Radical state pension reform cannot be delayed

by Dr. Ros Altmann

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The Rt. Hon John Hutton
Chairman
Independent Public Service Pensions Commission
HM Treasury
1 Horse Guards Road
London
SW1A 2HQ



29th July 2010


Dear John

I am attaching my submission to the Commission's inquiry into Public Service Pension provision. I have prepared a detailed response for you, as well as a note specifically about the little understood area of contracting out, reform of which offers a significant opportunity for immediate cost savings, plus long-term expenditure reductions.

I also attach for you some of my past papers on public service pensions, but please feel free to refer to the public sector pensions section of my website www.rosaltmann.com.

With kind regards





Ros Altmann





Response to Public Service Pensions Commission

Dr. Ros Altmann
29th July 2010

EXECUTIVE SUMMARY:
Public sector pension arrangements are far more generous than those now available to most private sector workers. The creation of a generation of public sector pensions aristocracy, with entitlements to much higher pensions than private workers, funded by taxpayers who will have far worse provision, is politically and socially unsustainable. It is unfair both within and between generations. Public sector workers are being given a first class ticket to retirement, are paying only the economy fare and the balance of costs is being paid by private sector taxpayers who have to wait for the bus.

The problems with public service pensions

  1. They are unfair
  2. Most schemes are unfunded, placing risk and cost burdens on future taxpayers
  3. Increasing costs raise concerns about affordability now and in future
  4. Contracting-out is an inappropriate hidden subsidy allowing lower National Insurance
  5. Lack of transparency, hidden costs
  6. Lack of consistency in official calculation assumptions
  7. Inadequate contributions being paid
  8. Negative demographic trends
  9. Sustainability of increasing disparity between public and private sector pensions
  10. Better pensions no longer justified by lower pay
  11. Cost-capping and sharing agreements do not protect taxpayers as suggested
  12. Risk of social strife

The urgent need for change - demographic and cost pressures rising
Average public sector pensions are not low, especially in comparison with private pensions. Indeed, a £6,000 a year public sector scheme pension, paid from age 60, is worth around £240,000. A £9,000 a year pension is worth £360,000. Such capital sums are beyond the wildest aspirations of most private sector workers, who will be expected to fund such pensions for millions of former public workers in future. The longer the situation continues, the higher those future costs will be.

What needs to be done?
Proper transparency, using independent discount rate assumptions:
The lack of transparency and hidden subsidies entailed in public service pensions need to be recognised and removed. It is no longer acceptable for Government to keep pretending the costs of paying public service pensions are much lower than they really are. Public schemes have been using an artificial discount rate of 3.5% above inflation - which has just been reduced to 1.8% above inflation for the latest departmental resource accounts, but this is still significantly above the rate at which Government can borrow in the index-linked gilt market, thereby artificially lowering the reported value of the pensions and artificially reducing contribution rates. This means much more money will need to be diverted to paying public pensions in future, thus detracting from other areas of public spending, to the detriment of public services for all.

Reassess public sector pensions' relative generosity: Public sector pension arrangements are far more generous than those now available to most private sector workers. This is unfair both within and between generations as public workers' will have much higher pensions than private workers, funded by taxpayers who themselves face far worse provision. The situation is politically and socially unsustainable.

Opportunity for short-term cost saving - end contracting out could save £6billion a year immediately: The best opportunity for short-term cost saving, as well as offering long-term cost reductions, is to stop the public service pension schemes from contracting-out of the state second pension. Contracting out of National Insurance makes no sense for unfunded schemes and is merely a way of allowing public sector workers to pay much less National Insurance than they should, while forcing extra costs on future generations. Public sector workers and employers should pay the right rate of national insurance (workers would pay 11% instead of 9.4% and employers would pay 12.8% instead of 9.1%). This should generate an extra £6billion a year in National Insurance revenue, as well as saving money on future pension payments.

Framework for change should encompass the following:
Ensure transparency - be honest with taxpayers and workers about the costs Ensure adequate contributions are being paid Redress the imbalance between public and private sector pay and pensions Share costs and risks fairly between generations Share burdens fairly between private workers and taxpayers. Look to save costs quickly



Detailed Consultation Response:
Review of public service pension provision

The consultation aims to identify problems with current public service pension provision and establish a suggested framework for solutions. The following is my response to the issues raised in your letter of 5th July, asking for evidence and views from me on the relevant subjects.

