The Independent Public Service Pensions Commission report, drafted by Lord Hutton of Furness, was a credible, well balanced plan to reduce taxpayer expenditure on public sector pensions over time. The analysis of our collective woes was great but Hutton’s preferred solution is only a half measure. Maintaining a defined benefit system delays a reckoning with public sector pensions, it does not make them financially sustainable. The Conservatives should transfer local government pension holders to a defined contribution scheme (John Hutton ruled out this option).
Defined benefit pensions stipulate that the pension holder accrues an entitlement to income through contributions to the pension scheme. At retirement the holder is guaranteed a certain sum each year, sometimes linked to inflation based on the number of years they have contributed and their salary (using either an average of their career earnings or their final salary). As an LGPS member I get an annual statement saying that I will get around £500 per annum, index linked, at a specified age based on my current contributions. This sum will increase if my wage increases and as I pay in for additional qualifying years. The risk is carried by the council that guarantee the payment.
Defined contribution plans are very different, these schemes allow the user to contribute to their own personal account, and the funds are invested (usually in equities or funds) according to their wishes. When they want to retire the pension holder can trade the sum they have invested in their personal fund to purchase an annuity, which guarantees them an income in retirement, or they can take income from the fund, while continuing to invest the capital. The risk and responsibility lies with the employee, who owns the pension fund. The employer simply makes contributions to the employees account. This model predominates in the private sector.
John Hutton's reforms adopt a classic New Labour approach – they advocate a statist approach but seek to make it more efficent. The report rests on the assumption that we should maintain a centralised Government backed pension scheme for public sector workers based on a defined benefit scheme. His proposal to save money is to change the existing scheme from a final salary (final salary can mean the highest salary they recently received) to a career average formula.
In the latter scheme the user accrues entitlement to a pension payment based on a percentage of their annual salary each year that they pay in. Each year is treated as a discrete entitlement unaffected by later pay rises or pay cuts. If you get a big pay increase just prior to retirement your pension does not increase rapidly as it does with a final salary scheme and if your pay remains stable (you don’t get promoted) then your pension entitlement remains the same as under the final salary scheme.
Our new reformed public sector pension system would see contribution levels still set by the Central Government (at an increased level). The rate at which people accrue benefits will conform to a central formula. There will continue to be a default age at which people draw their pension decided by the state. If individuals choose to retire earlier they will suffer a financial penalty as dictated by the Government. Pension benefits will be based on a career average rather a final salary scheme. Benefits will increase based on the nationwide Consumer Price Index. Local and national taxpayers will continue to supplement expenditure on pensions in an opaque manner through their council tax. State employees will continue to receive a better pension settlement than their private sector equivalents based on the implicit threat of strikes.
Individuals will not have a personal account in which their funds are invested to provide for their retirement. All funds in the local government scheme will be retained in local authority based investment funds. Individuals will have no choice over where or how they are invested. These assets are governed by a series of fund manager’s not private individuals. In the event of a pension holders’ death in retirement their families do not gain any right to any surplus funds invested over the years (although some will be entitled to a death grant). So public sector workers will still rely on the state to determine their future pension income, collect their contributions, decide their contribution rate, predict and set their benefit levels and honour its past pledges on pension levels.
Retaining a defined benefit scheme ensures that public sector pensions will remain an intensely political matter. State employees will continue to rely on taxation to fund their pension payments in retirement rather than the income from their pension savings. The pension’s apartheid between public and private sectors will remain but will be slightly reduced. Public employees will remain more likely to lobby Government to make up any shortfalls in their pension payments rather than increase their private savings. These reforms make state employees no more responsible for providing for their retirement and increase their interest in increased taxation to fund thier income in retirement.
The local government pension scheme is one of the few state pension schemes where contributions have been paid into a fund. This fund is inadequate given increased longevity and the financial pledges made to
retirees but it does provide a source of funds to smooth the transition to a defined contribution model. Under this system local government workers will begin to see the link between the success of private industry and their financial health. Individuals will decide whether they want to work more and have a larger pension or work less and receive a smaller one by looking at their pension fund and seeing what income it could provide. The change to later retirement ages would happen organically rather than by central government decree.
Given the scale of the opposition and the difficulty of implementing these minor reforms we could adopt a more radical and comprehensive solution. My preferred model is detailed here. I don’t doubt that in the short term it was a wise political tactic to have an ex Labour Minister review this important area. However, this short term political benefit carries a long term economic and political cost. There will be little sympathy from private sector workers if public sector workers strike to protect pensions better than those available in the private sector. We need to fight for a lasting solution which is fairer to the taxpayer.
The views expressed above are my personal views and not those of my employer or any other organisation with which I am associated