UK public sector pension costs understated by £15bn a year

Public sector defined benefit retirement schemes are unsustainable, says John Ralfe

Royal Mail has just announced plans to replace its very expensive defined benefit pension, for 90,000 of its 160,000-strong workforce, with a much cheaper and less generous defined contribution pension.

The postal company’s latest accounts show the existing DB pension costs 30 per cent of pensionable salary after member contributions, versus around 13 per cent for the new DC plan.

Moving to DC will boost Royal Mail’s operating profits — just £150m in 2016 — by around £230m in the first year and £300m after that.

When the UK government took on Royal Mail’s existing pension liabilities in 2012, before privatisation, it effectively left a £1.6bn “dowry”. This was used for a partial contribution holiday, so the current DB cash contribution is less than the full 30 per cent cost.

Almost all private sector companies have long since closed their DB pensions to new members, so the number of employee members continues to shrink as they retire or leave. Most smaller companies and many large companies, just like Royal Mail, have also closed to existing members.

Meanwhile, DB pensions — all but dead in the private sector — are flourishing in the public sector, with more than 5m employee members. All schemes, including those for the NHS, teachers, the civil service, local government and the armed forces, are still open to new members.

The previous government claimed to have tackled the public sector pensions problems highlighted by John Hutton, the Labour secretary of state for Work and Pensions between 2005 and 2007.

But the coalition government’s 2015 changes were a cop-out, and did nothing to bridge the huge and increasing gulf between public sector DB and private sector DC.

The reformed pension did not reduce the annual cost to taxpayers of new pension promises. Savings from imposing a higher retirement age and moving to a pension calculated on a career-average salary rather than a final salary, were more or less wiped out, because a higher pension is earned each year.

The government added insult to injury by saying these changes should last for 25 years.

The total official annual cost of the Teachers’ Pension Scheme in 2016 is 20 per cent of salary versus the Royal Mail total cost of 36 per cent. After 9.6 per cent employee contributions, the net cost to taxpayers is about 11 per cent.

Public sector DB pensions cost so much less than private sector not because the government has some magic beans, but because it deliberately fiddles how it calculates annual costs. Rather than using bond yields — required by private sector accounting, and reflecting the underlying economics — the government uses a higher arbitrary rate to give a much lower annual cost.

Helpfully, the Teachers’ Pension Scheme accounts disclose costs of calculating via bond yields: 33.8 per cent of salary, or a cost to taxpayers after employee contributions of 24.2 per cent. This is more than twice the official cost.

Across the whole of the UK public sector, the official costs of new pension promises are understated by around £15bn a year, versus the costs of calculating via bond yields. (Arguably using a corporate bond, not a gilt rate, understates the real cost.)

To make the real costs crystal clear to taxpayers, all public sector employers should use the same annual costing for new pension promises as private sector employers.

Recognising annual costs properly would make it clear that public sector DB pensions are unsustainable, just like the private sector, and would lead to genuine reform.

The government should start by providing a DB pension only on the first £30,000 of salary, with DC only above this, and reduce the annual DB pension earned to 1/80th of salary from the current 1/60th.

Understating annual public sector pension costs means this generation of taxpayers is not paying the full cost of the public services it uses, but passing it on to be paid by future generations — taxation without representation on a massive scale.

John Ralfe is an independent pension consultant

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