Identify the problems
There are many problems surrounding public service pension provision. These encompass the following factors:

  1. Fairness: Future taxpayers will be required to make up for inadequate contributions being paid now and extravagant pension promises which are being seriously undervalued. The increasing costs of funding public sector pension payments have become a focus of attention and caused significant concern in the media, economic and political circles. There has been extensive negative media comment describing public pension arrangements as unfair to taxpayers.


  2. Most schemes are unfunded: There is concern about the fact that the majority of the schemes are unfunded, so future taxpayers will have an open-ended commitment to pay these pensions without any money having been set aside at all. These unfunded public sector schemes have to be paid for by ongoing taxpayer commitments which drain money from current spending. In the past, contributions to public service pensions notionally covered the costs of paying current pensioners, and the drain on public resources was not really noticed, but this is no longer the case. More recently, the costs of paying current pensioners has been much higher than the amount received in contributions, so the apparent 'pay as you go' element is no longer working.


  3. Affordability of high and increasing costs of paying public service pensions: There is concern that the costs of paying public sector pensions have been rising sharply. On the Government's own estimates, the additional costs to taxpayers is forecast to quadruple (even if one counts the public sector employer 'contributions' as income) between 2007/08 and 20013/14 to around £9billion a year. Given the demographic profile of the workforce, net payments will continue to increase thereafter. Official figures forecast net public service pension expenditure increasing by 20% every year in real terms from 2009-10 to 2013-14. The recent NAO report on the cost of public service pensions1 shows that total payments to the 2.13million pensioners in the four largest UK public service unfunded pension schemes were £19.3billion in 2008-092. Over time the costs of providing the pensions in payment has consistently exceeded budgeted amounts. This is a result of a number of factors, such as: a). public sector salaries rising faster than expected, b). longevity rising faster than forecast and c). public sector labour force growing faster than expected. For example, the number of people employed in the four largest areas of public service unfunded pensions (NHS, teachers, armed forces, civil service) rose by 21% between 1999-2000 and 2008-09. Over the same period, the costs of paying pensions in these schemes increased by 38% in real terms.


  4. Contracting-out of national insurance is inappropriate: Public sector workers are not paying the appropriate rate of national insurance. They pay less than they should - paying only 9.4% instead of the full 11% rate, while public sector employers have been allowed to pay just 9.1% National Insurance, instead of the full 12.8%. Few people seem to realise this as it has been hidden behind the complexities of contracting-out rules, but it places additional burdens on taxpayers. It is an unfair, illogical subsidy to public sector workers. which costs taxpayers billions of pounds each year, and as unfunded public service pension schemes mature, continuing contracting out in this way will mean higher pension costs in future. Ending contracting out would be an obvious way to both increase revenue immediately, improve public finances in the short-term and reduce the cost of public service pensions in future. The details are explained more fully in the attached separate note.


  5. Lack of transparency, hidden costs: There is significant concern about lack of transparency, hidden costs and large future liabilities for public service pensions. The Government's calculation of longer term costs for public sector pensions have been heavily criticised by several independent studies, which have produced cost estimates consistently and significantly higher than the official figures. Public sector pension liabilities have been hidden off the Government's balance sheet, they did not feature in the 'fiscal rules' and there has been a consistent, long-standing lack of transparency on the costs and value of these pension schemes, as highlighted by independent studies (see references). These show that Government has failed to value its public service pension liabilities accurately. Taxpayers have simply been told that the pensions are 'fully affordable', but independent analysis suggests there is more of a problem than has been officially admitted. I hope this Commission will take advice from outside experts, such as myself, rather than relying on the Treasury or Government Actuary's Department. It was disappointing to note that the Office of Budget Responsibility's recent report, and one of the reports from the Pensions Policy Institute, seemed to accept the official discount rate and assumptions used by the Treasury and Government Actuaries Department. The Independent Public Sector Pensions Commission, on which I served, has highlighted many of the deficiencies in the discount rate assumptions used. Please refer to that report for further evidence http://www.public-sector-pensions-commission.org.uk/wp-content/themes/pspc/images/Public-Sector-Pensions-Commission-Report.pdf.


  6. Lack of consistency in official calculations: Concern has often focussed on the lack of consistency between official cost calculations of public service pensions, with different discount rate assumptions being used when calculating the costs and contributions (for SCAPE), from those used for assessing future liabilities, in official accounts. Recent resource accounts for 2010 have updated the discount rate assumptions used by each department from 3.2% to 1.8% above inflation. This is welcome, and confirms the independent views that official past estimates have been artificially depressed by inappropriate interest rate assumptions. Of course, 1.8% real interest rates are still well above current index-linked gilt yields.


