Thursday, February 28, 2008

Public Sector Pensions



If only he'd joined the civil service instead of invading Russia he'd have had no pension worries

Following our blog on the TaxPayers' Alliance NHS pensions paper, we said we'd update ourselves on public sector pensions. In particular, we wanted to confirm that they really are more generous than their private sector counterparts.

[WARNING- another blog with explicit numerical detail some readers may find unpleasant]

At the risk of the stating the bleedin' obvious yet again, the generosity of a pension arrangement comprises two key elements: what it costs the members in contributions, and what it gives them back in benefits. Luckily for us, the authoritative Institute for Fiscal Studies has recently examined the whole issue (see here and here), and much of what follows is lifted straight from them.

DB vs DC

Before getting stuck into the detail, we need to remember the difference between a Defined Benefit (DB) pension, and a Defined Contribution (DC) pension.

With a DB pension, the member's pension is defined - normally in relation to a certain percentage of final salary or career earnings. But with a DC pension (sometimes known as money purchase), all that's defined is how much will be contributed to his pension pot - what that pot is worth at retirement, and therefore how much pension it will buy, depends on a whole raft of unknowns, especially the performance of investment markets over many years.

So a DB pension is much more certain than a DC pension, and in almost all cases, infinitely preferable. And that points to a striking contrast between the private and public sectors.

In the private sector, DB scheme membership is plummeting as companies close these expensive schemes to new members (an established trend accelerated by Brown's 1997 dividend tax grab). But in the public sector, DB membership has soared, as Labour has cranked up staffing and kept their DB schemes open to new joiners. The following IFS chart tells the story:



Now, bearing in mind that the private sector employs around four times the number working in the private sector, we can see there's a vast difference here in terms of pension provision. The IFS gives us this handy summary:

So whereas only 17% of private sector employees are now members of the superior DB pension schemes, in the public sector the percentage is 76.5%. And 58% of those in private sector employment aren't in any employer sponsored scheme at all. With that in mind, let's press on, concentrating on the DB pension that most public employees get.

Contributions

Members of public sector DB schemes contribute a percentage of salary according to a fantastickal hotchpotch of arrangements, as follows:

3.5% -11%... this isn't just any hotchpotch: this is government hotchpotch.

Private sector DB schemes have an even wider range of employee contribution rates, as you might expect, but according to the ONS, the average in 2005 was 4.4%.

So on the basis of contributions, you might conclude that public sector DB pensions are on average less generous than their equivalent in the private sector. Except, of course, only 17% of private employees actually get them, which is very important overall (as we note below).

Benefits

In benefits, the public sector pension member definitely wins.

On accrual rate, there's little difference. Until recently, a typical public sector scheme accrued a pension of 1/80th of final salary for each year of service, PLUS a lump sum at retirement of 3/80ths for each service year. A typical private sector scheme accrues pension at a rate of 1/60th for each service year, but with no additional lump sum. Net net there's virtually no difference, and public sector schemes are now coming into line.

But there is a significant difference on pensionable age. Typically in the private sector it's 65, in line with the current state pension age. But in the public sector pensions are generally payable at 60, with some, such as fire and police pensions, being payable even earlier.

Earlier payment is expensive for pension funds. Not only are there more years to pay, but there are fewer years to gather contributions, and fewer years over which to earn investment returns.

There's also an important difference in respect of inflation protection. Public sector DB schemes offer full index-linking in retirement. Private sector schemes do not.

And finally, there's that all-important issue of security. Public sector schemes are fully guaranteed by HMG (well, OK, Local Government schemes- which are just about the only public sector schemes actually funded with real investment portfolios- are guaranteed by local Council Tax payers; but let's not split hairs).

Overall comparison

The IFS threw all this into their giant number cruncher and concluded:

"For public sector employees... the additional pension accrued for one more year in employment is on average worth a quarter of gross salary. So an average public sector employee who is a member of the pension scheme with a headline salary of £20,000 would have a remuneration package including pension worth not £20,000 but £25,000.

Private sector scheme members have a slightly lower accrual of about 20%, so that the scheme member on £20,000 would have a pay and pensions’ remuneration package valued at £24,000... The main reason for this difference is the lower normal pension age in most public sector schemes (generally 60, as against 65 in most private schemes)."

Now 25% vs 20% may not sound much of a difference. Until you remember the huge difference in DB membership rates (see above). Once they've adjusted for that, the IFS conclude:

"On average, to compare private and public sector remuneration including pensions, one needs to add about 12% more on to public sector wages than on to private sector wages – a dramatically large amount in this context."

So on average, public sector pensions are significantly more generous than private sector: to the tune of about 12% of pay (remembering also that average public sector pay is itself 10-15% higher than in the private sector- see this blog).

We will blog separately on what this all means for public sector debt and the true level of public borrowing.

PS Just found this useful Guardian article on some of the few DB schemes still open in the private sector.

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