the future of public sector pensions

The Future of Public Sector Pensions

JOHN HUTTON

The reform of both state and occupa-tional pensions arouses strong emotionson all sides. The debate has becomepolarised between those, on the onehand, who say we need radical reformand those, on the other, who say theproblems are exaggerated and we shouldjust carry on as we are. I hope at least thatwe could start a debate on pensions witha consensus in the country that a keybenchmark of a decent society is theliving standards of its older people. Thisis especially true of the poorest pen-sioners. It is certainly my point of entryinto the debate.In developed countries securing rea-

sonable living standards for older peoplehas become a partnership between theindividual and the state. The role of thestate can include tax and other subsidiesto support saving as well as direct welfarepayments to those with the greatest need.In the United Kingdom, individualsshoulder the primary responsibility tosave with the state playing an importantsupporting role. Financing the consump-tion of older people will obviously beheavily dependent therefore on a per-son’s ability to accumulate wealth andsavings over a lifetime of work and howvaluable this accumulation is when setagainst current income flows. The statecan help supplement inadequate savingsto some extent, but policy in this area hasalways rightly been calibrated to supportrather than undermine the notion of per-sonal responsibility for ensuring an ad-equate retirement income.The policy context is a deeply challen-

ging one. There is enormous publicuncertainty about both individual cir-cumstances as well as the winds of

change that are now re-shaping ourworld in ways that could not have beenimagined thirty or even twenty years ago.None of this makes pension policy easyor subject to quick fixes. Pension reformrequires very complex choices. So herelies the rub. Today, one of the hottestissues in politics is pension reform. Ithas become a central political issue forone very simple reason: demographicchange. Our society is rapidly ageing.Life expectancy did not change verymuch from the middle of the nineteenthcentury until the middle of the twentieth.Then it began to change very quicklyindeed. This has helped drive up thecost of pensions. If the increase in lifeexpectancy had been accurately foreseenand planned for, there would not havebeen a problem. Unfortunately, the pre-dictions were wide of the mark and wedid not put enough aside to deal with theinevitable rise in costs. Piecemeal reformwas attempted but it did not address thefundamental underlying problem—thatwe are all living very much longer thanwe ever thought likely or possible.Here are a few examples of what this

means to public service pensions. In 1956it was estimated that teachers would liveuntil they were 76. Today that figure is 89and is set to go on rising in future. Someof the most striking advances in lifeexpectancy took place in the 1980s and1990s—the life expectancy of teachersincreased by nearly seven years in thesetwo decades alone. In 1983, civil servantswere expected to live until they werenearly 80. In 2010 that figure hadincreased to 88—the figures were revisedupwards by nearly four years just in thelast decade. A woman retiring from the

# The Author 2012. The Political Quarterly # The Political Quarterly Publishing Co. Ltd. 2012Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA 311

The Political Quarterly, Vol. 83, No. 2, April–June 2012

National Health Service in 1956 aged 60was expected to live a further 19.8 years.By 2004 this had increased to 28 years andby 2010 to 32 years. These are unprece-dented advances in life expectancy andthey are set to continue, as a recent reportfrom the Organisation for EconomicCooperation and Development (OECD)has confirmed. The first person in Britainto reach the age of 150 has already beenborn. He or she is very likely to be ateacher or a civil servant as they havethe highest life expectancies of any groupof workers.In the private sector, the pension land-

scape has changed very considerably inresponse to these demographic shiftingsands. For much of the twentieth century,pension provision in the private sectormirrored pensions in the public sector.Most pensions were defined benefit—inother words, pensions that are in one wayor another linked to a person’s salaryrather than determined by the amountof their pension contributions. Much ofthis was driven by a prevailing consensusthat this was the best way to recruit andretain skilled labour. A forty- or fifty-yearworking life would be rewarded typicallyby a pension worth perhaps as much astwo-thirds of your final salary. The highpoint of private sector defined benefitpensions was the 1960s, but there wasan extended plateau of active definedbenefit (DB) membership in the privatesector until well into the 1990s.Today, private sector DB pensions are

in rapid and continuing decline. Cover-age has shrunk dramatically from thehigh water mark of eight million in 1967to less than three million today. Very fewexisting private sector DB schemes arestill open to new entrants and an increas-ing number of schemes are closing to newaccruals for existing members. The cost,risk and uncertainties involved in main-taining DB pensions have become toogreat for most private sector employers.In the private sector, DB has effectivelybeen replaced by defined contributions