  7. Inadequacy of contributions: Concern has been expressed at the inadequacy of contributions made by public sector workers to their own pensions in public service pension schemes. Employee contributions rates vary substantially across the public sector workforce. At one end of the spectrum, for example, civil servants do not pay anything towards their own pension at all. They pay 1.5% or 3.5% of salary into the scheme, but this is only for a partner's pension. If they retire single, all their contributions are returned. Teachers and NHS staff contribute 6% of salary and other schemes have different contribution rates, however none of them reflect the true cost or value of the benefits provided. The recent NAO report3 shows that employee contributions to the four largest UK public sector unfunded pension schemes were £4.4billion in 2008-09, while pension payments totalled £19.3billion, so taxpayers had to fund a shortfall of £14.9billion. Only £12.5billion of this came from 'employer' contributions (which are, of course, taxpayer funded by each department) while £2.5billion had to be paid from the Treasury directly. Official estimates expect the additional Treasury contributions in excess of employee (and employer) contributions, will rise sharply in coming years. As public expenditure elsewhere is being sharply reduced, is this cost increase sustainable or fair?


  8. Negative demographic trends increase risks and costs to taxpayers: Demographic trends mean the numbers of public service pensioners will rise sharply in coming years. Pension provision in the public sector has become increasingly generous relative to the private sector at a time when demographic trends are increasing the numbers coming up to retirement. Therefore, the relative costs will also increase. If public sector employment falls or salaries increase less rapidly than forecast, the contributions will be lower than expected and the extra net costs of pension payments would increase even faster. Thus, taxpayers are exposed to the risks of rising pension costs as a result of economic weakness or public sector cutbacks. The pay-as-you-go system falls down when more people start drawing pensions at the same time as fewer contributions are coming in.


  9. Sustainability and fairness of increasing disparity between public and private sector pension schemes. Most public sector workers have more favourable pension terms - better coverage and more generous - than most private sector workers. Public sector schemes tend to have earlier pension ages, unlimited inflation-linking and lower contributions. They also have much greater security as the schemes cannot be subject to Pension Protection Fund reductions. This is a further reason why valuing public service pensions in line with private sector accounting conventions is inappropriate and merely serves to undervalue the liabilities. Government borrows at gilt yields, not corporate bond yields and its security is greater than for private companies, whose pension schemes could end up suffering significant reductions in the PPF. The increasing relative generosity of public pension schemes seems unfair and unsustainable.


  10. Increasing disparity between public and private pensioners in future can no longer be justified by lower pay: There are increasing disparities between future pension income for public and private sectors. Official statistics show that public sector pay has risen above average equivalent private sector pay, so that previous arguments justifying generous public pensions on the grounds of lower earnings are no longer applicable. As the UK's state pension is one of the lowest in the developed world, and most private pensions will be Defined Contribution, rather than Defined Benefit in future, many private sector workers will not receive adequate pensions for even a basic minimum standard of living in retirement. Low average pension payments in public sector schemes do not, in themselves, provide a justification for the status quo, if taxpayer resources for pensions are increasingly diverted to just one group.


  11. Recent cost-capping and sharing agreements have been mis-represented to the public. Government has suggested that there is a cap on future cost increases in public service employer pension contributions, which will prevent taxpayer burdens rising too fast and stop employer contributions from rising above 20% of salary. This is not actually correct. The cap may not be a cap at all, since it only applies to longevity assumptions. Cost overruns can occur for other reasons too. If costs rise due to other factors, such as inflation or interest rates, taxpayer costs could rise well beyond the supposedly capped levels of 20% of salary. Taxpayers have, therefore, only been partially protected and significant risks remain that public sector pension costs will continue to pose open-ended large liabilities on future taxpayers.


  12. Perceived unfairness could lead to social strife: There are concerns about social strife in future as a result of the perceived unfairness of taxpayer resources being diverted to supporting public sector workers in retirement, while denying taxpayer funding for decent minimum pensions to the majority of the population who pay those taxes.

In light of all these problems, the Commission must consider whether current public sector pension arrangements are sustainable in the long-run on present terms and how they can be made fairer to future taxpayers. Especially in the context of the fiscal challenges ahead, can the Government justify maintaining high and rising expenditure on public sector pensions, in an environment where pension provision in the public sector has become far more generous than is generally available in the private sector, as well as being far more secure than for private sector workers? As public sector pay has risen above average private sector pay, is it affordable to expect taxpayers to also promise better deferred pay in the form of better pensions in future? In the context of significant reductions in public spending, is it affordable for expenditure on public sector pensions to keep rising sharply each year in future?

