The Pension Apartheid

Given that the burden of public-sector pension provision and pay is a major contributor to the Scottish Government’s acute fiscal problems, it translates into a problem for every taxpayer and for the wider economy.

But the picture is not necessarily a negative one. The current crisis provides an opportunity for reform that could put Scotland in a stronger position as the recovery takes hold.

So what issues are at stake? And, given that pensions policy is not devolved, what actions can the ­Scottish Government take?

At the core of the problem is the imbalance in pension provision between the public and private sectors. This has profound implications for government finances, taxation and economic growth.

Over the years it has become more expensive for individuals in the private sector to build adequate pension provision, as the return on the investment set aside during their working lives has dwindled, relative to the growing demands of funding retirement.

This trend, mainly a result of lower investment returns and higher life expectancy, results either in lower employer contributions, higher employee contributions or lower retirement benefits. This all equates to a lower pay package.

Typically, employers are ­abandoning final salary schemes, which require them to increase contributions to maintain the value of their employees’ pensions. Employees are left to make up the difference, or even to fund their own schemes in full.

By contrast, in the public sector, employee contributions -- funded by the taxpayer -- are hard to adjust because they are regulated by ­statute. Instead, employer contributions must rise to meet any shortfall in meeting the fixed “defined ­benefit” pensions payments.

The result of this “pensions apartheid” has been major erosion in the value of private-sector company pensions compared to their public-sector counterparts. But it also means an increasing fiscal burden to be met by government -- ­including the ­Scottish Government -- making it an issue for taxpayers too.

According to a recent report by the independent think tank the Pensions Policy Institute (PPI), while private-sector final salary schemes are roughly equivalent in value (at 21% of salary) to their public-sector counterparts, these schemes are increasingly rare.

Most private schemes are now “defined contribution”, worth only 7% of salary on average. Worse, only 40% of private-sector workers receive an employer pension at all, compared with 85% in the public sector. In total, average employer contributions to pension schemes are a whopping 2.5 times higher in the public sector compared to the private.

The same PPI report concluded that, while government reforms to public-sector pensions (primarily making pension schemes pay out at 65 instead of 60) will have some impact, savings will be modest (some 7% in the case of teachers, NHS workers and civil servants).

Lately, the PPI has estimated that government reforms to encourage company pensions will lead to an increase in private provision to 60% of the UK workforce. But the continued decline of private defined-benefit schemes will mean that the proportion of private-sector employees with this type of arrangement will fall from 18% to only 7% in the coming years.

With public-sector pension payments generally set in stone as final salary schemes, an increasing proportion of public-sector pension payments must be made from current (taxpayer-funded) budgets as investment returns fall and life expectancy increases.

The taxpayer liability to fund these is therefore growing. The imbalance threatens to develop into a vicious circle, with private-sector taxpayers paying more to meet public pension liabilities, making it ever harder to fund their own.

According to a 2006 Audit Scotland report, the total unfunded public-sector pension liability in Scotland was some £53 billion. There are six main pension-fund liabilities: local government, the NHS, teachers, the principal civil service, the police and the fire service.

Apart from the local government scheme, all of these liabilities are completely unfunded. That is to say, not a penny has ever been set aside or invested to pay for funds that must be paid out. Instead, these costs are taken out of current spending. The local government scheme is largely funded -- but the investments were sufficient only to cover 76% of ­liabilities, leaving an unfunded element of £5.9 billion.

Assessment of the current liability depends on the discount rate applied to the payments when they are due. In other words, it is based on a reasonable assumption about how much would have to be invested now, and at what rate, to cover the payments as scheme members retire.

The latest (2008) figures from the Scottish Public Pensions Agency (SPPA), a government agency, show that the liabilities in the NHS and Scottish teachers’ schemes are now assessed at £21.1bn and £19.3bn respectively.

So, total Scottish public-sector pension liabilities now stand at a staggering £65bn. This mountainous sum is one to which Scottish politicians have been strangely reluctant to draw attention.

In Scotland, some 20% of ­workers are members of a public-sector pension scheme, and public-sector pension liabilities are expected to grow over the next years and decades for reasons that include longer lives in retirement.

The Scottish Government’s 2010/11 draft budget showed payments to the SPPA at £2.65bn, 7.6% of the total budget, up from £1.36bn in 2002/3 (6.1%). This just about covers the NHS and teachers’ schemes, though it does not equate to total taxpayer payouts. Total payouts under the main public-sector schemes were some £1.7bn in 2007/8.

