Solutions to Britain's public-sector pension woes

Four largest funds have obligations of CDN$1.25 trillion
By Cecilia Valente
|hrreporter.com|Last Updated: 11/09/2010

(Reuters) — Facing the largest public pension deficit for generations, the British government has appointed former cabinet minister John Hutton to lead a review of public retirement provision.

The four largest state pension funds — the health service, teachers, the civil service, and armed forces — had obligations of 780 billion pounds (CDN$1.25 trillion) at the end of March.

No assets have been set aside to honour these commitments which cover 78 per cent of public employees but exclude significant branches of public service such as the police and fire services.

Around 2.6 million people work for the central government and a further 529,000 in its civil service. Total public pension costs have been estimated at well over 1 trillion pounds.

Hutton, due to publish his findings by the time the government unveils its budget next spring, was expected to publish a preliminary report by early October.

While he is unlikely to put forward a solution at this stage, he may highlight a few options available. Here are some likely to be mentioned:

Scenario: Raising pension age

This is an option being mulled across the Western world.

The government and, ultimately, the taxpayer will have to pay public employees' pensions for longer as life expectancy improves. To avoid pension obligations spiralling out of control, all public employees may be required to retire later.

"The hardest thing to defend for a government (is) that we all have to work longer while at the same time continuing promising public servants pensions that can be claimed at 60," senior consultant David Robbins of Towers Watson said.

Exceptions are possible for categories such as the armed forced, he said.

Probability: This is "virtually certain," Robbins said. Between 2007 and 2008, the pension age was raised by five years to 65 for new members of the teachers', civil service, and health service's pension schemes.

Robbins said this change will likely eventually be introduced across the board for all pension scheme members.

Scenario: Replace final salary pensions with career average

Most civil servants receive a pension equal to a percentage of their final salary. This is more generous than most of their private-sector counterparts who have seen pension promises plummet in the past 10 years.

Aligning pension payouts with the employees' average, rather than final, salary over their entire career would significantly reduce obligations while still guaranteeing a defined income.

The most highly-paid civil servants would see entitlements cut significantly.

Probability: Very likely. Independent consultant John Ralfe estimated that by combining a switch to average with a five-year increase of pension age to 65, the government could save 10 billion pounds a year, reducing annual pension costs to 20 billion a year.

Scenario: Defined contribution schemes for new employees

Defined contribution (DC) schemes do not guarantee a predetermined retirement income and place most of the responsibility for accumulating sufficient funds on the individual.

These saving vehicles are common in the private sector worldwide. Setting up DC schemes for new public employees would be the most radical solution, turning volatile costs into predictable liabilities and shifting longevity and inflation risks onto employees.

Because assets would be invested by fund managers, public employees would also have to bear the brunt of market falls.

This option would boost business for insurers and fund managers but the government would no longer be able to use employees contributions for other public expenditure. It would also commit the state to paying into the schemes.

Probability: Unlikely, at least in the short term. "It is not going to happen", said Neil Record, a fund manager and author of reports on public pension liabilities.

"Taking billions away is a non-starter," he said.

Scenario: Create ‘notional’ DC plans

This is a model used in Sweden. Unlike conventional DC schemes, the contributions are allocated to each person's account and payouts are calculated according to an agreed index, such as the rate of inflation or wage growth, rather than being invested externally.

British employers' association, CBI, suggested this structure in April.

"It will allow greater levels of transparency and flexibility when compared with the current defined benefit pension regime," said Tony Clare, head of Deloitte's pensions practice.

Probability: Possible. "It has been looked at. It is a sort of look-alike DC pension scheme but the money goes to the government," said Record.

Scenario: Earmark assets

France, Norway and Ireland ring-fenced assets from a round of privatizations into pension buffer funds which are investing in the market and whose purpose is to help with ballooning state and public pension costs in the future.

The government, however, would be hard-pressed to divert assets for this purpose as it is committed to reducing the public deficit first.

Probability: Unlikely. "My recommendation is that all the (pension) obligations are securitised, namely that the government issues a trillion-plus pounds in index-linked gilts and puts (them) into a fund, but that won't happen," Record said.

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