This situation has developed because most people do not understand it and because the lack of transparency has allowed Government to consistently underestimate the costs, while refusing to accept independent input to the calculation of liabilities.



Assessment of current provision
The reality is that current provision in the public sector is far more generous than for most private pension schemes.

Contributions to public sector schemes vary, but in no case do they cover the costs of the pensions being promised. (As highlighted earlier, contributions paid by workers in the four largest unfunded public sector pension schemes were just £4.4billion in 2008-09, while the costs of paying pensions to existing pensioners in those schemes was £19.3billion). Independent assessments, including the recent publication from the independent Public Sector Pensions Commission suggest that the true cost of a public sector pension in the unfunded schemes is approximately double the amount which the Treasury calculates for the purposes of both employer and employee contributions. Therefore, the amount being collected in the pay-as-you-go unfunded schemes is neither sufficient to cover the costs of future liabilities nor to offset the costs of today's pension promises. That means taxpayers will have to find significant additional sums to meet the costs in coming years.

The costs of paying public service pensions has been rising sharply and will continue to do so, as the demographic profile ages in the next few years. In fact, the current service cost of paying public service pensions in unfunded schemes in 2009-10 was estimated as £25.4billion. That is more than the total value of council tax collected across the whole country (which is around £24.8 billion), and more than the total revenue raised from all business rates (which is around £23.7 billion). Moreover, independent estimates calculate the actual current service costs, based on more appropriate discount rates, are far higher than these official figures - perhaps double the cost.

The terms and coverage of public sector pension schemes are better than for the private sector. In recent years, most private sector pension schemes have closed - initially to new members but increasingly to existing members too, yet 90% of public sector workers are still covered by defined benefit pension arrangements. Bank pension schemes have already been bailed out by the taxpayer and many other schemes have fallen into the Pension Protection Fund. The costs of paying final salary pensions have increased significantly in recent years and private employers have, in many cases, found those costs unaffordable or are struggling with affordability. With public sector schemes, the issue of affordability does not become apparent in the same way, because there is no 'fund' and because taxpayers are obliged to pay the pensions. Nevertheless, the issue of affordability must not be ignored.

Public sector pension schemes are more generous than for most private sector schemes. They generally have lower pension ages, lower contributions and better additional benefits such as early retirement terms, public sector pensions in payment are also fully linked to inflation with no 2.5% or 5% cap such as in the private sector. Of course the recent announcement that future increases will be linked to the consumer price index (cpi), rather than the retail price index (rpi), will reduce the generosity somewhat. However, the changes may also apply to private sector schemes and state pensions, so the relative generosity of public sector pensions will remain.



Potential justification of current arrangements:

Some arguments have been advanced in defence of the existing unfunded public service pension arrangements.

Average public sector pensions are not high. It is often argued that public sector pensions are not really generous because the average public sector pension payment is quite low. Average teacher's pensions are around £9,000 a year and average NHS staff pensions are around £6,000. This, in itself, is not a justification for the status quo.

Firstly, a fully guaranteed, inflation-linked pension of £6,000 or £9,000 a year is significantly higher than most private sector workers could hope to achieve. Purchase of a £6,000 joint-life, index-linked annuity from age 60 would cost around £240,000 and a £9,000 a year pension would cost £360,000. Such huge capital sums are beyond the reach of almost all private sector workers, yet this is the average value of public sector pensions. Of course public sector workers deserve decent pay and pensions, but such a statement cannot be considered in isolation from the rest of the economy. Surely, everyone deserves deserve pay and pensions, it is just that society may not be able to afford to fund this aspiration. With limited taxpayer resources, how much can we expect taxpayers to contribute towards the pensions of public sector workers, who make up about one fifth of the labour force, at the expense of the rest of the private sector? In 2009, official figures show that public sector employment was 21.1% of the total UK workforce, up from 19.5% in 2008. Of course, public workers perform essential work, but their pay and pensions are funded by taxpayers and, therefore, the costs will fall on others who will have to cut spending elsewhere to meet those costs. It is important to assess the level of costs on a relative basis. If 1% of total national output is devoted to paying public service pensions, then that 1% is not available for other essential spending on pensioners or elsewhere.

Secondly, the low average public sector pension is a reflection in part of the large number of very small pension entitlements that are paid to part-time workers or short-stayers. Averages are misleading as the figures are depressed by many deferred members who have tiny entitlements, after working for just a short-time, or pensions for part-time workers.

