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Commercial Question

Public sector pensions: time for change?

updated on 20 July 2010

Question

What reforms have been proposed for public sector pensions in response to broad economic and social factors?

Answer

The Office for Budget Responsibility has estimated the liability of public sector schemes to be at least £1 trillion. With costs rising, major reform under the new government is inevitable.

Deputy Prime Minister Nick Clegg stated in his speech on 15 June 2010: "The current situation is not fair. Private sector workers have already seen final salary schemes close, while returns from defined contribution schemes fall. So can we really ask them to keep paying their taxes into unreformed gold-plated public sector pension pots? It’s not just unfair, it’s not affordable."

So what exactly is in store for public sector workers under the new reforms?
Chancellor George Osborne announced that a new Independent Pensions Commission, headed by the former Secretary of State for Work and Pensions John Hutton, will make recommendations for pension reform across the public sector. The director of HR policy at the Confederation of British Industry, Katja Hall, has warned that the public sector's lack of transparency has enabled it to "draw a veil over the real position", and that the first steps by the new commission must be to improve transparency over pension costs. She went on to suggest that the commission should suggest guiding principles and parameters for change, allowing public sector employees to shape their own reforms.

The reforms are likely to include requiring staff to work for longer before being permitted to draw their pension, changing or removing final salary arrangements and increasing contributions. The government's coalition document, published in May, stated that while existing rights would be protected, future retirement benefits were likely to be less generous. From a practical point of view, primary legislation may be needed to amend the public service schemes (which would require parliamentary time which might not be readily available); from an economic viewpoint, the disincentive for the workforce to enter the public sector and the consequent difficulty in attracting the best talent could have an adverse impact on the quality of services provided by government. Further, many public service employees are low-paid or part-time workers, and to remove their primary employee benefit would have a major demotivational effect and consequently impact on services. Politically, it would be an unpopular measure with a significant proportion of the working population.

The four main public service schemes include the Local Government Pension Scheme (LGPS), the Principal Civil Service Pension Scheme (PCSPS), the National Health Service Pensions Scheme (NHSPS) and the Teachers Pension Scheme (TPS). The LGPS is unique among these arrangements as it is a funded scheme, whereas the others are unfunded and backed by a Treasury (ie, taxpayer) promise to meet benefits.

Possible reforms to public service pension schemes
All the public service schemes have changed in recent years:

  • The PCSPS ended final salary benefits for new joiners from the end of 2007, with new employees after that date entitled to benefits based on their average salary over their civil service career.
  • The TPS, NHSPS and LGPS changed their benefit structure to provide for higher levels of member contributions and different rates of accruing benefits under the schemes.
  • All the public service schemes introduced the concept of cost sharing, so that if contributions rise above a specified level, the excess is shared between employers and employees in specified proportions.

The Public Service Pensions Commission reported (in "Reforming Public Sector Pensions", July 2010) that while the changes may make schemes affordable now, there is a serious question about whether they are sustainable in the future (which, of course, is the purpose of a pension scheme).

An option for controlling accruing risks for future service would be to close the public service schemes to future service. However, closure of the schemes would have practical, motivational and political consequences.

More likely is that an amendment will be made to the benefit structure of the schemes, and debate is already raging about what form such an amendment should take. There is no political consensus on this point: a pre-election statement by John Denham indicated that the recent changes to the LGPS need time to "bed down", and that further changes would be unwelcome and unnecessary at the moment. As set out above, the coalition does not agree.

Other than the future service provision of pensions, the focus of government and other commentary has been on the past service liabilities which have built up under the public service schemes. As set out above, this could be anything up to £1 trillion. However, the PCSPS, NHSPS and TPS are unfunded schemes, so they technically do not have a deficit (or have a 100% deficit, depending on your point of view) and are backed by the tax payer on a pay-as-you-go basis. The main focus of deficit issues in the public service schemes is in the LGPS, so how could the government deal with those liabilities?

Alternatives available to deal with the past service LGPS deficit include:

  • changes to the investment strategy to reflect the more accurately liabilities of the funds. Currently, the LGPS is constrained in relation to certain investment strategies. However, this would mean taking higher risks, to which the authorities might be unhappy to expose themselves; and
  • conversion of the LGPS to an unfunded statutory scheme similar to other statutory schemes. On the face of it, this would have some attractions for the government in the current economic climate. Funds could be passed from the LGPS to Her Majesty's (HM) Treasury, releasing £97 billion into the economy at a time when government borrowing is severely stretched. In exchange for the release of funds, HM Treasury would provide a funding guarantee similar to that offered to the TPS or NHSPS.

The second option is unlikely to be palatable, as it would bring the LGPS liabilities onto the government balance sheet at a time when such liabilities should be being reduced, not increased.

In conclusion, the recent budget report published by the coalition government is likely to create substantial changes in public service pensions and potentially impact on the private sector. As the law on pensions is so dynamic and continuously changing, it will be interesting to see what adjustments we are likely to observe in the future. The review which John Hutton has been asked to produce - with "early steps" provided by September and full proposals ready for the 2011 budget - will be greatly anticipated by both the public and academics.

Laura Sewell is a trainee solicitor in the pensions team at Pinsent Masons LLP.