January 5, 2011 10:35 pm

Osborne faces dilemma over cap on pensions

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George Osborne, the chancellor, faces a dilemma if he wants to go ahead with proposals to cap “fat cat” public sector pension pay-outs, according to evidence submitted to Lord Hutton’s independent review of public sector pensions.

Before the election Mr Osborne said he wanted to cap pension pay-outs in the public sector at £50,000 a year. Whether there should be such a cap, or a cap on the amount of salary that can count towards a public sector pension, is one issue Lord Hutton is examining for his final report on the future of the schemes.

However, imposing a cap could deprive the Treasury of large sums of contribution income from better paid public sector employees, according to Hymans Robertson, a firm of actuaries with wide experience of public sector pensions.

Under the pay-as-you-go pensions that apply in most of the public sector, that income is used to pay out pensions to current retirees, rather than being invested.

A cap would therefore reduce contribution income, increasing the gap between the overall amount employees pay in and the amounts paid out to pensioners – a gap that stands at £4bn a year and rising.

“If the cap was set at say £40,000, or around 1.5 times average pay, the Treasury would lose about £1.8bn of contribution income,” said John Wright, a public sector pension partner at Hymans Robertson. “That’s quite a lot of money.”

It would not be fair, he said, for higher earners to continue to contribute above that level in return for no extra benefit. “But if they cap the contributions the Treasury would lose contributions to the pay-as-you-go scheme. So there is a dilemma there.”

Lord Hutton, in his interim report, said there should be an end to final salary pensions in the public sector, describing them as “fundamentally unfair” as they pay out disproportionately more to the highest earners.

He is widely expected to recommend a switch to career average. That still pays out a defined benefit but tends to favour lower-paid and part-time workers over those who rise to the top.

Mr Wright said: “One of the big concerns has been how to deal with the excessive pay-outs for some at the top under final salary pension schemes.

“There is an argument that if you move to career average then you have removed the excesses of final salary, so you would not need a cap.

“Whether there is a cap – perhaps with a funded arrangement on top for higher earners – will be a critical decision when Lord Hutton produces his final report. If there is a cap, there will be a problem over how to contain the funding gap.”

Forecasts indicate this ìs already set to rise from £4bn this year to £10bn by 2015. And while Mr Osborne has announced that a rise in employee contributions is on the way, his plans will raise only £1.8bn by 2014-15 to help plug the shortfall.

A move to career average pensions has been backed by the National Association of Pension Funds in its evidence to the Hutton review, as well as by the London Pension Fund Authority, the largest of the local authority schemes which, unlike pensions for civil servants, NHS staff, teachers and most other public sector workers, is funded, as opposed to pay-as-you-go.

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