Thirdly, public sector pensions are more secure than those in the private sector, so they are more valuable. In fact, they are also more secure than the state national insurance pension too. Government can (and indeed it has) cut national insurance pensions or change their terms at any time. However, accrued public service pensions cannot be reduced. As the inflation-linking for state pensions and private sector pensions is being recommended to change from rpi to cpi alongside similar changes for public sector and state pensions, the relative generosity of public service pensions will remain largely unchanged.

Good pensions are needed to ensure attractive recruitment and retention: This argument is weak. If public sector pay is already higher than comparable private sector pay, it is not logical to argue that pensions in the public sector must also be better than those in the private sector. In fact, the superior security of public service pensions would suggest that public sector pensions could even be less generous than those in the private sector, without reducing the attractiveness of public sector employment.

Just because private sector employers are cutting pensions, does not mean it is right to cut public sector workers' pensions: This argument is understandable, but ignores affordability, sustainability and fairness. If these open-ended, unlimited pension commitments are too expensive for private employers, they are probably too expensive for public sector employers as well. Government needs to urgently assess this. As it is taxpayers who fund the pensions, policymakers also have to consider how taxpayer resources are divided between public and private sectors. Taxpayers' funds support public sector pensioners, but are also used to pay state pensions to all citizens. If state pension spending has to be cut due to affordability problems, as has been the case for the past years and will continue in future, it seems difficult to justify an ever-increasing proportion of tax revenues being used to pay better pensions to just one group of pensioners. Surely, all pensioners need decent pensions. Taxpayers need to fund at least a decent basic minimum amount for everyone, rather than committing guaranteed amounts to public sector workers, while continually cutting payments to the rest of the pensioner population and leaving them at the mercy of means-testing and markets. If we have radical reform of the state pension, ensuring a decent pension is paid to all, (even if it is from a later age) then the issue of fairness would be less of a problem. If taxpayers cannot afford to fund both public and private sector pensions at a decent level, it seems unwise to keep promising relatively more to public sector workers while private sector workers receive less and less.



Objectives of a framework for change to guide future public service pensions

  • Ensure proper transparency in costs.
  • Ensure that pension provision in the public sector is properly valued and properly accounted for.
  • Open the public sector pension arrangements to independent scrutiny, with a truly independent assessment of the costs. The Treasury cannot, by definition, be independent, nor can the Government Actuary's Department, since they are staffed by members of the schemes.
  • Try to reduce ongoing risks to taxpayers in future.
  • Ensure that public sector workers pay fair contributions to their pensions.
  • Ensure fairness between public and private sector pay and pensions, so that the public sector is not offering much better terms than private sector workers can obtain. This would help protect taxpayers from unnecessary expenditure.
  • A reform framework should allow flexibility in future public service pension payments, so that taxpayers are not saddled with open-ended, ongoing commitments that can damage the rest of the economy. A proper means of risk and cost sharing with the public sector workforce is needed, rather than forcing taxpayers to bear the burdens of unexpected pension cost increases.
  • This means there is a need to reassess the cap and share agreement. The current cap and share arrangement is not a true cap, so taxpayers still bear a disproportionate share of the risks. The Commission should ensure that public sector workers shoulder a fair share of the costs and risks value of their pensions.

Sharing costs and risks of public service pensions.
At the moment, the costs and risks of unexpected increases in future pension liabilities are falling almost entirely on the taxpayer. Workers themselves and, in particular, existing pensioners, are not bearing much of the burden, while taxpayers have to find whatever money is needed to meet accrued liabilities in future. The cost-capping and sharing arrangements, announced with much fanfare as a means of limiting future taxpayer costs to 20% of salary, are not all they seem. The cap only applies to changes in longevity assumptions. If pension costs rise for other reasons, taxpayers will still have to fund all the increase without public sector workers paying more.

Intergenerational fairness
Today's workers are funding today's pensioners and tomorrow's workers will be asked to fund tomorrow's pensioners. Taxpayers in future, i.e. the current younger generation, will have to find significant extra sums to finance the pensions for public workers who are rapidly increasing in number and who are likely to receive far more generous pensions than those future taxpayers themselves can hope to achieve. The result of past promises, for which no money has been set aside, despite the widespread knowledge of a looming ageing demographic profile, will be a burden on taxpayers which diverts future resources from alternative spending, thereby depressing long-term economic growth and prosperity. Will that younger generation remain sanguine about the situation?