(DC) with dramatic consequences.Today, only a third of employees in theprivate sector are members of anemployer-sponsored pension scheme.As life expectancy has risen, annuity rateshave fallen, so reducing the value of aperson’s pension pot—as a result, manypeople are getting smaller pensions thanthey had hoped for.For many people this is now causing

serious anxiety and distress. Other sav-ings are therefore needed to supplementadequate retirement incomes. Some peo-ple will be lucky enough to draw on theseadditional assets—some will not. In theworst case scenarios, pensioners have torely on means tested welfare benefits.Government has responded to this loom-ing crisis over the living standards ofolder people. The pension commissionheaded by Lord Turner recommended anew system of workplace automaticenrolment whereby every worker wouldbegin to save something for their ownretirement in an employer-sponsoredDC scheme. Hopefully this will markthe beginning of a turn around. Onlytime will tell.Public sector pensions by contrast have

taken a very different course over thesame period. DB has remained the normand as the sector has grown, so has thenumber of active scheme members.Today, there are over twelve million Uni-ted Kingdom citizens who are covered bya public service pension scheme: over fivemillion active members, over three mil-lion deferred members and three-and-a-half million retired members. One in fivepeople have some form of reliance on apublic service pension for their standardof living when they retire.A growing ‘divide’ has therefore

opened up between the two sectors,which begs the questions: How fair isour current pensions system? Does it actas a barrier to labour market flexibilityand productivity in the wider economy?For all these reasons, pensions havemoved to the centre stage of politics. My

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The Political Quarterly, Vol. 83, No. 2 # The Author 2012. The Political Quarterly # The Political Quarterly Publishing Co. Ltd. 2012

own view is that pension reform is notjust a matter of cost. It raises wider issuesof equity. I agree very strongly with NickBarr, Professor of Economics at the Lon-don School of Economics and PoliticalScience when he commented recently:

Any approach to the formulation of policiestowards pensions that tries to oversimplify byfocusing on just one element, such as effi-ciency, risks grave policy errors which canhave a profound effect on the welfare of manyindividuals.

So the policy challenges are great andgrowing. Some politicians are drawn tothe sound of gunfire—others are repelledby it. There is undoubtedly something ofthe lion’s den about the politics of pen-sions. My central argument today is thatentering the lion’s den of pension reformis no longer optional for politicians. It is anecessity because standing still is nolonger a safe option. The status quo cannotbe successfully defended.Rising above the sound of gunfire,

there is growing realisation that changeis coming. Companies and governmentsin all the developed economies havemoved well beyond the stage of talkingabout reform. They are moving to imple-ment it. All of it is proving controversial.In less than a decade, pensions havegone from being ‘techy’ to ‘mainstream’.Six months ago in France for example,two million people took to the streets tooppose President Sarkozy’s reforms tostate pensions. The loose consensus thatprevailed for decades, based on the ideaof earlier and earlier retirement andgenerous, defined benefit pension pay-ments, is beginning to look less and lesscredible.The main threat to this consensus and

the status quo is obvious: the amount oftime we spend working compared to thetime we spend in retirement is movingdramatically in a direction that is castinga shadow over our entire pensions sys-tem. Today, for example, a public servantretiring at the age of 60 is likely to spend

45per cent of their adult life in retirementcompared to about 30 per cent in the1980s. This poses another obvious ques-tion: Is this sustainable? The rightresponse to the challenge of rising lifeexpectancy is less clear cut. There is nomagic solution. Finding the right wayforward will involve the application ofethics as well as economics. It is not ‘justabout the maths’. What are the valuesthat we want to bring to bear?Reform that only has the effect of redu-

cing the value of a pension will itselfcreate additional problems elsewhere inthe form of possible poverty in retire-ment—the very issue that pensions weredesigned to address in the first place.Increasing the costs of saving for a pen-sion will almost certainly result in fewerpeople saving for their retirement. Work-ing longer before being able to draw apension seems like the least worst optionif it is combined with scheme re-designthat helps ensure adequate retirementincomes. Yet this solution takes us into adifferent area altogether. To bring aboutthis kind of change will require us tobegin re-thinking our attitudes to workas well as retirement. Powerful lifestyleissues begin to surface at this point.One thing is clear: the generous

pension promises of the past are nowcolliding with the rapidly changingdemographic structures of the future.Whether we welcome this fact or not, itrequires honest debate. In my view, find-ing the most efficient way to finance theretirement incomes (and the associatedhealth care costs) of our ageing popula-tion is the most significant fiscal problemfacing the industrialised countries. This iswhat today’s politicians have to wrestlewith whether they like it or not. So thequestion facing all our societies is whatchanges do we need to make to ourpensions systems to keep them affordableand sustainable for the future?Duck this challenge and we face the

risk of higher and higher taxes, reducedwork incentives, economic disadvantage

The Future of Public Sector Pensions 313

# The Author 2012. The Political Quarterly # The Political Quarterly Publishing Co. Ltd. 2012 The Political Quarterly, Vol. 83, No. 2

