Pensions World

Public sector employees are being asked to work longer and pay more for their pensions. Deborah Cooper, Mercer, looks at the arguments

Until recently, pension provision has been a virtually invisible part of employees’ remuneration packages, viewed as something employers must provide to pass a “good employer” test, rather than as a valued benefit. Now, following Lord Hutton’s review, British public sector workers have taken to the streets to defend their pensions.

Faced with proposals that the perceived ubiquitous public sector final salary model should be replaced by career average provision with a higher normal pension age and higher employee contributions, HM Treasury and some public sector trade unions have entered a debate about what is “affordable”. But this is likely to be unproductive – instead, each group should consider the public sector’s remuneration package as a whole and the relationship between immediate (salary) and deferred (pension) pay. Then they might understand the tensions imposed by the current arrangements as well as any weaknesses in what is being proposed.

The two most significant features of HM Treasury’s proposals are that both normal pension age (NPA) and contributions should increase – which can be portrayed as though workers should pay more to get less.

Normal pension age

Public sector employers have already negotiated increases to their employees’ NPAs – the earliest age at which employees can normally retire from work with an unreduced pension – although only in the context of new employees. So, although most public sector workers still have a NPA of 60, those who joined in the past five or so years are likely to have a NPA of 65. Exceptions to this rule include the uniformed services, where different considerations and lower NPAs apply, so they are outside the scope of this article, and local government workers, who have moved to an NPA of 65 in respect of all future service, albeit with certain protections for older workers with long service.

Lord Hutton has proposed that, in respect of future service, the NPA for all public sector workers should be linked to the state pension age, which is intended to increase to 66 by 2020.

Life expectancy

Currently, for the demographic employed in the public sector, life expectancy at 60 is about 26 years for men and 29 years for women; at age 65 it is 22 years and 24 respectively. So, for every year worked, those employees with an NPA of 60 are expecting to receive a further eight months’ income (albeit at a lower level); those with NPA 65 expect a further six months’ income. On the basis that public sector pensions target retirement pensions of 50% of pay, following a full career, striking to maintain the NPA of 60 is like striking because your employer refuses to provide you with four months (that is 50% of eight months) paid holiday each year.

Rather than arguing about whether it is affordable to pay pensions accrued in the future from the earlier age, the question should be whether the balance between immediate and deferred income is reasonable.

Regardless of how pensions are provided – that is, whether financed via funded or pay as you go arrangements – pensioners rely on younger generations to remain sufficiently productive to generate enough taxes or investment returns to finance their incomes. If one generation’s rights to deferred pay become excessive relative to the incomes of subsequent generations, the cross generational subsidy will fail: take home pay for those employed will be depressed by the cost of meeting pensioners’ incomes, the incentive to continue to work and pay taxes in the UK will reduce, productivity will reduce and pension security will fail.

No one can indicate at what point this breakdown in what is as much a social as an employment contract will occur. However, in the 1970s, when the legislation that currently underpins public sector schemes was established, life expectancy (among the relevant population) for men at 60 was around 18 years (at 65 it was 14 years), so they were expected to be paid for less than six months for every year worked. This is closer to, but still less than, what would be achieved if the NPA 65 proposal was adopted: it means that the value of the pension scheme has increased by over one third, since the public sector employees currently reaching retirement age first joined the workforce, without any real discussion about how appropriate this is in terms of overall levels of total remuneration.

Finite resources

This increase may well be “affordable”, since over that period rates of pay and productivity have also increased. But, in a world of finite resource, that is scarcely the point. Rather, we should recognise that time spent in retirement is both a valuable commodity and a social good that affluent societies ought to be able to provide for their citizens, to a degree. There are then three decisions for each society to consider:

• what the minimum share of this commodity should be (that is, when should the state step in to provide an income than ensures that most people can afford to stop being treated by the welfare system as seeking work)
• to what extent employers should enable their employees to access this commodity and
• to what extent it should be left to individuals to make their own provision.

There is no single answer to these – but just arguing to retain a benefit because it seems affordable will not be a productive way forward.

Contributions

Lord Hutton’s review pointed out that the member contribution rules vary considerably between different public sector schemes and these should be put on a more consistent footing. The argument is that, except where contributions are already relatively high, employees should contribute a larger part of the cost of pension provision.

In principle, a mature look at total remuneration would suggest that the level of member contribution should be irrelevant: higher member contributions should result in higher salary relative to an otherwise identical situation where the pension scheme is non-contributory. However, in reality there is little evidence that this occurs, since recruits tend to consider gross pay as a more important measure than total remuneration; also, member contributions have other effects, such as reinforcing to members the value of the provision.

Contribution rates do vary considerably between public sector schemes and the NHS and Local Government Pension Schemes have already introduced contribution scales along the lines suggested: that is, those on higher wages pay higher contribution rates. Teachers also have relatively high contribution rates, so the largest group affected are likely to be members of the Civil Service Pension schemes.

While it seems legitimate for the choice of NPA to be debated publicly, the discussion about member contribution rates seem narrower, since it relates only to how pay is distributed over an employee’s lifetime. Relevant issues include:

• Having determined an overall level of remuneration, to what extent is it appropriate for employers to determine how it is distributed over an individual employee’s lifetime? While some will accept a lower standard of living when young in return for a more comfortable retirement, others will prefer a different balance. In the private sector, increases in member contributions have often been accompanied by an offer of lower pension accrual for a lower member contribution to reduce this problem.
• Any increase in contribution rates will have to be in the context of auto-enrolment, which gives the Pensions Regulator power to determine that “excessive” contributions act as an inducement to employees to opt out of pension provision. The expected member contribution rate under auto-enrolment is 5% of pay between (about) £5,000 and £33,000; the Local Government and NHS pension schemes require a contribution rate of 6.5% on all pay for people on median incomes (around £26,000) and it is proposed this should increase to 7.1% (or 7.7% at incomes over £26,550).
• The cost of defined benefit accrual is age related. At younger ages, contributions of 7% will be a high proportion of the cost of accrual, particularly for those not expecting large pay increases. Non-age related contributions make pension design appear simpler, but actually make comparing remuneration between age groups more difficult.
• Rather than relating contributions to age, the government has chosen pay related scales, to avoid imposing high contribution rates on those least able to afford them (and reducing the possibility that the Pensions Regulator would treat the high rates as an inducement). However, they will make it harder for members to understand the value they receive from the scheme.

Conclusion

It is reasonable for employers to review the remuneration they provide to employees from time to time. In the context of changing demographics, it is reasonable to reassess pension provision and consider how long people should remain in the workplace and what support employers should provide towards their retirement.

In this context, increasing the normal payment age for an occupational scheme seems entirely defensible; employees can save themselves if they want to retire early, and with the removal of the default retirement age they can work longer if they want larger pensions without saving more.

The proposed changes to the contribution structure will place a higher share of the cost of pension provision on those that are deemed able to afford it. However, depending on their personal circumstances the exchange might seem poor value; unless alternative arrangements are available, some employees might be discouraged from joining their employer’s scheme as a result, thus forfeiting a material part of their remuneration.

These two reforms are fundamentally different and so should be considered separately, to ensure a solution that is equitable to public sector employees, employers and taxpayers can be found.

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For more information on the debate about public sector pensions and the proposed changes, visit Local Government Pension Schemes and NHS Business Services Authority.