Case for delivering pension cost savings immediately, even ahead of the Government's spending review
The case for delivering cost savings in public service pensions is strong, irrespective of the upcoming spending review, given the sharp rises in pension costs, the increasing disparity between public and private sector pension arrangements and the perceived unfairness of forcing taxpayers to fund pay and pensions for others which are far more generous than their own. The fact that there is also a need to cut public spending immediately merely reinforces the urgency of the required changes, but reform is required in any event.

The longer reform is delayed, the greater the future burden on taxpayers will be. As the scale of future pension liabilities has been significantly underestimated and as there is no money put aside to meet the costs of the unfunded schemes, each day that liabilities are unchanged results in a greater burden to bear in future. The sums involved are not insignificant. Especially as the size of the public sector labour force is unlikely to continue to increase, and may even fall, the net contribution required from taxpayers can be expected to increase further and faster than expected.



Options to deliver quick savings in the spending review period

There are several ways in which costs can be cut and spending reduced. End contracting-out: The most effective, fairest way is to stop the unfunded public service schemes contracting out of National Insurance. I have prepared a separate note, attached here, which outlines the issues involved. Essentially, it makes no sense for unfunded schemes to be contracted out of NI. By ending this anomaly, public sector workers would have to pay the correct rate of national insurance (they currently pay just 9.4% instead of 11%), and public sector employer contributions would have to rise to the full 12.8% instead of the current 9.1% paid. This could generate a potential extra £6billion in revenue each year immediately, thus helping the fiscal situation. In addition, all future S2P rights would be taken out of the public service pension schemes, so workers will receive their S2P from state pension age, as private sector workers will do. This will save money in the longer term as well, because public sector workers would no longer receive their S2P replacement from scheme pension age (55, 60 or 65) but would have to wait till 66 or later like the rest of us. A review of contracting out should be urgently undertaken. Please see separate note attached.

Other options for reform:

Please see the Report from Independent Public Sector Pensions Commission for more detailed analysis and suggestions. I will not repeat the findings and recommendations here. Some of the options for reform that need to be considered are as follows:

  • Increase employee contributions
  • Cap pensionable salary increases, perhaps at inflation increases only
  • Redesign the public sector scheme benefits -
    • change pension age
    • change accrual rate
    • switch final salary to career average revalued earnings (CARE) benefits
    • reduce the unlimited inflation-linking by capping at, say, 2.5
  • Only allow a certain level of pension accrual on a defined benefit basis for public service workers - perhaps just for salary up to £20,000 a year. Any additional accrual would be in a notional DC arrangement. This would ensure the lower paid have a base level of guaranteed pension accrual but higher paid have to save more for themselves. This would also ensure that officials who oversee pensions policy better understand, first hand, the practical difficulties and challenges facing private sector Defined Contribution scheme members!
  • Move all future benefits onto a notional Defined Contribution basis
  • Establish an independent commission to oversee pension and pay arrangements to assess fairness between public and private sectors, fairness between generations, level of contributions required, total reward structure and so on.
  • Ideally, public sector remuneration should be expressed as a total reward package, amalgamating the cost of both current and deferred pay. Workers paid £20,000 a year, but also accruing a pension worth an extra 40% of salary, would see their total pay stated as £28,000 a year, ensuring they could value their pensions correctly. If they believe their pension is worth only 20% of pay, they do not recognise the full value of their pay package and will expect to be paid more than they might otherwise demand.


Conclusion
There are many problems with public service pensions - especially those which are unfunded, pay-as-you-go arrangements. The schemes seem both unfair and unaffordable to taxpayers and are, therefore, likely to be unsustainable in their present form, irrespective of the public finances. However, in light of the current need to cut public expenditure, changes are particularly urgently required.

The framework for changes should focus on transparency and fairness, guided by proper independent cost estimates of future liabilities, consideration of total pay and pensions packages for public sector workers compared with private sector employees and fair division of costs and risks between public employees and future taxpayers.

So far, Government has consistently underestimated the costs of public service pensions. This means the true scale of future liabilities has been hidden from the public and the true value of pension accruals has not been reflected in the SCAPE contributions. Workers have been led to believe the value of their pensions is half its true level. Taxpayers have been misled about the future costs and risks and have also been misled into believing there is a proper cap and share arrangement to protect them in future from open-ended rises in taxpayer contributions to fund future pensions.

The current system allowing public sector workers in unfunded schemes to contract out of S2P is difficult to defend and means public sector workers effectively receive their S2P for free, from a younger age than the rest of us and pay lower national insurance than they should. Remedying this anomaly could be a powerful tool to save money and cut pension costs in both the short and long-term.