So the Scottish Government faces a growing bill for pension payment -- an ever larger proportion of its budget that cancerously eats away at spending on other programmes.

Private-sector business and their employees thus face a pensions double whammy: higher taxes to pay this bill, and lower savings under their own schemes. This pincer operation is a major inhibitor to economic growth, and one that will only worsen with time. Economic growth has fallen ­risibly short of matching growth in the public sector. Pensions are a major contribution to the mismatch.

It is not as if preferential public-sector pensions are needed any more to compensate workers for the lower pay they receive compared to their private-sector counterparts. Public-sector earnings are now higher than in the private sector, and the gap between them is growing. Whatever the comparisons between public and private-sector packages at any one time, the balance is shifting remorselessly in favour of the former. This shift must be addressed if we are to avoid long-term damage to the economy, and thus to public services.

Business in Scotland has long been concerned that high levels of government spending, together with inflated public-sector pay and conditions, act as a drag on economic growth because it limits the private sector and distorts the labour market.

The latest Fraser of Allander economic report estimates that Scotland will be slow to recover from the recession because of its dependence on the public sector, which accounts for 22% of gross value added (GVA) compared to 18% UK-wide.

This imbalance has probably worsened in the recession. The latest UK figures show that average earnings rose by only 0.8% in the private sector in the year to September, while public-sector pay grew by 2.8%. In the second quarter of the year, private-sector employment fell by 230,000 while growing by 13,000 in the public sector.

The Office for National Statistics has earnings growth in the private sector falling to 2.1% in the year to June, dwarfed by a 3.7% rise in the public sector. Meanwhile, it reports that public-sector employment rose in the UK in Q1 by 15,000, while employment fell in the private sector by 286,000 in the same period.

Solutions

Option 1: Pension equivalence -- the Westminster route

Government should strive to establish equivalence between private and public-sector workers. Reforms to UK private-sector company pensions from 2012 set standards that could be applied in the public sector. There would be major gains from such an approach:

a. It would make proper comparisons between the sectors easier, reducing distortions and improving the efficiency of the labour market. Any unjustifiable differences in overall pay and conditions between private- and public-sector workers could then be dealt with openly and accountably by adjusting salaries.

b. It would allow major and growing savings for the Scottish Government. NHS and teacher pension provision will account for £2.5bn, nearly 8% of the budget in 2010/11, and the total liability amounts to £65bn. Fluctuations in rates of return and the pattern of employment make it difficult to predict exact annual savings from reform, but over the lifetime of existing employees this liability would be paid off.

c. The shift would provide a major boost to the fund-management sector. In practice, reform must mean, over time, moving the bulk of public-sector workers to defined contribution schemes with employees becoming responsible for their own pensions, as is the norm in the private sector. These measures could be applied to new recruits only, honouring commitments to current employees.

Public-sector schemes are mostly administered in Scotland by the SPPA, accountable to Scottish ministers. But their terms are set in Westminster statute. There has been some reform but the Scottish Government would need to negotiate with its UK counterparts to implement further change.

Option 2: Pension equivalence -- a Scottish alternative

The Scottish Government need not rely entirely on Westminster for reform, however. It could ensure new public-sector employees were recruited on a defined-contribution pension basis. One way might be to buy services from independent providers or new government bodies, which would hire employees under the new terms.

Option 3: Localisation of public-sector pay

Pay and conditions need to respond to market conditions to avoid labour market distortions that can inhibit economic growth. Pay deals should be negotiated at as local a level as possible so they reflect real conditions. Individual government bodies -- whether quangos, schools or NHS boards -- should be freed to establish their own arrangements on pay and conditions.

Option 4: Establishment of a public-sector pay commission

A commission should be established to monitor pay and conditions. Its remit would be to ensure public-sector pay and conditions stayed in line with labour market norms. It would report to the Scottish Government with annual recommendations for pay limits that would act as guidance for public-sector employers.

Option 5: Response to reflect economic conditions

The Scottish Government could act to ensure overall recruitment levels stayed in line with overall conditions in the wider economy.

Ron Hewitt is chief executive of Edinburgh Chamber of Commerce.

This article is part of the Chamber’s Time for Renewal series on public-sector reform.