One of the least edifying aspects of the febrile debate on public sector pensions is the charge being made, often by people who should know better, that current public sector pensions are in some way “Gold-plated”. It is certainly true that the retirement prospects of employees in the private sector have been dealt a series of blows over the past decade – blows from which employees in the public sector have hitherto been immune. But it is facile and wrong to say that the problem is one of equity and that public sector pensioners should “suffer” in the same way that those in the private sector will.
Defined Benefit schemes
The basic premise of the pensions offer to employees in the past was broadly the same in the public and the private sectors – although whereas all public sector employees benefited far from all private sector employees had workplace schemes. The Defined Benefit (DB) pension schemes that were constructed in the immediate post-war years had two elements at their core. Firstly there was the understanding that the longer you worked for a particular employer the more pensions rights would accrue. Second there was the guarantee that when you retired your pensions would be directly related to your income at the time of your retirement. These DB schemes were predicated on the “Final Salary” principle. Typically a scheme would offer (say) 1/54th of the final salary for each year of service – so If an employee had a salary of £26,000 on retirement and had 35 years’ service his pension would be around £16,000 – roughly 65% of his final earnings. In addition, but not in all cases, he would be entitled to a State pension at 65 and this combination of “workplace” and State pensions offered the prospect of a comfortable retirement.
Lord Hutton’s Commission recommendations broadly retained the key elements of the DB scheme that public sector employees have traditionally benefited from. Crucially the DB principle itself is retained albeit that pensions will in future be based not on final salary but on a career average. However although the DB principle is retained, and there are other protections built in, public sector employees will have to work longer before they can enjoy a full pension and the annual increases to their pensions that they will enjoy in retirement will be linked to a lower index (the Consumer Price Index - CPI) than the Retail Price Index (RPI) that was used in the past. They will also have to pay more towards their pensions in “contributions” over their years of employment.
Public Sector Pensions are unfunded
The absolutely crucial point about pension schemes in the Public sector is that they are mostly “unfunded” and this fact lies at the heart of the Government (and Lord Hutton’s) proposals. Unlike schemes in the private sector there is no “pot” from which the pensions of a retired nurse or teacher will be paid. The “contributions” are not set aside but just go into the Treasury along with taxes - in effect contributions are just another part of the tax on incomes, like National Insurance. And the pensions payments are and will continue to be made from taxation. If this is understood the true driver of the Government’s actions becomes clear. it is promoted as a significant element of the deficit reduction programme - the Government wishes to reduce its expenditure and pension payments are in the firing line. The size of the public sector pensions deficit is enormous – between £780bn and £1200bn depending on which accounting convention you choose. In truth the changes proposed will have only a minor effect in the short-term and, like so much of the Government’s “Cuts” programmes, they can be seen as being more about maintaining economic confidence and protecting the UK’s AAA rating than anything else!
The strike is an action against spending cuts
The strike which took place on 30th November by public sector employees needs to be seen primarily as a strike against Government budget cuts. Arguably the most insidious element of what the Government proposes to do to public sector pensions is to change the annual increment indexation (from RPI to CPI) because this affects directly the income of today’s pensioners. In effect this is a retrospectively applied income tax. Pensions are deferred earnings – during years of employment workers accrue rights and make contributions and thus they defer some of their income until later (pension) years. To change this after employment is finished is a highly questionable action - almost a breach of contract (the social contract if not the legal one).
Pensions are deferred income
The comparison that should be made when the public sector debate is underway is not the comparison with the private sector but a comparison with other elements of public expenditure. If we look at a public sector employee from the date of their commencement of employment to the date of their death the Government pays them for their services over this full period. Some of the income is paid during the employment years and some is deferred until retirement – but it is all a payment made for a service rendered. Arguably the Government should no more change a pensioner’s rights than they should ask that same pensioner to return some of the salary they have already received! And certainly the “in service” change to an employee’s contract implicit in the Government proposals is a clear breach of the social contract that existed when that employee was originally recruited and throughout their employment to date. Pensions promises once made will not now be fully honoured because the changes proposed are not just to the deal for new employees but to the entire existing public sector workforce as well.
