lots more about how pensions work on the TUC’s advice website workSMART.

Defined benefit schemes have become more expensive for employers in recent years because people are living longer. Some have been renegotiated, but many have been closed to, at least, new members and replaced by DC schemes that not only put the risk on to the member, but on average, have much less generous employer contributions.

But in the public sector there is a third kind of pension scheme. The main schemes for civil servants, teachers and health workers, to name the big three, are unfunded ‘pay-as-you-go’ schemes. While they offer a defined benefit they do not have a pension fund backing them. Members’ contributions simply go into the public purse each year and pensions are paid out from general funds. Not all public sector schemes are unfunded. The two big ones that are not are those for local government and the universities. These are traditional funded DB schemes.

When a private sector employer replaces a DB scheme with a DC scheme, they start to save money straight away. The pensions contributions they pay for people in the DC scheme are almost always much less than the contributions they would pay if the employee was still a member of the DB scheme. At the same time they are reducing the future commitments of the DB scheme and thus the risk that they would have to make extra future payments to honour the pensions promise.

But it is very hard to see how a Conservative government could replace an unfunded public sector scheme with a DC scheme. This is because they would have to run both pensions alongside each other until everyone with any rights in the unfunded scheme was dead. They would have to both continue to fully fund today’s pensions from tax revenue to meet the benefits built up under the unfunded scheme and start to build up the fund from which tomorrow’s DC pensions would be paid. It would actually cost more for many years to both fund the payment of today’s pensions and build up the funds to pay tomorrow’s pensions before any savings were achieved.

Indeed it is hard to see any way of achieving quick savings (other than by increasing member contributions) in unfunded schemes as the pay outs are all the result of benefits accrued in previous years – and the Conservatives have said that they will not touch accrued benefits.)

These arguments of course do not apply to funded public sector pensions which is why local government workers and university staff have every right to be concerned.

But pointing out the technical problems with Mr Cameron’s proposal is not enough. The arguments of the opponents of public sector pensions should also be answered.

Their arguments are three-fold:

They say that it is unfair that public sector workers get decent pensions while most people in the public sector don’t. They say they are unaffordable. They say that haven’t moved with the times.

Of course they are right that the difference between the public and private sectors is unfair. For that matter the difference between pensions in the boardroom and those for other staff reported in the TUC’s anuual PensionsWatch report (pdf) is also unfair, though the critics seldom mention that.

The question is what should you do about this unfairness. Pensions are inadequate in most of the private sector, should you make them as mean in the public sector? Levelling down is what the right always used to try to hang on the left.

Of course the same people blame this government for the decline of private sector pensions, and in particular some of Gordon Brown’s early tax changes. While they may have played some small part, it is increasing longevity, employer aversion to risk and the change in the nature of capitalist ownership that leads to today’s boardrooms giving priority to short-term shareholder value over long-term commitment to staff that are the real reasons for the employer retreat (probably not helped by employees undervaluing pensions as a benefit- at least until recently).

But it does leave right-wing newspaper both blaming the government for ending good pensions in the private sector and simultaneously demanding the government end good pensions in the public sector – not an entirely consistent position.

Good pensions are expensive and as public sector costs are dominated by wages, public sector pensions are inevitably a good part of a sizeable wages bill. But we should still treat the figures with some caution. There is almost no other item of public spending that can be estimated in advance for so many years. You can work out how much future pensions will cost because they depend on benefits built up in the past and actuaries can estimate how long people will live. There is no equivalent government promise to fund the health service at all in the future, but of course in real life they will.

But while you can work out the future cost of pensions it is not very helpful to present the figure as a total as if it all has to be paid straight away because it won’t. It’s a significant but affordable annual commitment.

The total number you get also depends on arcane stuff like what discount rate you choose to present spending promises in say 20 years time in today’s money. Read the PPI report for more on this.

Lastly (and I think this is the longest ever Touchstone post so probably no-one’s still reading), it is simply not true that public sector pensions have not changed. They have all been (or some may still be in the process) renegotiated. The retirement age is being raised to 65, and indeed some now have a novel risk sharing element where members and employers will jointly fund the costs of any unexpected increases in mortality.

You can read the formal TUC response to the PPI report here.