Why public sector pensions need a radical overhaul

A fortnight ago, I delivered a call to arms to the Government, detailing the need for immediate action to address the parlous state of UK public pensions.

The estimated total shortfall is a staggering £1.7 trillion, across funded and unfunded public sector schemes. This exceeds UK GDP. On the basis of a 2012 ONS study, virtually all of these schemes, numbering in their tens of thousands, are underfunded; many have no hope of getting to a fully solvent position; and few have the skills to manage investments in house in even core asset classes, let alone illiquid asset classes.

By pooling London’s pension fund assets with Lancashire’s, we made the first step towards the creation of a UK sovereign wealth fund. This will save millions in overheads; and pave the way to investing in long-term infrastructure assets.

Much of the focus of my submission was on the less ambitious but nonetheless important issue of tax relief. Pension tax relief is a considerable cost to the Exchequer and is in urgent need of reform in order to help reduce the huge deficit.

Despite the £1.7 trillion hole, the public sector still lobs out generous defined benefit pensions – a pension accrual value of £50bn is being created for UK public sector employees each year. Spread across the 5.4m public sector employees, this is worth some £9,250 per annum each. Quite apart from the cost to the taxpayer of the pension, the benefit-in-kind tax relief on the accrual is worth another £12bn each year to such employees.

In the private sector, pension tax relief is mainly granted to higher earners as they make the biggest contributions. The private sector has mostly closed its DB schemes as simply unaffordable.

It is my view that up-front pension tax relief should be abolished; all employer payments into pension funds be subject to income tax on the employee as they are made; and the value of the accrual of future pension benefits be subject to income tax.

Public sector defined benefit pension funds should be closed both to new members and to future accrual of benefits for current members, and public sector employees should be treated in the same way as those in the private sector.

To help address the enormous legacy issues and to avoid accusations of retrospective tax changes, contributions made to closed pension schemes in order to meet shortfalls in DB pension promises (accrued in the past) will continue to be tax deductible.

Once the value of defined benefit pensions becomes transparent and taxable, the true cost to the taxpayer will become apparent. At the same time, the removal of tax relief up front would mean that the provision of further DB benefits to the public sector employee would result in a higher tax charge on the employee. This would hasten the end of these schemes and so deliver a sustainable public sector.

As we work towards our loftier sovereign wealth fund goal, it remains important to make shorter-term improvements to the overall system where we can. Tax is just one such area and one that should receive immediate attention.