Private sector employees are increasingly vulnerable
If public sector pensions are a burden on the taxpayer (they are) the same does not apply to private sector pensions. And if some people decided to work in a career in the public sector because they felt that their financial future would be more protected then in the private sector they were certainly right to do so – at least so far as pensions are concerned. As we have seen the basic pensions premise in the past was broadly the same in the public and private sectors – even if the funding arrangements were different. In the private sector DB pension schemes have always been “funded” – that is a “pot” is built up by levying a contribution from employee and employer over the years of employment. For some well-managed schemes the pot is today broadly large enough to cover the likely future call on it. The Assets of the Fund match its Liabilities. However partly as a result of mismanagement and partly as a result of changing demographics (particularly significantly increased longevity expectations) many funds have a shortfall – a situation that is exacerbated by a difficult investment and economic climate. Over the last decade the mismatch between Assets and Liabilities has led many employers to make changes to their Pensions arrangements - changes that impact far more negatively on their employees than anything that the Government proposes in the public sector.
Companies are walking away from their Pension obligations
Publicly traded corporations are not charities and however much they might like to argue otherwise their principal and overriding obligation is to their shareholders. It was ever thus. As we have seen, in the past a company would offer its employees a compensation package which included Final Salary pension arrangements. They did this not because they felt any social obligation to look after their employees in retirement but because it was a pragmatic thing to do. If your competitors are offering a Defined Benefit pension scheme you better do so as well – in order to attract and retain staff. This was, of course, at a cost (the employer’s Pension Fund contributions) but it provided ancillary benefits in terms of loyalty and maybe also the opportunity to do a bit of bragging about being a socially responsible employer. This paradigm was largely unchallenged for over 40 post-war years.
But in the 1990s things began to change. The compensation culture, especially at the top of companies, moved from any element of “jam tomorrow” to a mainly “jam today” mind-set. Post Margaret Thatcher’s “big bang” the earnings potential in the City spiralled upwards and the bonus culture was born. Little of this trickled down to ordinary employees but it certainly trickled sideways moving from the financial sector to most other British businesses. As the head honchoes of British companies (especially the FTSE 100 ones) paid themselves more and more so they sought to find specious justifications for this largesse to themselves. This was to come from performance metrics which showed how “well” they were doing and why it was legitimate to pay themselves as much as they wanted to. Business is simple really. You sell things to generate income and in so doing you incur costs. There are two ways of boosting the resultant cash or profit generation. You sell more and/or better things and generate more income. Or you cut your costs. And if cutting costs means you cut off your long term nose to spite your short term face so be it. Bonuses are paid in the short term. So if you can find some fat in the system and cut it that has to be good doesn’t it – even if that “fat” sits in the pensions obligations you have to your staff.
The downward spiral in the corporate world’s commitment to making proper pensions provisions can be traced back to those companies whose Pension Funds got into trouble – that is to say their Liabilities began far to exceed their Assets. The very fact that many companies did not let their Funds get into difficulties shows how venal it was that some did. In short some companies mismanaged their Pensions schemes for years - and the Trustees of these schemes let them do it. Having got into trouble these companies tried to find a way out - one that would reduce their (the companies not the schemes) liabilities. Briefly they sought to minimise the statutory obligation of having properly to fund a scheme now or at some point in the future if that fund had a shortfall.
The Defined Contribution scam
The biggest change comes from a decision to close a DB scheme to new entrants. It’s comparatively easy to do, has little direct effect on existing employees and can have an immediate benefit on the bottom line. In place of the DB scheme the employers who took this course generally created a Defined Contribution (DC) scheme in its place. For public consumption and in the forums in which Corporate Social Responsibility is discussed this would be presented as both an economically sound decision (lowering costs) and a socially responsible one. But a DC scheme is a pale shadow of its DB cousin. Essentially it is a savings pot owned by the employee into which he and the employer make contributions over the period of the employee’s working life with the company. On the face of it not that different from a DB scheme – except in one crucial particular. The Pension received on retirement is solely determined, not by the retiree’s final salary or by a career average, but by the size of the money pot accumulated on the date that an employee retires. That pot has to buy future income flows through an annuity purchase and the cost of an annuity is unpredictable. The pot size itself is a function of the health (or otherwise) of the retiree’s investments. So whilst a DB scheme offered a very high degree of certainty which would help an employee plan a comfortable retirement a DC scheme does anything but. And the benefits, such as they are, are very expensive as well – as the employee will find to his cost. In the DB example above, based on average UK earnings, an employee would have a pension of £16,000 a year (plus the State pension). To achieve a similar pension from a DC scheme that employee would have to have built up a pot of around £400,000 at current annuity rates. In 2011 money assuming that the employee had worked for 35 years at £26,000 per annum he would have earned a total of £910,000 over his employment years. That means that to have enough money in his pot he would have needed to build up a pot equivalent to around 45% of his aggregate pre-tax income. Put another way every year he and his employer would have had to make contributions of £11,500 per annum to fund a pot sufficiently large to allow him to retire on a pension of 65% of his final salary! Not very likely is it?
