Public sector pension crisis

Public sector pensions are going to shrink by more than many people realise.

If you work in the public sector, you probably know that your pension isn’t going to be as generous as you once expected. However, I fear that the cuts are going to be even bigger than many people realise.

I’ll start with the change that has had a fair amount of publicity. Public sector pensions will no longer be linked to the Retail Price Index (RPI); instead they’ll be linked to a different measure of inflation – the Consumer Price Index (CPI). Historically, the CPI has nearly always been lower than the RPI.

This may sound like a minor adjustment but it will make a significant difference to many pensioners’ income. In fact, the government says that annual public sector pension payments will be 7% lower by 2016. That reduction will only get bigger as the years go by.

The switch to CPI follows cuts made by the last government. These included increases to employee contributions and an increased pension age for many new public sector employees. In other words, new employees won’t receive a public sector pension until they’re 65 as opposed to 60 for most existing employees.

The combination of Labour’s cuts and the switch to the CPI has reduced the value of the public sector pension by 25% on average, according to the Pensions Policy Institute.

And there are more cuts to come. The coalition asked Lord Hutton to chair an inquiry into public sector pensions and he’s already published a preliminary report. Based on what Hutton has said so far, here’s what looks likely to happen:

Probable changes

-          employee contributions to pension schemes will be increased. In other words employees’ take home pay will fall as more of their salary goes into their pension

-          the standard retirement age for the public sector will probably rise to 65 from 60

Possible changes

-          there could be a cap on ‘pensionable pay’ for higher earners. So a doctor who earns £100,000 a year may find his pensionable pay is reduced to £50,000 – as a result, his pension will be lower when he retires

-          Final salary pensions may be switched to ‘career average’ pensions. As things stand, a public sector pension is normally calculated as a percentage of the employee’s salary at the end of his/her career. As a result, a teacher who is promoted to a headship at 55 gets a much higher pension than a colleague who stayed in the classroom until retirement. With a career average pension, your pension would be based on your earnings across your career, not just on your salary at the end.

Now all this is bad enough for public sector workers, but a Treasury announcement last week raises the prospect of even higher pension contributions from employees.

The announcement was about a rather dry technical issue but it’s an issue that could make a big difference to public sector pensioners. Basically, the Treasury is considering a change in the ‘discount rate’ that is used to calculate pension obligations.

Here’s an example to explain: imagine you’re a big employer and you know that you’re going to have to pay out £100 million in pensions in 2040. You’ll want to know what that obligation costs in today’s terms and you’ll use a ‘discount rate’ to calculate that.

If you use a 2% rate, you’ll reduce £100 million by 2% every year for 30 years. Once you’ve done that, you know that the size of the obligation in 2010 is £55 million.

In other words, if you put aside £55 million now, and then increased it by 2% a year for 30 years, you’d have £100 million by 2040.

If you increase the discount rate, today's value is lower. So if the discount rate is 5%, you only need put aside £23 million. But if the discount rate is 1%, you’ll need to put aside £74 million.

There’s no hard and fast rule on how you select a discount rate. You could look at several possible benchmarks including inflation expectations or predictions for stock market growth.

Right now, the government uses a discount rate of 3.5% plus inflation for calculating public sector pension obligations but Treasury advisers think the rate is too high. A consultation document has suggested that the rate should be cut to 3% or lower.

Every half a per cent reduction in the discount rate could increase required pension contributions by about 3% of the total pay bill. That's £3 billion to £4 billion! These increased contributions could, in theory, come from the taxpayer but in the current climate that looks unlikely to me. Much more likely is that employees will foot all or most of the bill. Employee pension contributions will have to rise further. Not a happy thought for public sector employees.

The thing that makes me especially sorry for public sector workers is that the obvious answer to the initial cuts is to increase the amount you’re saving personally for your retirement. If you build up your own savings pot, you can then use those savings to boost your income in your old age.

Trouble is, you’ll be trying to save more at a time when you’ve got less money in your pay packet because your pension contributions have risen. Given this cocktail of bad news, a good job in the private sector looks ever more attractive.

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