Observations

Public service pension reforms: an improved structure, but impact on generosity and cost as yet unknown

Date: 10 March 2011
Authors:
Publisher: IFS

Lord Hutton's review of public service pensions contains a number of recommendations. Perhaps the three most important for both the taxpayer and the members of these schemes are:

  • Rights employees have already accrued should be honoured in full;
  • Future accrual should continue to operate on a defined benefit basis but this accrual should be based on the individual's average earnings rather than their final salary;
  • The age at which a full pension should be paid (Normal Pension Age, NPA) should be equal to the State Pension Age (SPA), with the notable exception of the armed forces, police and fire fighters.

What would the impact of a shift from final salary to career average and the planned increases to NPAs be, and what would the whole package do to the overall generosity of public service pension schemes?

Much commentary on Lord Hutton's report has asserted that career average schemes are necessarily less generous than final salary schemes. But how the generosity of a career average scheme compares to a final salary scheme will depend on how that average is calculated. Lord Hutton has proposed that earnings in each year of an individual's active membership of a public service pension scheme should be revalued in line with average earnings growth. This reform certainly makes the scheme less generous than a final salary scheme to high flyers who would see their salaries increase by more than average earnings, but it will also make the scheme more generous than a final salary scheme to those whose salary grows by less than average earnings. This change might well be deemed sensible: as Lord Hutton's interim report showed public sector workers who experience high salary growth can currently benefit from almost twice as much pension per £1 of pension contributions than those who experience low salary growth. Where these reforms would change the level of remuneration significantly the Pay Review Bodies should consider carefully whether offsetting changes in pay would be appropriate.

The proposal to set the NPA equal to the SPA for most public sector workers does reduce the generosity of the schemes: those affected would typically have to contribute for longer to receive the same pension for fewer years. There are at least two good arguments in favour of such an increase. First, many new members of public service pension schemes already have an NPA of 65 while those who were members of such schemes before the last set of reforms came into force often have an NPA of 60. Aligning these would mean that individuals who were doing the same job, with the same pay, also accrued the same pension regardless of whether they happened to have joined the pension scheme before or after the cut off date set out in the previous reforms. Second, rising longevity led Lord Turner's Pensions Commission to recommend that the SPA should increase in future from 65 to 68 and this proposal was accepted with cross party support. Increasing the NPA in public service pension schemes would seem consistent with this decision, and there is also an attraction in aligning the ages at which an individual can start to receive their state pension and the age at which a full public service pension is available. In addition a formal link between the NPA in public service pension schemes and the SPA would mean that were future Governments to decide to increase the SPA further (presumably in the light of further increases in longevity) then the default would be that this led to an increase in the NPA in public service pensions.

Those in the uniformed services - the armed forces, police and fire fighters - are to have an NPA of 60 for future accrual rather than an NPA equal to the SPA. In some cases this also represents a substantial reduction in the generosity of these schemes (although not in the case of recent entrants to the fire fighters scheme who already face an NPA of 60) although significantly less than had their NPA been increased to the SPA. The desire to provide generous support to these individuals after they leave these careers - in particular where these careers typically can only be pursued up to a relatively young age - is understandable. What is less clear is whether more generous pensions, presumably with an expectation of early retirement, is the best way to provide such support. An alternative that might be more attractive would be to increase the NPA to the SPA for all public sector workers including those in the uniformed services and instead offer some of those leaving the uniformed services specific payments to support a transition into alterative careers. Careful targeting of such payments - for example for retraining and relocation - could offer better value for money for the taxpayer than using universally more generous pension arrangements, and were it deemed appropriate would also allow the payments to some individuals to be significantly more generous.

Overall many features of these reforms recommended by Lord Hutton are welcome. But what these reforms would do overall to the generosity of these schemes to public sector workers will not be known until a decision on other key parameters is announced. This will also affect the cost to the taxpayer of these schemes. In particular, Lord Hutton's report leaves open the choice of accrual rate in these schemes and the level of employee contributions. Once these are known we will be able to assess the extent to which the reforms are leading to an average reduction in the generosity of public service pensions (if that is the case). In addition it will be possible to calculate whether there are likely to be any overall winners - such as low flyers - from the reforms.