I have called DC schemes a scam but this is perhaps a little unfair. A well run DC scheme may be quite a good and a tax efficient savings opportunity. But the only beneficiary when a Company closes a DB scheme and offers a DC scheme to new employees is the company itself. That’s why they do it. But it doesn’t stop there. Companies can and do attempt to reduce their pensions liabilities (real or imagined) in other ways as well. They may decide to change the index used for the calculation of annual increments from RPI to CPI as is proposed for the public sector with the same outcome – lower pensions. This is what British Airways is trying to do and it has caused a furore in their Pension Fund Trustee Board. They may stop existing employees from accruing benefits which means that for an employee in mid-career their pension will be substantially reduced. (In the example above had the scheme been closed to further accrual half way through the employee’s career his pension would have been halved). Or they may decide to close a scheme entirely – as Unilever has announced it will be doing. The Unilever case is an interesting but sadly not atypical one. This is what Unilever’s Chairman says “…the changes have been proposed to help tackle the increasingly unaffordable and unsustainable costs associated with Unilever's UK pension fund”. Unilever made profits of over £6 billion in 2010 and there can be no doubt that if they had wanted to they could have maintained their existing Pension arrangements which were in reality far from “unaffordable”. No the real reason is that Unilever judged that to offer employees pensions scheme as they had in the past was no longer necessary – i.e. necessary to give them an advantage or maintain their position as an employer. In their promotional literature they make all the usual motherhood statements about how important their employees are but they are not the only employer whose pensions actions don’t match their corporate rhetoric.
Whilst the first imperative to abandon – either completely or partly – the old DB scheme Pensions arrangements came from those companies with Pension Funds in difficulties now it is the target for all. Profitable businesses as well as struggling ones are seeking to reduce their pensions burden (or potential burden) by moving away from DB to DC. It becomes almost a virility symbol of the corporate world to have closed a DB scheme to new entrants, to stop further accrual, to change indexation arrangements, to move from final salary to career average or, in extremis, to close a Fund completely. In the first wave of the move away from the presence of a significant element of worker power at the workplace companies sought to de-unionise, often by contracting out many of their operations. We are now in the second wave of this process under which the workforce begins to resemble just another factor of production along with land and capital. In a high unemployment world, and despite minimum wage and other protecting legislation, employers will feel increasingly empowered to reduce costs by offering lower benefits. The major changes to pension arrangements for so many are just part of this seemingly unstoppable trend and it is happening at a time when those in Government, the Media and in political parties and the trades unions are fighting other bigger battles.
The chilling prospects for retirees of the future
We find ourselves in a world of unparalleled uncertainty – a world in which all too many of the old assumptions no longer apply. We cannot guarantee Growth or employment or probably anything like the welfare benefits that we have enjoyed for more than sixty years. Many on the Right are relishing the commercial opportunities of what they see as the “post-welfare” world in Europe. These people expect most European states to be unable or unwilling to have the public sector active or the sole provider in traditional areas like healthcare and education. Whether this happens or not remains to be seen but it is undeniable that our economic systems are struggling to adapt to the new realities and as individuals we struggle as well. One thing is, however, abundantly clear. The old paradigm of cradle to grave care – be it from the State or (partly) from an employer is disappearing. The Welfare State is under threat as never before and the hidden agenda of many politicians, and not just Conservative ones, is to change the mix so that private enterprise does many of the things that the public sector once did. The disparity in retirement benefits between the private and public sector described in this article may mean that the pension cost advantages of privatisation as opposed to public sector provision could tip the case over in the direction of private enterprise. In the past Companies “contracted out” to save money and hassle so that they could concentrate their efforts on the added value rather than the cost side of the P&L. To offload any concern for Pensions provision from a DB into a DC scheme is more of the same.
The most suffering victims of the new economic realties are actually in the private sector. For here the logic is much less defensible than the Government’s Public sector intentions and Lord Hutton’s thoughtful proposals. In truth, it is private sector employees who are the main causalities of the fiercely market-oriented world in which we now live.
Paddy Briggs is a Member Nominated Trustee Director of the Shell Contributory Pension Fund. He writes in a personal capacity.
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