July pensions supplement: time to cut public sector pensions?

Are public pensions the best use of government money?

June 17, 2015
Cutting public sector pay or benefits can be politically tricky, but is it necessary? © DAVE EVANS/NEWZULU/PA Images
Cutting public sector pay or benefits can be politically tricky, but is it necessary? © DAVE EVANS/NEWZULU/PA Images
Read the rest of our July pensions supplement

Largely unremarked upon (other, perhaps, than by those affected) are substantive reforms to two of the biggest public sector pension schemes which were implemented on 1st April this year. These changes to the National Health Service and the teachers’ schemes mark the end of the series of reforms set in train following John Hutton’s report, published in 2011.

Why should we care? One reason is that gross spending on unfunded public service pensions is expected to surpass £40bn next year. That’s well over half total spending on the basic state pension. Admittedly that £40bn is offset by the nearly £30bn of contributions that current public sector employees and their employers make. But that gap, the measure of net spending on public service pensions, has been growing rapidly and has played a small but important role in the squeeze on other public spending. The gap has been growing despite increased contribution rates being charged to both employees and employers. Higher employer contributions have a direct effect in reducing money available for service delivery, and planned further increases will make budgets for the NHS, schools and other public services even tighter than they appear.

In addition the period of reform may not be over. The public sector remains out of step with the private sector in its patterns of remuneration in general and its provision of pensions in particular.

It is not that this spending is in some sense “unsustainable.” In the long run spending on public service pensions will fall as a fraction of national income. The question is not whether we can spend money in this way; it is whether this is the best use for public spending.

What reforms have been implemented? The big unfunded public service schemes—NHS, teachers and civil service—used to offer an inflation-linked pension of half final earnings from age 60 after 40 years of work, plus a lump sum worth one and a half times final earnings. The last Labour government increased the pension age to 65 for those joining after 2007 or 2008. The coalition government increased the pension age to match the state pension age for all those in the schemes whenever they joined—though those within 10 years of their normal pension age in 2012 were spared this change. It also altered indexation arrangements such that pensions—both deferred and in payment—will rise in line with the CPI inflation measure, not the, generally rather higher RPI, a different measure of inflation. And it also reformed rules such that instead of pensions being linked to final salary, they will be linked to a measure of average salary.

Curiously perhaps the least radical sounding of these changes—the move from RPI to CPI—will have much the biggest effect on future spending.

The other changes look broadly sensible in isolation. Aligning pension ages among people in the same organisation and between the public sector and the state scheme looks reasonable. (Under the Labour reforms, your pension age depended on when you joined the scheme.) Offering a pension related to average salary also has advantages over final salary schemes which reward those whose earnings increase steeply over their working life. Under a final salary scheme the contributions made by a teacher early in life buy a much bigger pension if he or she goes on to become a headteacher than if she remains in the classroom.

So why might these reforms not be the end of the story? First, pension arrangements for public sector workers remain much more generous than those for private sector workers. Over 80 per cent of employees in the public sector are accruing rights to a defined benefit pension. That is now true of fewer than 10 per cent of employees in the private sector. We estimate than on average in the public sector the pension accrued for each year of employment is worth about 18 per cent of earnings.

In other words the total remuneration can be thought of as pay plus 18 per cent. The average across the whole private sector is more like 6 per cent.

And second, the reforms have if anything exacerbated differences in the pattern of remuneration between public and private sectors. Broadly speaking those who have done best from the reforms—those in relatively low paid jobs who can benefit from the move to a lifetime average earnings formula—have an estimated pay premium over similar workers in the private sector, who are themselves especially unlikely to have a good employer sponsored pension. Conversely those who have done worst from the reforms—the high paid who have both seen their contributions rise most steeply and will lose most from the move away from the final salary formula—are the ones who appear more likely to suffer a pay penalty for working in the public sector.

As the new government looks to reduce the costs of the public sector workforce it might be tempted not to honour the pledge of the former Chief Secretary to the Treasury, Danny Alexander, that the new schemes would “be sustained for decades to come.”