Public sector braced for pensions shock

FORMER Work and Pension Secretary John Hutton is due to visit Scotland over the next few weeks for talks with the Scottish Government, unions and pensions experts ahead of next month's publication of his interim report into public sector pension reform.

Around 610,000 teachers, nurses, policemen, civil servants and other state employees in Scotland are bracing themselves for a pensions shock when his work is complete.

This first report will analyse all the available data on public sector pensions, whether taxpayers can afford to continue footing the bill and consider cheaper alternatives. In a final report he must come up with detailed proposals for change by the Budget in March.

Top of the list of issues the coalition asked him to address is the growing disparity between public service and private sector pensions.

Also in September we will have a statement on the future of the government's own low-cost quasi-compulsory Nest (the national employment saving scheme), which will automatically enrol all staff into an investment-based saving scheme.

Nest will provide a small top-up to the state pension, and is designed for low-paid workers without any pension, many of whom do similar jobs for similar pay as those working in hospitals, schools and public buildings. There will be no guarantees, and the size of the pension will depend on how much the employee puts in and how that investment performs.

If the government was serious about ending the disparity between the public and private sector, then the logical conclusion would be to enrol state employees on average or below earnings into the Nest regime.

However painful the coming reform may be, such a step looks unlikely.

The expectation is public sector workers will retain the guarantees which go with a salary-linked pension, and which are rarely available in private industry. But this safety net will operate at a significantly reduced level. On top of this, staff will see the pension age increase for future accrual, and some will see their contributions rise.

The unions have responded angrily to any suggestion that their members' pensions are not affordable, and argue their pensions have already been reviewed, with alterations for new recruits. They warn they will fight any attempt to unwind pension arrangements, although if they are simultaneously battling to save jobs, one wonders how.

Their task will be tougher still if Hutton gets to the bottom of how much public sector pensions are actually costing. The Public Sector Pensions Commission argues if the pensions of nurses, teachers and so on were properly accounted for they would represent a taxpayer contribution of nearly 40 per cent of earnings.

A spokeswoman for the Hutton Inquiry said: "There are many facts and figures flying around. It is our job to decide which are relevant and which are not."

To bring some clarity, the actuarial profession has established a working party to examine how future bills for taxpayers should be valued. There is an established practice for valuing pension funds and measuring them against the pensions which have been promised in the private sector.

This ought to break down in the public sector because, with the exception of local authorities, there are no funds. The pension contributions made by a nurse today are not saved for her retirement but are used to pay the pension of a retired NHS worker.

Nevertheless, the government goes through a "pretend" exercise where it mimics the valuation exercise carried out by private pensions funds.

However, it uses more generous calculations which artificially reduce the cost to the taxpayer by 20 per cent, or so pensions experts claim. This makes them look cheaper and more affordable than they actually are, it is argued.

Instead of using a market interest rate to judge a fund's solvency, the government uses what is known as a "social time preference rate".

This significantly more generous accounting method uses higher interest rates, based on the fact that these pensions have not only a financial but a social value, albeit one which the individual himself does not value and would not be prepared to pay. Society picks up the bill instead.

All kinds of figures for pensions accrued to date have been floated, from 700 billion to more than a trillion pounds, but until a fair method of valuing the debt appears, no-one is any the wiser. However, Stewart Ritchie, a former president of the Faculty of Actuaries, stressed the importance of the new valuation, once a mechanism is agreed, being conducted by an independent body.

He said: "This must not be left to civil servants. They have a vested interest. Only an independent valuation will bring confidence."

The Pensions Policy Institute says even under existing calculations, the cost of public sector pensions will grow more quickly over the next two decades than any other part of government spending, climbing by 40 per cent.

When the true numbers are known, and the alternatives costed, it will be for the Treasury to decide how it wants to cut the bill, and how quickly. Increasing contributions would raise money, but many public sector employees already pay a good slice of their earnings into their pension.

Policemen already pay an 11 per cent of salary contribution, with new recruits paying 9.5 per cent, and would hardly welcome more taken out of their pay packet.

On the other hand, some can still retire on a full pension at 50, which one pension expert described as "bonkers".

Raising retirement ages would also save cash, although any reform on this front may be wrapped up with the other review taking place into how quickly the state pension age can be lifted to 66.

Once these have been tackled, it will be a question of how far the government is prepared to go in dismantling the existing final salary regime.

The written submissions sent to the Hutton Inquiry clearly favour maintaining a link with salary, but at a much lower level. Instead of accruing one-eightieth of your salary in pension for each year of service, and after 40 years receiving half your final salary, you might accrue at one-hundredth, and only get a half-salary pension after 50 years. Or it could be lower still.

Guaranteed annual increases could be abandoned, as could the link with final salary. Pension could be based on your average salary, rather than final earnings, which is the regime for some new recruits.

Finally, it could be some form of a hybrid scheme which was essentially investment-based, but with guarantees if markets turn against the employee.

Actuaries at Hymans Robertson see the review as a "once-in-a-generation opportunity" for lasting pensions reform. To this end, it would like to see the introduction of a new defined benefit scheme which offered a low level of salary-linked guarantee, which staff can then top up with private savings if they wish.

The National Association of Pension Funds added: "It is difficult to make the case for taxpayers to fund public sector pensions that are much more generous than those available in the private sector, and clearly steps need to be taken to reduce the gap. However, we do not believe that the public sector should get into a Dutch auction with the private sector, competing to provide the least generous pensions."