What proportion of your salary should a good employer contribute to your pension? Is it 3 per cent, the legal minimum? How about 6 per cent, the UK private sector average? Or even 10 per cent, in line with some of the very best private sector pension schemes?
For those in the public sector, the answer may seem more like 24 per cent, for NHS workers; 29 per cent for teachers and civil servants; or 35 per cent for police officers. For those who have become accustomed to gold-plated public sector pensions, it can be hard to comprehend the reality for those in the private sector — more than 4 in 5 of Britain’s workforce. Furthermore, most of those in the public sector continue to enjoy defined benefit pensions, where their retirement income is guaranteed, while only 7 per cent of private sector workers have access to such a scheme.
Some argue that higher pensions in the public sector make up for lower salaries. But comparing like-for-like, public sector salaries are only 5 per cent lower than their private sector equivalents — a differential that is dwarfed by the disparity in employer pension contributions. Furthermore, repeated studies have shown that public sector employees do not value their pension at anything close to the amount it costs — and that a total reward package better balanced towards headline salary would be more effective at attracting and retaining good people.
In addition to the inherent unfairness, public sector pensions comprise a hidden burden upon future taxpayers. Except for the Local Government Pension Scheme, the pension contributions of existing public sector workers are not invested, but instead returned to the Treasury — while the pensions of current retirees are paid for out of current spending. This leaves future taxpayers on the hook for future pensions. The unfunded commitments from public sector pensions total £1.4 trillion, a figure equal to 45 per cent of GDP, or almost half the official national debt.
In a new report published today for Policy Exchange, Public Sector Pension Reform we propose that all new public sector employees, with the exception of the armed forces, should be moved to a funded defined contribution scheme, with employer and employee contributing 10 per cent and 5 per cent respectively.
Such a scheme would compare favourably with most private sector schemes and ensure public sector employees continued to receive a good income in retirement. At 15 per cent, the total proportion of salary being invested into an employee’s pension would remain above the 12 per cent recommended by Pensions UK.
In the short-term, the reform would cause a small increase in public spending, as existing pension liabilities would continue to need to be met, while contributions from the new scheme would be invested. Our modelling shows that, in 2025 prices, this would be £1.1 billion one year after adoption, rising to a peak of £3.4 billion six years after adoption.
However, these costs would then fall, after which the longer-term savings begin to accrue rapidly: £6.1 billion per year 20 years after adoption; £19.4 billion per year 30 years after adoption; and £37.4 billion per year 50 years after adoption (all figures are in 2025 prices).
With the reaction of the bond markets dominating Government fiscal decisions, adopting such a policy would send an important signal about the Government’s commitment to controlling long-term public spending. As part of a broader package of tax and spending decisions, it would be an important element impacting the interest rate at which the Government can borrow money, and therefore help to keep the amount spent on debt interest payments under control. A fall in interest rates of just 16 basis points — an amount comparable to how much 10-year gilt prices rose when the Government abandoned plans for welfare reform — would entirely negate the peak additional short-term costs, and create additional savings in every other year. But such an impact, if it occurred, would be the cherry on the cake — the real prize would be the elimination of one of Britain’s largest long-term liabilities.
The unfunded nature of public sector pension schemes have long posed a barrier to reform, with Governments unwilling to make necessary changes that will not pay off for 15 years. Yet Policy Exchange’s modelling shows that, if done sensibly, the short-term costs are eminently manageable – and the annual savings, in the long-term more than ten times as large.
With debt at record levels, we must not continue to balance today’s books on the backs of our children and grandchildren. It is time for politicians to look beyond the five-year electoral cycle and bite the bullet on public sector pension reform. The truth is, Britain cannot afford not to do it.
