Right now everyone is distracted by eye-watering credit-crunch numbers – the Treasury’s combined injection this week of not far off £40bn into RBS, LloydsTSB and HBOS, for example. But these are dwarfed by estimates of what the FT’s Steve Johnson labels “the public-sector pension black-hole”. This, say some independent consultants – such as actuaries Watson Wyatt – stands at between £850bn and £1,200bn. The UK’s total GDP is only £1,500bn.
Public sector pensions: why is the black hole so big?
State employees – from doctors to council workers – get “defined benefit”, or “final salary” style pensions. That means the amounts they receive on retirement, both as an immediate tax-free lump sum and subsequently as an income stream, are guaranteed and driven by their career earnings and length of service. The longer they work and the more they earn, the higher their pension as a fixed proportion of their final income. What’s more, this is usually “index-linked” – their annual pension rises in line with inflation. Add an ageing population and the recent expansion of the state to this already generous equation and you can see how it gets expensive.
Public sector pensions: so ‘final salary’ schemes are untenable?
Not always. The problem is that the UK state scheme is “unfunded”. Under a “funded” arrangement, an amount is set aside each year to meet a future liability. For example, if you knew you had to pay someone £100 in ten years’ time, you could fund the liability by saving £10 a year for ten years. You might even get away with saving less than £10 if you invest the money in an asset you hope will grow in value over the next decade. That’s the kind of approach taken in the likes of Canada and Australia. But with an “unfunded” arrangement you contribute nothing now, wait ten years and then hope to conjure the full £100 from tax revenues. That, in essence, is the basis of the British government’s state pension provision.
and does that differ from the private sector?
Indeed it does. Many firms used to offer defined benefit pensions, but most have cut them because the costs are just too high. Instead, firms are increasingly offering a “defined contribution” or “money purchase” scheme. With these, while the employer may contribute to an employee’s pension, any payout relies entirely on the performance of the assets the pension is invested in. So all the risk is borne not by the employer but by the employee. Some firms have even ceased offering pensions altogether. Overall, says pensions consultant Dr Ros Altman, while 90% of public-sector workers are members of any defined benefit scheme, only 15% of private-sector workers are.
But don’t public sector pensions compensate for lower pay?
No. National Statistics Office data reveal that average full-time public-sector weekly pay is now just under £500. It is £440 in the private sector. Add in the value of pension benefits, says Altman, and a private-sector worker with no pension arrangement effectively earns £210 a week less than their public-sector equivalent. And that, says former head of pensions at Boots, John Ralfe, is because a typical teacher’s state pension is now worth a staggering 28% of salary, or 33% for a civil servant.
Public sector pensions: can we meet the cost of all this?
It is hard to see how. Firstly, we’re all living longer – according to the Government, average life expectancy has risen by around 2.5 years in just the last decade. So people get their pensions for longer. But that’s compounded by the expansion of the state and with it the number of people on final salary arrangements – today one fifth of the entire workforce is in the public sector. And the tax base from which state pensions are drawn is set to drop as the population ages, leaving fewer workers supporting growing numbers of retirees – National Savings & Investments statistics show that the average age for the UK shifted from 37 to 39 in just ten years to 2007, yet most state employees expect to be retired by 60. The core problem, as The Daily Telegraph’s Ian Cowie puts it, is that the liability is “not on the balance sheet, not in the budget and not even being accurately valued”.
So what’s the government doing about reducing it?
Not a lot. Steve Johnson in the FT describes action taken so far as “minimal”. Sure, new teachers, civil servants and NHS employees now face a retirement age of 65 not 60, but, as Ralfe points out, adjustments to the pension calculation mean “you may have to wait five more years to get it, but when you do it’s a jolly sight more valuable”. Former government consultant David Craig, quoted in the FT, estimates that UK private-sector workers are now “paying more in taxes to fund the pensions of the public sector than they save for their own retirement”. So big is the problem that Altman believes the Treasury may have resorted to “a deliberate attempt to hide the true costs”.
What public sector pensions mean for taxpayers
The government hopes that future tax receipts will always cover its future pension costs, but for the reasons outlined above, that’s unrealistic. Raising government borrowing to plug the gap is an option, but action to save the banking system will already saddle the country with debts not seen since the end of World War Two. That leaves either massive public expenditure cut backs, or more likely, hefty and sustained tax rises. Yet another reason why we’ll all soon be feeling a lot poorer.