Detailed note for Hutton Commission on ending contracting-out :

Policy option for short-term cost savings and improvement of fairness and affordability of public pensions

Summary:
Ending contracting-out will save money in the short-term and long-term. It will deliver fairer and more affordable pensions in the public sector, as well as tackling some of the complexity and inequalities in the current system. Public sector workers pay the wrong rate of National Insurance - they pay 9.4% instead of the full 11% and public employers pay 9.1% instead of the full 12.8%. It is illogical for unfunded public sector schemes to contract out of National Insurance and, in practice, this arrangement merely represents a hidden subsidy to public sector employment, benefiting today's workers and public sector employers at the expense of future taxpayers.

Advantages:

  1. Improve fairness and affordability of public service pensions, ending the unfair subsidy that currently allows them to pay lower National Insurance
  2. Bring in extra revenue now to help reduce fiscal deficit and reduce public spending in future by ensuring public workers' S2P is not paid before state pension age
  3. Could save £2 billion a year as public sector workers pay higher NI
  4. Could save £4.6 billion a year as public sector employers pay higher NI
  5. Public workers would start paying for their S2P instead of receiving it 'for free'
  6. All workers would receive S2P from identical age, on the same terms, in future
  7. Public sector workers would receive S2P from state pension age (65, 66 or higher), rather than age 60 or below from their unfunded public pension scheme
  8. Future costs could be reduced by £10m a year for each 10,000 workers retiring
  9. Reduce complexity of state pension and possibly pave the way for radical state pension reform to finally deliver a decent pension for all residents
  10. Could help private sector schemes too - ending contracting out could improve private sector scheme funding and also improve Government finances immediately

Disadvantages:

  • Making the changes could be complex. May need to be phased in
  • Public sector workers - and employers - will pay higher National Insurance, rather than the artificially low rate they are paying now
  • What is the situation at the moment?
    Public sector workers in unfunded schemes pay the wrong rate of National Insurance - 9.4% instead of the full 11%. Public employers pay 9.1% instead of the full 12.8%. This seems to be due to an historical anomaly that has never been corrected. As we are re-evaluating public sector pensions, this is an opportune moment to re-assess the contracted-out status of these schemes.

    How does contracting out benefit public sector workers and employers?
    Instead of paying 11% full National Insurance contributions, public sector workers are allowed to pay just 9.4% - so they receive a 1.6% discount.

    Instead of paying full 12.8% National Insurance contributions, public sector employers have been allowed to pay just 9.1% - a 3.7% reduction.

    These 1.6% and 3.7% underpayments of National Insurance are called 'contracting out rebates'. They are designed to allow workers to opt out of the State Second Pension (S2P) scheme and replace their future National Insurance S2P payments with an alternative non-taxpayer-funded pension. For private sector employees this works by transferring S2P pension rights into private schemes, thus reducing pension costs and risks for future taxpayers. However, with unfunded public sector schemes the system does not work since taxpayers will pay S2P as part of the public sector scheme anyway. The idea of contracting out is that workers do not pay full National Insurance contributions when working, but then they will not get any additional state pension when they retire, so that future taxpayers will not have to pay them S2P in the future. In other words, workers and employers are allowed to pay less National Insurance when working only if they give up the right to a taxpayer-funded S2P payment when they retire. They are supposed to only be eligible for the Basic State Pension (BSP).

    Contracting-out with an unfunded public sector scheme defeats the purpose of contracting out, it is just a hidden subsidy for public sector workers and employers allowing them to pay lower National Insurance. This is because public sector schemes actually include S2P payments in the scheme benefits. So taxpayers will effectively have to pay S2P to public sector workers anyway, as an unfunded pension scheme has no money set aside to fund the future pensions. However the public sector workers have not paid National Insurance contributions towards it. This is not generally understood and seems to be an anomaly that defies economic logic.

    The situation is illustrated below:





    Public sector workers effectively receive S2P for free. And, what's more, it will be paid to them as part of their public sector pension, so it will start from the public sector scheme pension age, not state pension age. Therefore, when state pension age rises to 66 or 68 or beyond in future, public sector workers will still receive their S2P pension rights from age 60 or below.

    What could be done to address this?
    If unfunded final salary schemes are no longer allowed to be contracted out of S2P, then public sector workers would have to pay the proper rate of National Insurance contributions and the public sector employers would be charged the right rate too. This would bring in extra revenue to the Exchequer immediately.

    Extra potential £2billion a year from employee NI contributions
    By charging public sector employees the full 11% National Insurance, Government revenue could potentially immediately rise by around £2billion a year.

