The fairness of public sector pensions
Posted by Christie Malry on June 19, 2011 at 9:29 am
This post is based on an e-mail I sent to those nice folk at FullFact to help them factcheck government and union claims about public sector pensions.
This week has seen the government and the unions trade blows over the affordability of public sector pensions. Francis Maude claimed that a civil servant who retires after 40 years service on the average salary of £23,000 will have a pension pot worth £500,000. In return, the unions said that the average public sector pension is £4,200 per year and that the fortunate civil servant would need to live to 104 for Maude's claim to be true.
So who is right? It's important to understand that there are two broad types of pension: defined benefit (DB) and defined contribution (DC). DB schemes define the benefit the employee will get from the scheme. Historically, this has been a function of the number of years served and the salary on retirement. So, if the scheme promises you 1/80th of your final salary, and you end up retiring on £50,000 after 40 years then you'll get a pension of £25,000pa. Typically there are lots of other benefits, such as rights for spouses and inflation protection. There is no "pot" in the employee's name. The employer makes promises and, in the case of a private sector employer, pays amounts into a fund to support the future obligations.
DC schemes don't do any of this. Instead, the employer defines the amount it will contribute to the employee's pension. A pot of money accrues in the employee's own name. On retirement, the employee must convert this into an annual pension by buying an annuity.
From this, you'll be able to understand that Maude's use of the term "pot" is a little bit confusing. There is no pot. However, you can calculate what size of pot you would need to purchase an equivalent pension under a DC basis. This is, after all, how most private sector workers will save for their own pensions.
The civil service scheme looks like it's based on 80ths. You also get a lump sum of 3x annual pension tax free. So our civil servant on £23,000 will get an annual pension of £11,500 plus the lump sum. Annuity rates vary, but at the moment inflation protected annuities with spouse rights work out at about 3.0% of your lump sum amount (ie £100,000 would buy you £3,000pa). The FSA annuity tables suggest that an annuity with equivalent rights to the civil service scheme would be 2.9%. So, to buy an income of £11,500, you'd need a pot of £396,500 (11,500 / 0.029). Add on the three years lump sum and you get a total pot of £431,000. That's certainly close to what Maude said (and my calculation is sensitive to the precise annuity rate used) but perhaps is a touch overegged.
Now what of the union claims? The unions are incredibly stupid to claim that an employee would need to live to 105 to get value of £500,000. Because they ignore the time value of money and the cast-iron inflation protection that public sector pensions provide. And they're being extremely deceitful to use the average public sector pension figure. That includes all pensions in payment, including people who only worked for the public sector for a short period of time.
Instead, the right way to look at is to decide whether it's feasible for a private sector worker on a lifetime wage of £23,000 to build up a pot of £431,000 over their lifetime. If it's not, then we must rethink how we allow all workers, not just those who work in the public sector, to build up sufficient pensions. It's certainly unsupportable to tax private sector workers heavily merely to hand that cash over to the gold-plated pension plans of the public sector.
I think that Mr Maude, whilst he may have been a little bold with his figure, gets to the nub of the issue here.. the value of the benefit accruing is huge, and out of reach of any comparable private sector worker. Even someone on one of the low pensions that the Unions talk about has got something worth significantly more than what they put in.
However, to an extent the debate needs to move beyond the public vs private thing.. it's divisive and accusations of private sector envy are too easy to make, it's too easy to talk about a race to the bottom, it's too easy to blithely claim that private employers simply need to up their game and provide better benefits.
This is about equality. It is wrong for one group of workers to have a benefit underwritten by the state.. that benefit has to be made available to all workers. The fact that someone worked for the state is irrelevant.. we are all part of society and we all contribute. Leaving aside any questions of affordability, I'm all for defined benefit schemes remaining for the public sector, so long as that scheme is opened up to everyone on equal terms and with equal (and mandated) employer and employee contributions. And, y'know, with a suitable cap (say, no pension could be more than 2/3 average earnings) both in terms of benefit received and contribution made, that's a scheme I could even support. It might be expensive, but it would be fair. It would also be progressive because beyond the capped level, people would have to fend for themselves and there would be no taxpayer subsidy of large pensions for public sector elite.
This is where the debate needs to go... sidestep the envy, the ignorance, and the manipulation.. and ask why it's fair that a certain group of workers should get a benefit that is entirely impossible to replicate elsewhere. Either that, or make DB schemes mandatory for all private sector employers, and give them tax raising powers, a monopoly position, and a broadly unlimited credit facility.
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