and the long-term decline in living stan-dards. Action to address these conse-quences has its consequences—bothpolitical as well as economic. But sodoes inaction. That is why there is nohiding place any more when it comes topensions. Establishing the terms for thishonest debate is not going to be easy orstraightforward. Pension reform,whether affecting occupational pensionsor state social security pensions, is guar-anteed to generate noisy headlines andstrong political reactions. People are fear-ful of change and feel powerless to influ-ence the course of events. ‘Reform’ has, inthe minds of many people, becomesynonymous with a race to the bottomwhere everybody pays more and gets lessback in return. Is this inevitable?The best place to start any debate is

with the facts, but in politics, as we know,this does not always ensure an informeddebate. One person’s fact is another per-son’s allegation. And in politics we knowthat there is a well established tendencyfor politicians to torture the data until iteventually confesses. Politicians exagger-ate for a living. Mark Twain, who had afamously low regard for the species oncesaid: ‘Get your facts first and then you candistort them as much as you please.’There is something familiar to me aboutall of this.What are the key facts about public

sector pensions? About one in five UnitedKingdom citizens has some entitlement toa public servicepension. So they are a vitalpart of ournational savings infrastructure.But the costs are rising fast. Pension pay-ments from the largest schemes increasedby a third in the last decade. All of theseextra costs have been funded by taxpayersrather than pension scheme membersthemselves. These schemes are also takinga rising share of gross domestic product,although best estimates suggest that thismight be expected to fall gradually overthe next five decades.We should not read too much into this.

These sorts of predictions are inherently

uncertain and highly sensitive to assump-tions about longevity, size of the publicsector workforce and earnings growth.The present design of public service pen-sion schemes, based on a final salary, isby its very nature highly volatile. It isvery difficult to be precise over pay levelsgoing forward. Unexpected increases inpublic sector wages could have a bigimpact on long-term sustainability.The amounts involved are huge. In

total, public service pensions paid out£32 billion last year—about two-thirdsof the cost of the state pension. Employercontributions are substantial in allschemes and higher on average thanthose in the private sector. Employeecontributions range from zero in someschemes to nearly 12 per cent in others.Most schemes in the public sector arebased on a pay-as-you-go model—thatis; there is no fund of assets. Contribu-tions from current active members todayare used effectively to help offset the costof meeting payments to today’s pen-sioners. Contribution rates, however, areset to reflect the cost of meeting futurepension commitments. This explains whythere is a mismatch between contribu-tions and payments—a gap that is set torise from about £3 billion a year today to£10 billion in the next decade. This canclearly cause short-term cash flow prob-lems for government but does not itselfaddress the issue of long-term affordabil-ity. The local government scheme, withover four million members, is a fundedscheme with enormous assets at its dis-posal. It is not however 100 per centfunded.Nearly all schemes offer a pension

based on final salary, but the design ofmost public service pensions has not beena planned and coherent process. Some ofthe key features such as retirement at age60, final salary structures and accrualrates go back to Civil Service terms ofthe early nineteenth century. However,we know one thing in particular aboutfinal salary schemes: they involve a cross

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subsidy between those whose careersfollow a normal trajectory and thosewho enjoy rapid promotions. In finalsalary schemes high flyers can receivealmost twice as much for each poundthey contribute towards their pensionthan low flyers. Those on the lowest payeffectively pay for the pensions of thosewho earn the most.There have been significant reforms in

the last ten years but these have mainlyaffected new entrants alone. Someonewho joined the Civil Service at the ageof 25, for example, in 2006 would, unlessfurther changes are made, still be able toretire on a full pension 35 years later atthe age of 60, when life expectancy bythen will be over 90. However, it is wrongto claim that public service pensions aresomehow ‘gold plated’. They are not.Most public service pensions are worthless than £6,000 a year. In conducting myreview of public service pensions I triedto start with the facts and build an evi-dence base to justify reform. I rejectedwhat I considered to be the extremes of‘slash and burn’ and ‘steady as you go’.My view is that there are serious concernsabout the affordability and sustainabilityof the current arrangements, but that wedo not have to follow a downward spiralin order to address them. That would inmy view be a counsel of despair.Instead, I wanted to find a balance

between the justifiable expectations oftaxpayers that there should be a limit onhow much they could be asked to paytowards public service pensions, and theobvious need to ensure as far as possiblethat reforms did not undermine the ade-quacy levels of these pensions which helpto keep retirees off any form of relianceon means tested pension benefits. Shift-ing the cost of achieving this very import-ant objective from pensions to welfarebenefits would not be a sensible thing todo as it would undermine the importantprinciple of personal responsibility, jeo-pardise the savings culture itself andprobably cost more in the long term.