    Potential £4.6billion a year from employer NI contributions
    By charging public sector employers the full 12.8% National Insurance, there could be an extra potential £4.6billion a year notionally received in National Insurance - although the saving would only occur to the extent that the higher NI forced public sector employers to make offsetting savings elsewhere in order not to overshoot their spending targets.

    Save £100 million a year for each 1,000 public sector workers retiring
    By removing the replacement S2P rights from the public sector pension scheme benefits, the long-term costs of providing public sector pensions would be reduced. The S2P pension payments would only start from state pension age, not from scheme pension age, so workers would have to wait longer, just like other workers, to receive their S2P. Assuming an average S2P entitlement of £1000 a year, the saving could amount to £10million for every 10,000 public sector workers each year between their scheme pension age and state pension age.



    Conclusions:

    If the Public Service Pensions Commission is looking for a policy change which can cut the taxpayer costs of public service pension provision in both the short-term and long-term, then ending the ability of unfunded public sector schemes to contract out of the National Insurance system would be a powerful policy option. Indeed, ending contracting-out for all defined benefit pension schemes could raise billions of pounds of much-needed additional revenue for the Exchequer in coming years.



    APPENDIX 1 - Further information

    Ending contracting-out could also benefit private sector pension schemes
    Ending contracting out of S2P could benefit employers struggling with final salary scheme deficits. Contracting back in to National Insurance would reduce future scheme liabilities as well as bringing in extra National Insurance revenue. It could also allow a simpler benefit structure for all final salary schemes, ultimately ease the burden on employers and help scheme funding.

    Employers are desperate to find ways to reduce the funding burdens of their final salary schemes. Government has not yet managed to introduce policies to do so. The impending introduction of Solvency II, the downward pressure of Quantitative Easing and the recession on interest rates and continued volatility of asset prices have all added to the costs and risks of running final salary pension schemes. The recent announcement about linking revaluation and inflation increases for private pensions to cpi, instead of rpi, may not help much if schemes cannot change their Trust Deed. However, by ending contracting out for all schemes, the Government could help mitigate some of the ongoing costs of pension provision by reducing the future liabilities. Of course, changing benefit structures could be complex, but once we determine to end contracting-out, this could offer longer-term benefits to scheme funding, as well as the potential of increasing Government revenue in the shorter-term. In fact, as scheme trustees will already need to revisit their Trust Deed terms to accommodate a possible change from rpi to cpi uprating, it could make sense to consider the implications of ending contracting out at the same time. Reform of GMP and protected rights rules would be a welcome relief to many schemes.

    Ending contracting out could also pave the way for a better state pension
    If Government seriously wants radical pension reform, overhauling the State pension system is the best way to start. The UK state pension is far too low and far too complex, with nearly half of pensioners ending up entitled to means-tested benefits in retirement. This mass means-testing also undermines incentives for pension saving.

    Rather than slowly increasing the state pension, by tiny amounts each year, we should sweep away the complexities of having a Basic State Pension guided by one set of rules, S2P guided by a different set of rules plus Pension Credit and many other benefits on top. Merging the Basic State Pension with S2P, could provide a decent, flat-rate, universal pension for all British Citizens - perhaps from age 70 or 75. This would be truly radical reform and could finally free the private market to sell pensions safely to all.



    APPENDIX 2 - Calculation of cost savings estimates:

    Employee National Insurance: £2billion extra revenue each year if public Sector workers pay full National Insurance.

    Assume that 6.25 million public sector workers pay the reduced 9.4% rate, instead of the full 11% rate.

    If we assume an average salary of £25,000, then the National Insurance will be levied on salaries between £5,000 (lower limit for NI) and £25,000, so the extra revenue from the additional 1.6% NI will be:

    1.6% x £20,000 = £320 extra per year per worker

    £320 x 6.25 million workers = £2 billion per year

    Employer National Insurance: Extra potential £4.6billion a year if public sector employer National Insurance contributions rise from 9.1% to 12.8%

    Assume 6.25 million public sector workers with an average salary of £25,000.

    Employer contributions are levied on salaries between £5,000 and £25,000, so the extra 3.7% National Insurance received could be:

    3.7% x £20,000 = £740 per year per worker

    £740 x 6.25 million workers = £4.6 billion per year


    1. Report by the Comptroller and Auditor General HC 432 Session 2009-10 12 March 2010 'The cost of public service pensions' National Audit Office
    2. The Office for Budget Responsibility quoted official figures that the current service cost for public sector pensions was around £26billion last year. Independent estimates suggest this current service cost figure is significantly underestimated
    3. NAO ibid

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