The £37bn public sector pension opportunity
Unfunded public sector pensions amount to a £1,4 trillion liability to the taxpayer. there is a better way, says Ben Sweetman
The UK’s public finances are under acute pressure. The government faces difficult choices, made tougher by our lack of growth. One of the largest components of the public sector’s future spending commitments is unfunded public sector pensions, a £1.4 trillion liability, a sum equal to almost half of the official national debt – and yet is not recorded in official estimates of how much Britain owes. New estimates from Policy Exchange show that reform here could present massive savings, reaching £37bn annually in the long term.
Public sector pensions are extremely generous, offering employer contributions of 25-30 per cent compared to a private sector average of six per cent. Decades ago, the private sector began its transition away from offering generous defined benefit schemes on the basis that they were simply too costly. And given that such generous pension schemes are not available to most workers, how can it be right that the costs of this financial burden is placed on ordinary taxpayers? Reforming public sector pensions is not simply about saving money, but about fairness.
Moving to defined contribution
What are the potential benefits of transitioning away from this system? A new report from Policy Exchange models the costs and savings associated with gradually shifting public sector pensions onto a funded, defined contribution basis, with an employer contribution of 10 per cent and employee contributions of five per cent. Such a scheme would still compare favourably with the majority of private sector schemes and would ensure public sector employees continued to receive a good income in retirement, with the total proportion of salary being invested into an employee’s pension being above the 12 per cent recommended by Pensions UK. Critically, current members of defined benefit schemes would continue to accrue benefits under their current regime – it would only be new joiners placed onto new defined contribution schemes.
Our estimates suggest that, after an initial period of modest costs, savings could accrue rapidly. In 2025 prices, annual savings reach £6.1bn after 20 years, £19.4bn after 30 years and £37.4bn after 50 years.
Because most public sector pension schemes are unfunded there would be short-term costs for any transition to a funded system. This is because currently, instead of investing the contributions of employees and employers to fund future entitlements, these contributions are paid to the Treasury to help finance current government spending. Meanwhile, payments made to current pensioners are paid from current revenues and borrowing. This design feature is what creates the significant future liabilities that must be borne by the taxpayer.
At their peak, we estimate these short-term annual costs to reach £3.4bn after six years – a modest investment to eventually unlock £37bn of annual savings. Furthermore, this short-term cost could be mitigated by a positive response from the bond markets. Such a policy would send a signal that the government is committed to controlling public spending, which could impact the interest rate at which the government borrows money. If interest rates fell by just 16 basis points, a plausible magnitude, this could completely offset the annual cost of the policy in its most expensive year.
Various studies have shown that many public sector employees do not value their pension at the cost which it takes to provide it
There is an argument that reducing the generosity of public sector pension schemes would discourage the best, most productive workers from joining the public sector. But various studies have shown that many public sector employees do not value their pension at the cost which it takes to provide it. If our concern is attracting the best people to work in the public sector, that money would be better spent on increasing headline salaries, not expensive defined benefit pensions.
It cannot be sensible, for example, to have a system where public sector workers earning up to £30,000 can achieve a higher income post-retirement compared to during their working life, once you account for the state pension. This is simply irrational economic policy. We should alter the structure of the remuneration package we offer public servants, by putting a higher proportion of the package into salaries rather than splashing out on over-generous yet underappreciated pensions. A pay-rise could be offered in conjunction with this reform, while still saving the government a significant amount, in order to alleviate the political challenge that introducing this policy might present.
The public finances are under strain. The looming threats of an ageing population, massive forecasted increases in welfare payments and ever-increasing demand for the NHS risk further economically damaging tax increases at best, and a fiscal collapse at worst. Given the expense, unfairness and underappreciation of the benefits of the current public sector pension system, we cannot afford not to reform it.
Ben Sweetman is head of data analytics at Policy Exchange