My final report, published in March2011, set out 27 principal recommenda-tions for change. I will not go into thedetail of all of these and will just addressthe principal reforms that I am proposing.In essence, I wanted to re-distribute someof the inherent risks associated with pen-sion provision in the public sector.Employees should in my view shouldermore of the longevity risk than they do atpresent and I do not consider it reason-able that taxpayers should take all of thesalary risk as well. Linking retirementages in future to the state pension agewill help establish a better balance of riskand represents the only effective way tobalance the competing objectives ofaffordability and adequacy. People willwork longer but still expect to retire ondecent incomes. The closer someone is toretirement, the least affected they will beby this recommendation and that is howit should be—they are not in a position toadjust their retirement plans and cannotfairly be asked to do so.My reforms are not a ‘work till you

drop’ recipe. Far from it. I also want toextend greater choice to people overwhen they decide to retire from work inthe public services. Crucially, however, Iam recommending that we spread thechange as widely as possible. It is notfair for current members to pass on allthe cost of living longer to younger peo-ple. That is why, this time, reform shouldnot be confined solely to new entrants.We must all be part of solving the prob-lem. The changes I am proposing willhelp restore a proper balance betweenthe amount of time someone spends inwork and the time they can expect toenjoy in retirement. This is fundamental.If wemake this change, it would bring theproportion of adult life in retirement backto around a third—where it was in the1980s. At present this figure is nowalmost reaching 50 per cent, which isunsustainable in my view.My recommendation that we bring an

end to final salary schemes and replace



them with ‘Career Average RevaluedEarnings’ (CARE) schemes addresses analtogether different issue—that of fair-ness rather than cost and affordability.A CARE scheme along the lines I haveproposed with earnings indexation willprovide fairer outcomes than those seentoday in final salary schemes. What do Imean by ‘fairness’ in this context? In anequal value career average scheme thebottom tenth of pension payments wouldbe almost 90 per cent higher than thosefrom a final salary scheme. The top tenthwould be 6 per cent lower. I think weshould bring an end to a system wherethe many on low and moderate earningssubsidise the pensions of the few whoearn the most.I am not recommending DC for the

public sector and I am in favour of keep-ing the pay-as-you-go (PAYG) model. Ithink government is better placed than itsemployees in taking on investment riskand that is why I did not recommend ashift to DC. Instead, the new fixed costenvelop I am recommending, which willlimit taxpayers exposure to unforeseenincreases in cost going forward, meansthat there should an effective limit onthe extent of taxpayers exposure. I con-sider this a better balance. And movingaway from PAYG would mean a bigincrease in public spending as pensioncontributions would be ring fenced ratherthan form part of general revenuestreams. This would have increased thefiscal challenge we already faced ratherthan help reduce it.The gap between the public and private

sector will remain but hopefully narrowas a result of the changes I have recom-mending. I hope the reforms I am propos-ing will also help those private sectoremployers who remain committed to DBpensions sustain their own schemes forlonger. CARE will certainly reduce thelonger term risks around outsourcing andencourage greater diversity of public ser-vice provision. In this sense it may help tostimulate greater labour market flexibility

and productivity in the wider economy.However, I accept here that the currentreview of Fair Deal (which relates to thepension arrangements of staff transfer-ring from public sector employment)will be of greater importance.Finally, I wanted to keep the reforms

simple and understandable—as far aspossible! That is why I ruled out the otheroptions of notional and collective DC,hybrid schemes and lump sum accrualsystems. All were perfectly capable ofaddressing the fundamental problems,but all were more complicated andharder to explain. The harder it is toexplain reform, the more difficult it willbe to implement it and successful imple-mentation will be key.The reaction to my report confirms the

complexity and the sensitivity of pensionreform. I have tried to be clear about whywe need reform on sustainability as wellas fairness grounds. I have stressed theneed to treat people properly and to in-volve their representatives fully in theprocess of change. Those who are closestto retirement will be impacted the least,but fairness requires us all to contributeto finding the right solution. I have alsoproposed a series of measures to smooththe transition away from final salaryschemes. I accept that change cannothappen overnight, but neither shouldchange be put off or delayed as thatwould be unfair to those who currentlypay the lion’s share of the costs of thesepension schemes—the taxpayers.I am delighted that ministers have

decided to accept my recommendationsin full and will now begin the next stageof the process—the preparation ofdetailed proposals on scheme design.This is the critical stage of reform. Ihave proposed a new architecture. Nowwe must have the detailed drawings. Ihope, and have every reason to believe,that people will sit down and try andthrash out an agreement on the wayforward. How would I summarise thepresent position? I think the left will say

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I have gone too far. The right will say Ihave not gone far enough. I hope thatmeans I have probably found the rightbalance after all.

This article is based on a lecture delivered bythe author at the University of East Anglia on31 March 2011.



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