The Reality of Public Sector Pensions
In an era of pension reform that began in earnest with a review of public sector pensions by Lord Hutton in 2011, we have heard an awful lot about the pension schemes offered to public sector workers ranging from local council officers to maintenance workers. There is still a general perception in the UK that these pensions are significantly more generous than their private sector counterparts, whether they are defined contribution or defined benefit schemes.
In this guide, we aim to set the record straight about public sector pensions. There is both good and bad news to consider in light of the reforms enacted by the government in 2015. Public sector workers still enjoy comparatively lucrative pension schemes, but they are by no means as generous as they were in the past.
For the record, the pensions we will be talking about in this guide are those offered to the majority of local, county, and national civil servants. Military pensions, along with a small handful of other specialised pension schemes are excluded as these are administered separately. With that said, let's get to the details.
Defined Benefit to CARE
The biggest and most important change relating to public-sector pensions is the transformation of the defined benefit scheme to career average revalued earnings (CARE) scheme. Almost all public-sector pensions in the UK now follow the CARE model for all new members and the vast majority of existing members. Transitioning from the old model to this new one has been seismic, to say the least.
Under the old defined benefit model, pension members were guaranteed a certain payout in retirement based on a single year of salary earnings. For example, one employer may use the salary a pensioner was earning in his or her final year of work to calculate future payments; another may look across the last 5 to 10 years and choose the highest amount within that time frame.
The new CARE system doesn't use a single number from a single year of work. Instead, it starts with the average salary a worker earned throughout his or her entire career. Employers take the total qualified earning and divide it by the total number of years served to come up with a career average. That average is then revalued to account for cost-of-living increases over a worker's career. The final number provides the basis for determining future pension payments.
The one thing that has not changed in this regard are the three factors used to calculate pension payments:
- Pensionable Earnings – Not every pound earned by a public-sector worker can be used to calculate future payments. Bonuses and overtime pay, for example, are usually not included in pensionable earnings.
- Years of Service – Not every year of service is counted toward a worker's pension either. Years of service can be influenced by any number of factors, including when a member actually began contributing to the pension plan.
- Accrual Rate – A pension scheme's accrual rate is used to determine a certain percentage of a worker's earnings that will be paid as pension payments. The simplest formula multiplies the accrual rate (say 1/60, for example) by the worker's career average earnings; the result is then multiplied by the number of pensionable years of service to come up with an annual payment.
Transitioning to the CARE model makes public-sector pensions more fair by rewarding all workers equally. Higher wage earners no longer benefit by earning their highest salaries within the last two years of work while, at the same time, lower wage earners are not punished by virtue of the fact that they earn less.
Still More Generous Scheme
Advocates of public sector pensions have insisted that pension reform has brought government pensions more in line with their private sector counterparts. This is true, to a certain extent. But public sector pensions are still more generous by and large. A study conducted in 2015 by the Institute for Fiscal Studies concluded that even with the transition from defined benefit to CARE, pensions in the public sector will still pay more to members who retire before the state pension age reaches 66. Those who retire after that point will have higher accrual rates to make up for any lost income as a result of having to work longer.
Beyond the simple maths of accrual rates and pensionable years of service, public sector pensions also remain more generous for the following reasons:
- Guaranteed Benefits – Regardless of the payment model used by a public sector pension, one thing has not changed: members are guaranteed benefits irrespective of the financial markets or the economy as a whole. Most private sector pension members do not have that luxury.
- Lower NI Contributions – Public sector workers still contribute to National Insurance for the purposes of funding the state pension system, but their contributions are lower as a result of their participation in public sector pensions. They pay less while reaping the same benefit from the state system.
- Additional Benefits – Because public sector pensions are used to entice the best workers, they tend to include additional benefits that may not be offered to private sector workers. For example, some public sector workers are able to pass on the full value of their pensions to survivors should they die before a certain age.
The data is clear in suggesting that public sector pensions are still more generous than their private sector counterparts are. They are less generous than they used to be, but they remain one of the best ways to save for retirement. The only major concern for these pensions right now is whether or not schemes will have the resources in the future to make good on payments. That leads us to the final point of discussion about pension liabilities.
Public Sector Pension Liabilities
The last thing you need to know about public sector pensions might be the most uncomfortable part of this discussion: as of late 2015, the UK's funded and unfunded public sector pension schemes were running a combined shortfall in excess of $1.5 trillion. What does this mean? It means these pensions schemes do not have enough assets to meet future obligations.
There is no way to tell when a particular scheme – and there are literally thousands of them across the UK – will reach a point that it can no longer pay members already in retirement. This makes the problem even more challenging. Yet the risks remain high as long as the government does nothing about it. Transitioning from a defined-benefit model to the CARE model was a good first step, but it cannot be the only step.
A number of suggestions have been offered, including:
- ending government tax relief on pension contributions
- ending the tax-free status of employer contributions
- closing all remaining public sector defined benefit plans
- the establishment of a sovereign wealth fund to make up any shortfalls among insolvent schemes.
Whether the government will enact any of the suggestions remains to be seen. We believe that something will be done, one way or another, to make sure public sector workers receive the pension benefits they were promised at the start of their careers. An obligation is an obligation whether or not people believe it is overly generous.
There is no debating that public sector pensions have changed significantly over the last five years. If you are a participant in one of the schemes, take the time to educate yourself about how the changes affect you. Also take advantage of the advice of a certified financial advisor who can help you make retirement plans based on what your pension promises.
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