How will we pay the huge bill for easing the impact of the COVID-19 pandemic? More borrowing, higher taxes and lower public spending look inevitable.
The chancellor could save big money by making public sector defined benefit (DB) pensions less generous – and this would narrow the gulf between public and private sector pensions.
Private sector DB pensions, inflation-linked pensions for life based on salary and the number of years worked, are all but dead. They have been closed to new employees for many years. Marks & Spencer, Tesco, Royal Mail and even John Lewis have replaced DB pensions with much less generous defined contribution (DC) pensions, a glorified savings scheme, leaving all the investment and longevity risk with employees.
Public sector DB pensions, meanwhile, are flourishing with more than six million employee members and all schemes — NHS, teachers, civil service, armed forces, and local government — open to new members.
Although the coalition government changed public sector pensions in 2015, this did nothing to reduce the annual cost to taxpayers. The changes raised the normal retirement age in most schemes to match the rising state pension age, as well as basing the pension on a person’s “career average” earnings, not their final salary. But these savings were wiped out by the higher pension earned each year. The government added insult to injury by claiming the changes should last for 25 years.
How much do new public sector DB pension promises cost taxpayers each year?
The annual cost of a DB pension depends on the level of long-term interest rates – if interest rates go down, pension costs go up, if interest rates go up, pensions costs go down. Annual costs for private sector DB pensions, based on long-term corporate bond interest rates, have been included in company accounts for many years. Public sector pension scheme accounts also include annual costs, albeit buried in footnotes.
Taking the NHS as an example, for 2015/16 – the first year of the new pension terms – the total cost of new pension promises was 36 per cent of salary, a cost to taxpayers of 26.5 per cent of salary, after 9.5 per cent member contributions. Four years later in 2019/2020 the total cost has gone up to around 50 per cent of salary – because of lower interest rates – costing taxpayers 40.5 per cent of salary, after member contributions.
The annual cost to taxpayers has ballooned from 26.5 per cent to 40.5 per cent of salary, £11.2 billion to £18.9 billion.
In the four-years from 2015/16 to 2019/20 the total cost for all public sector pensions – NHS, teachers, civil service, armed forces and local government – has gone up from around £51 billion to £71 billion. After member contributions, the cost to taxpayers has gone up from about £40 billion to £60 billion.
These costs are there if you know where to find them – they are included in individual public sector pension scheme accounts, and the totals are in another Treasury document. But they are ignored by the Treasury and Office for National Statistics; successive governments have conveniently fiddled real pension costs for the last 20 years.
It means that this generation of taxpayers are not paying the full costs of the public services they use, but passing them on to their children and grandchildren. The government should make annual pension costs crystal clear to taxpayers and use the real costings for all decision-making.
So how should the government make savings on public sector pensions, while protecting the lower-paid? My suggestion is that it should reduce the annual value of all public sector DB pensions to an 80th of the salary, with increases at inflation. This would be on the first £30,000 of salary — protecting the-lower-paid — with DC pensions on any pay above this. Member contributions would remain unchanged. Even with these changes public sector pensions would still be much more generous than most private sector DC pensions.
MPs, who get a pension costing around £32,000, taking their salary and pension to more than £114,000, should move entirely to DC. It would help them to live in the real world of DC pensions, not a gold-plated DB pension guaranteed by taxpayers, enabling them to understand their constituents’ pension worries.
These changes would save around £20 billion a year, reducing the annual cost to taxpayers from £60 billion to £40 billion. They would also begin to bring public sector DB pensions more in line with private sector DC schemes. And make public sector pensions more sustainable – if we do not make controlled changes today, DB pensions may end up being scrapped altogether.
John Ralfe is an independent pension consultant