The Centre for Policy Studies publishes proposals for dealing with the unaffordable public sector pensions framework

Michael Johnson is the author of Self-sufficiency is the key: addressing the public sector pensions challenge published today by the Centre for Policy Studies.

There are few themes more suited to the Chancellor’s sentiment of “we’re all in this together” than occupational pensions.  But this is far from being a reality.  When today’s workforce comes to retire, their subsequent incomes will be largely influenced by their sector of employment.  Pensioners formerly working in the public sector will be much better off than their private sector brethren.

Last June, the Government temporarily side-stepped this political landmine by asking Lord Hutton to make some recommendations for reforming public sector pensions.  Lord Hutton will report shortly, thereby handing back to the Government not only the responsibility, but also what may become the political hot potato of 2011.

The issue is that today’s public sector pensions framework is unaffordable, and hence unsustainable, as I explain in my Centre for Policy Studies report published today. It is akin to a Madoff-style pyramid, now collapsing under the weight of insufficient contributions, rising longevity (the DWP expects more than ten million people in the UK today to live to see their 100th birthday) and an ageing workforce (fewer workers to support each pensioner).  The forthcoming workforce contraction will exacerbate the cashflow problem, as pensions in payment race ahead of contributions; a gap of more than £10 billion is forecast for 2015-16 (to be plugged by the taxpayer).  Without reform, we are embarked upon a slippery slope to fiscal calamity.

Public sector workers enjoy certainty of income in retirement, commonly referred to as a defined benefit (DB).  They have no exposure to investment risk, and, crucially, the state assumes their longevity risk.  Conversely, the risks within a significant majority of private sector schemes are assumed by the individual, retirement income being dependent upon contributions, whilst working, and subsequent asset performance, i.e. a defined contribution (DC) framework.  And, unless an annuity is purchased, retirees are exposed to how long they live.

But no one in the private sector has access to the same, valuable, state-provided longevity protection.  It is unfair to expect private sector workers, as taxpayers, to assume the longevity risk of others, whilst also having to provide for their own retirement.  The state’s limited capacity to absorb pensions-derived longevity risk should be shared amongst everyone, ideally via the State Pension.

Most public sector pension schemes are unfunded; they have no assets; instead, contributions are recycled to meet pensions in payment.  This pay-as-you-go (PAYG) approach readily accommodates opacity, not least because the immediate funding requirement is disconnected from the cashflow consequences of pension promises.  The PAYG approach also harbours behavioural risk, notably the temptation of employers to defer some of today’s employment costs.  But the most serious unintended consequence of our PAYG framework is the perpetration of generational injustice.  Without reform, we will continue to foster on the younger generations a legacy of rising contributions (and taxation), to meet the older generation’s pensions in payment, as the burgeoning liability manifests itself as increasing demands for hard cash.

There are two alternative strategies for reform that the Government could consider; viewed from an implementation perspective, one is “cautious”, the other “brave”.  The “cautious” route would be to offer a diminished pension promise that is certain, based upon career-average, rather than final, salary, up to a salary cap.  Above the cap, there could be some form of DC provision.  Sensibly parameterised, the cost in 2060 could be reduced from 1.37% of GDP (Lord Hutton’s forecast, based upon today’s public sector pensions arrangements) to nearer 1% of GDP; a saving of roughly £5 billion per year, in terms of today’s money.

The “brave” approach would be to timetable the closure of the public sector’s DB schemes, and then move to a DC framework, with implementation by 2020, say.  Public and private sector workers with similar skills and responsibilities (whilst working) would then have broadly equivalent incomes in retirement….which feels fair, and resonates with the Chancellor’s “we’re all in this together”.

The Government is in an invidious position.  If it were to implement the “cautious” strategy, it would be tacitly signalling its acceptance that the quality of pension provision in the (wealth-creating) private sector is to remain second class.  What is more, within a few years private sector will have become a DB desert, i.e. pure DC.  The weight of public opinion may then force the Government to embark upon a second round of reform.

Conversely, pursuing the “brave” route at a time when the public sector is concurrently facing a pay freeze, the risk of job losses and rising taxes, risks serious union-inspired disruption.  Pensions could be some union leaders’ personal and professional Alamo, their influence having been long on the wane.

Perhaps the most pragmatic strategy would be to first substantially increase the State Pension, as a pre-requisite to reforming public sector pensions.  This would help allay pensioner poverty concerns, thereby weakening the unions’ position in the forthcoming negotiations.  Thereafter, the Government could pursue a “two step”; an initial phase of watered-down DB provision, followed by the introduction of a pure DC framework, signalled years ahead of introduction.  Indeed, reforming public sector pensions is foremost an exercise in effective communication and negotiation, rather than a technical challenge.  There are few, if any, themes more loaded with technical detail and jargon; perfect material for obfuscation and bamboozlement.

Irrespective of the adopted strategy, we should start tip-toeing towards a funded framework; public sector employees should be compelled to participate in the DC-based NEST (the National Employment Savings Trust; auto-enrolment of private sector employees commences in 2012).  This would require the Treasury to forego the cashflow from the widely-anticipated additional contributions, but “spend to save” thinking is not entirely alien to it.  Furthermore, the opportunity to catalyse a savings culture amongst 20% of the working population should be seized (subsequently boosting investment).  In the meantime, “pensions” (with their attendant inflexibility) may entirely disappear, to be replaced by incentivised, DC-based, saving.