The impact of the 2007-08 changes to public sector pensions - Public Accounts Committee Contents

1  Achieving affordability

1.  Projections by the Government Actuary's Department suggest that the changes made in 2007-08 to the civil service, NHS and teachers' pension schemes will bring substantial savings in taxpayer costs worth £67 billion over 50 years and stabilise their costs at around 1% of GDP.[2] Additional changes announced in 2010 are expected to reduce costs further. These changes include using the Consumer Prices Index rather than the Retail Prices Index to uprate pensions in future, and a phased increase in employee contribution rates to most schemes by an average of 3% of pay.[3]

2.  Some of the assumptions underlying the projections have not been tested. The Treasury carried out sensitivity analysis on one key assumption, the age to which pensioners are expected to live, but did not do so for other assumptions.[4] Important areas of uncertainty are: the validity of assumptions that the public sector workforce will remain static over time and that long-term GDP growth will average 2.2% a year to 2050;[5] the rate of opt-out from the schemes if employee contributions rise;[6] and the impact of declines in the value of public service pensions on the attractiveness of public service employment and on payments of means-tested benefits.[7]

3.  At the time of our hearing, a further area of uncertainty was the discount rate used to determine the annual level of employee and employer contributions to public service pension schemes. Since the late 1990s, a discount rate of 3.5% above the Retail Prices Index has been used.[8] Dr Ros Altmann told us that this was too high for schemes to be sustainable and that a lower rate based on the government borrowing rate would be more appropriate.[9] A lower discount rate would result in higher pension contributions from either employees or employers, or from both.[10]

4.  The Treasury acknowledged that the existing discount rate was "beginning to look a bit on the high side",[11] and recognised that this may have a distortionary effect since departments will not bear the full costs of the people they employ.[12] It conducted a public consultation on setting a new discount rate, which concluded on 3 March 2011.[13] Following our hearing, the Government announced in the 2011 Budget that the discount rate would be set at 3% above the Consumer Prices Index. This is 1.3% lower than the current rate and is based on the long-term expectation of GDP growth. In future, the level of the discount rate will be subject to review every five years.[14]

5.  The review of the discount rate has held up implementation of cost sharing and capping,[15] a key element of the 2007-08 changes which is projected to deliver 60% of the overall savings in taxpayer costs to 2059-60.[16] Cost sharing and capping is a mechanism designed to ensure that the taxpayer does not bear the extra cost of people living longer than expected and therefore drawing their pensions for a longer period. If longevity increases beyond projections, the mechanism increases employee contribution rates and/or reduces the value of pensions received in the future.[17] The mechanism is to be applied at the actuarial valuations of pension schemes which routinely take place every three or four years.[18]

6.  The delay in implementing cost sharing and capping created a risk that employees might face higher and more sudden increases in contribution rates than would otherwise have been the case.[19] Since our hearing, the Hutton Commission has recommended developing cost sharing and capping into a cost ceiling for schemes, which would set an upper limit on the amount the Government contributes to employees' pensions.[20] It also recommended controlling future costs by linking the age at which members can draw a full pension to the state pension age.[21] In the 2011 Budget, the Government accepted these recommendations as the basis for consultation with public sector workers, unions and other interested parties.[22] However, until the Government sets out firm proposals in the autumn, it will not be clear whether or how cost sharing and capping will be implemented, or the likely impact on employee contribution rates in the future.

7.  While the Government Actuary's Department projections suggest that the 2007-08 changes will stabilise public service pension costs as a proportion of GDP, it is not clear whether this means they can be considered affordable.[23] The Treasury monitors its preferred financial measure of affordability, taxpayer cost as a proportion of GDP, but has not set out a benchmark level of expenditure which it considers to be affordable.[24] There are also other measures of affordability which could be used, such as public service pension costs as a proportion of public expenditure, or the level of public service pensions compared to private sector pensions.[25]

8.  Public service pensions are paid either on the basis of an individual's final salary or on earnings averaged over his or her entire career (career average salary). Final salary schemes, which predominate, create anomalies that skew reward to high earners and those promoted late in their careers.[26] Some senior civil servants have built up pension benefits with a capital value of more than £2 million, which means that those individuals would receive pension payments of over £100,000 a year on retirement.[27] On average, however, public service pensions are not high: in 2008-09 the average annual pension received ranged from £5,900 for civil servants to £9,400 for teachers.[28] The Treasury told us that it had favoured all schemes moving to career average salary schemes in 2007-08 since this would produce fairer outcomes for most staff.[29] However, the civil service scheme was the only one that did so, and only for its new staff.[30] The Hutton Commission has since recommended widespread adoption of career average salary schemes.[31]

2   Q 58; C&AG's Report, HC 662, para 5 Back

3   Qq 58, 70; C&AG's Report, HC 662, para 2.6 Back

4   Q 68; C&AG's Report, HC 662, para 10 Back

5   Qq 23, 61-63, 68; Ev 21  Back

6   Qq 143, 148, 151; C&AG's Report, HC 662, para 10 Back

7   Qq 83-85, 144-147; C&AG's Report, HC 662, para 12 Back

8   Q 69. This discount rate is equivalent to 4.3% above the Consumer Prices Index over the long term, based on Office for Budget Responsibility analysis. Back

9   Qq 29, 38-39 Back

10   Qq 28, 77; C&AG's Report, HC 662, para 3.14 Back

11   Q 69 Back

12   Q 100 Back

13   Qq 69, 100; C&AG's Report, HC 662, para 4 Back

14   HM Treasury, Budget 2011, HC 836, Session 2010-11, 23 March 2011, para 2.13 Back

15   Q 124 Back

16   Qq 70, 123; C&AG's Report, HC 662, para 2.7 and Figure 9, page 25 Back

17   Q 134; C&AG's Report, HC 662, paras 3 and 3.3-3.4 Back

18   Q 124 Back

19   Qq 123-129, 139, 142; C&AG's Report, HC 662, para 6 Back

20   Independent Public Service Pensions Commission, Final Report, 10 March 2011, Recommendation 12, page 13 Back

21   Independent Public Service Pensions Commission, Final Report, 10 March 2011, Recommendation 11, page 13. Back

22   HM Treasury, Budget 2011, HC 836, Session 2010-11, 23 March 2011, para 2.12 Back

23   Qq 58, 65 Back

24   Qq 58, 65 Back

25   Qq 19-20, 65 Back

26   Qq 10, 80 Back

27   Qq 95-96; Ev 21 Back

28   Qq 11, 80; C&AG's Report, HC 432, Figure 3, page 13 Back

29   Qq 80, 91 Back

30   C&AG's Report, HC 662, para 12 Back

31   Independent Public Service Pensions Commission, Final Report, 10 March 2011, Recommendation 7, page 10 Back

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Prepared 26 May 2011