(and expensive) changes in the offing for public service pensions

Our viewpoint

You may have recently read in the press that employers in some of the big public service pension schemes (eg those for the NHS and Teachers) will need to make big increases in their pension contributions next year, following the latest round of actuarial valuations. 

For example, employers in the Teachers’ Pension Scheme (including schools, local authorities, higher education colleges and universities) have recently been warned that their pension contributions could increase by more than 40% next year, compared to their current levels.

So far, so bad – but also so normal, as this is an experience shared in recent years by many private sector employers with defined benefit (DB) pension schemes, which has led to most such schemes being closed to new joiners, and many ceasing to build up further pensions on this basis and switching their employees into defined contribution (DC) pensions. 

What’s really odd, however, with what’s happening now with the public service schemes is that these big increases in employer contributions are set to be accompanied by significant improvements in future service benefits for employees from April 2019. It is not yet clear exactly which employees will be affected, but initial indications from the Treasury are that it may well include all the main unfunded public service schemes (ie those for the NHS, Teachers and Civil Servants).

You may be wondering how on the one hand future-service benefits can be improved, if on the other pension costs are rising dramatically with corresponding increases in employer pension contributions?  How this has happened is described in more detail below.

The key actuarial assumptions used to determine the costs of running a traditional DB pension scheme include:

1) how long you expect members to live;

2) the expected increases to pensions before and after retirement; and

3) the investment returns you expect to achieve between now and when the future pension is paid (the discount rate). 

Recently, changes to 1) and 2) have meant that pension scheme costs (ignoring investment returns) have actually come down, and this is true in private sector DB schemes as well as the public service pension schemes. In particular, the Office for Budget Responsibility (OBR) has reduced its forecast for short-term pay growth and lengthened the period over which these pensionable pay increases would apply. This means that pensions built up before retirement will be less than expected. Also, the latest research undertaken by the Office for National Statistics (ONS) shows future life expectancy improvement rates falling, which means people are not expected to live as long they previously were. 

When the public service schemes were reviewed in 2014, a 25-year deal was reached by the government with unions that employee contributions would be protected for that period, subject to a cost-cap review mechanism to protect the public purse against costs rising due, for example, to people living longer. So, if the actuarial cost of benefits were to increase by more than 2% of pay, benefits would be cut back to keep the overall employer costs the same. The flip side of this was that if the actuarial cost reduced by more than 2% of pay, benefits would need to be increased. A breach of the cost cap/floor would trigger statutory changes to bring the cost of pensions back to its target. Crucially, changes to the discount rate, based on long-term expected growth for the UK economy, was excluded from the calculations for this cost-cap mechanism.

What’s happened now is that the Government Actuary’s Department (GAD)’s initial reports on the latest valuations show the cost floor has been breached for some of the public service schemes, so benefits will need to be improved from April 2019.  This will result in this instance in increases to the value of employees’ future service benefits, which we estimate could be up to a 10% increase in the value of benefits being earned.

However, in terms of the total costs, the changes in 1) and 2) have been more than offset by changes in 3), ie lower economic growth expectations. Unlike private sector pension schemes, public service pension schemes (except the Local Government Pension Scheme) are unfunded pension arrangements. Therefore, the Government developed a methodology for setting contributions in the absence of a fund of assets and this is called the Superannuation Contributions Adjusted for Past Experience (SCAPE) methodology and the discount rate used is called the SCAPE discount rate. In 2016, the SCAPE discount rate, which reflects the OBR’s long-term projections of GDP growth in the UK, reduced from 3% pa above CPI inflation to 2.8% pa above CPI inflation, with a further reduction being proposed from April 2019 to 2.4% pa above CPI inflation. Lower expectations of future economic growth means more money is needed now to pay for future pensions. This has led to proposals to dramatically increase employer pension contributions from 2019.  Furthermore, this additional cost must be borne entirely by the employers and cannot be shared with members still accruing benefits.

As a consequence of this outcome, the Government has asked GAD to review the employer cost cap mechanism to ensure that it is operating as it was intended. This review is expected to conclude ahead of the next round of actuarial valuations due on 31 March 2020.  Only time will tell if any changes will be made in order to avoid this type of scenario happening again in future.

In summary, these changes may on the face of it be good news for employees that are members of the public service pension schemes that did breach the floor, as they’ll earn bigger pensions from April 2019.  However, this is likely to cause more financial pressures on already cash-strapped employers, potentially further limiting pay rises and causing job cuts.  As such, surely it would be more sensible to use the savings from lower life expectancies to offset the increasing pensions costs due to lower economic growth, so that the valuable pensions provided by the public service schemes can be kept more sustainable for the economy as a whole? But that doesn’t look likely to happen, so this could well be a short-term pensions windfall for public service employees that will damage the schemes in the longer term.