Hutton pension report rejects "race to the bottom"

Lord Hutton's interim report rejects a "race to the bottom" for public service pensions, and hints at recommendations for major structural change in his final report next spring. These are likely to include changing the basis of schemes and revisiting the protections given to existing members when schemes were last reformed.

On this page:
Pension contributions should rise
Unfunded pension schemes can stay
Shaping long-term pension options
Intergenerational unfairness
CARE option high up the list.

Public sector pension schemes once led the way in scheme design, but have not kept pace with changing patterns of work and increasing longevity, Lord Hutton concludes in the interim report (on the Treasury website) of his Independent Public Service Pensions Commission. Schemes have not developed in a coherent way, resulting in complex provision and overlapping coverage. Benefits are far from "gold-plated" in most cases - the average annual public sector pension in retirement is about £7,800, and half of pensioners receive less than £5,600 per year.

The TUC welcomed Lord Hutton's report, particularly its rejection of public sector pensions as gold-plated handshakes: "Many of the critics of public sector pensions - including ministers - have been rebuffed." Its general secretary, Brendan Barber, added: "On important issues, John Hutton has firmly pushed the ball back into the Government's court. These should be negotiated with unions rather than imposed from above."

National Association of Pension Funds chief executive Joanne Segars believes the interim report dispels some of the myths about public sector pensions, but is realistic about the need to reshape them. "The long-term solution to public sector pensions mustn't become a race to the bottom," she says, expecting that retirement ages will "head upwards" in future.

Recent reforms to many schemes made by the previous Labour Government were "welcome and necessary", the interim report recognises, but do not fully address the underlying issues of sustainability and fairness. In particular, the cap and share provisions introduced by the reforms in the late 1990s and early 2000s, which were designed to split the cost of unexpected increases in future liabilities, cannot take account of the increases in the cost of pensions in recent years because people have been living longer. "Untested, complex cap and share arrangements" also fail to address underlying issues of structural reform, or cut current costs to taxpayers, the interim report maintains.

Pension contributions should rise

Lord Hutton makes a number of recommendations for short-term changes to public sector pension schemes to deliver savings within the next spending review period. These include increasing member contributions, for which there is a "clear rationale", according to the interim report. While accepting that the manner and level of increases are a matter for government, the commission feels that any increases should protect the low-paid and be staged over time in order to prevent vast numbers of workers leaving the schemes.

The report points out that a one percentage point rise in contributions for all active public service scheme members could raise approximately £1 billion per year across the unfunded schemes (Lord Hutton rejects the introduction of member contributions for the armed forces).

The most important outcome of the commission's work "will be establishing a roadmap for ensuring that public sector pensions are well-designed for the long term", the interim report suggests, and the detailed arguments it presents provide an early indication of Lord Hutton's thinking on a more fundamental redesign of schemes.

Unfunded pension schemes can stay

The unfunded basis of most public sector schemes should stay, according to Lord Hutton, whose commission concludes that "it remains reasonable to continue to operate arrangements without actual funds", given the risks, and lack of obvious economic benefits, of moving to a fully funded model. On the other hand, he is not recommending that funded public sector schemes, such as that for local government, should move to an unfunded basis.

However, the actuarial profession (the Institute and Faculty of Actuaries) believes the unfunded nature of most schemes needs re-examining in the second phase of Lord Hutton's work: "In looking forward, we believe there is considerable debate to be had about the merits and demerits of a funded against an unfunded approach." In its response to the interim report, the profession argues that unfunded provision leads to a "crossover point", when pension payments to former public service workers begin to exceed contributions, loading costs onto the Exchequer.

The Institute of Economic Affairs and other bodies represented on a right-leaning Public Sector Pensions Commission, believes the interim report of Lord Hutton's commission "ducks some of the crucial issues", particularly around the accounting basis for public sector pension provision. "We must put the accounting for public sector pension schemes on a proper economic footing," it says, suggesting that the groundwork for making schemes more financially transparent has already been done, and urging Lord Hutton to make recommendations on the issue in his final report.

Shaping long-term pension options

"Adequacy and fairness" is one of the four principles informing Lord Hutton's recommendations for long-term future reform to be set out in the final report. The commission points out that a reliance on a final-salary basis in most public service pension schemes favours those who receive rapid promotion and who stay in the public sector for their whole career.

This promotion effect means that "high-flyers" can receive almost twice as much in pension payments per pound of employee contribution as "low-flyers". Further, salary-related member contributions, such as the tiers recently introduced for local government and NHS scheme members, reduce but do not remove the higher effective benefit rates for high-flyers.

In its response, the Pensions Policy Institute reinforced the commission's views on the unfairness of final-salary arrangements. "Alternative models of pensions, that are based on average salaries or which share risks in other ways, tend to produce less diverse outcomes between high- and low-flyers in the same pension scheme," its director says. The CBI also welcomes the report's implied rejection of the final-salary model. "Lord Hutton is clear that traditional final-salary defined-benefit schemes are not a viable way forward," deputy director-general John Cridland stated.

Intergenerational unfairness

There is also an issue of fairness between different schemes, and indeed between members of the same schemes, the report concludes. Lord Hutton highlights the case of workers performing the same role but having very different pension expectations depending on when they joined the pension scheme. For example, members who joined public sector schemes before the most recent reforms to accrual and normal pension age can generally expect higher returns from their contributions than subsequent joiners due to the protections given at the time.

"There will be intergenerational unfairness if costs are being passed to future taxpayers or employees, or if members of schemes before recent reforms get better deals than new joiners," the report says, raising the prospect that the final report may revisit the future accrual of long-serving public sector workers. The interim report concludes: "Although it may not always be possible to avoid intergenerational unfairness it should be minimised wherever possible. Key elements to this include transparency around costs and ensuring mechanisms are in place to share any change in costs, including for pre-reform scheme members."

The protections given to existing members of schemes when they were last reformed are highlighted, and the commission states that it will consider the extent of accrued rights, their protection and the implications for future pension terms in the final report. In a forthright statement on the issue, the interim report adds: "The commission is clear that protecting accrued rights does not extend as far as protecting current terms for future pension accrual." It should be possible to make changes to pension schemes for existing members relating to their future service, the report argues.

CARE option high up the list

Lord Hutton will consider a range of alternative structures in the next stage of his work, but the option of a career-average alternative to the current final-salary model is likely to figure high on the list of preferred options, given his discussion of the "high-flyer" argument in the interim report. Other possible alternatives being considered include notional defined-contribution (DC) schemes of the kind operated in Sweden, and the Netherlands' collective DC schemes. Risk-sharing models that combine elements of defined-benefit and DC scheme design will also be examined, as will further changes to normal pension ages.

The Institute for Fiscal Studies (IFS), in its response, argues that certain features of current provision are difficult to justify on fairness grounds, adding that reforming them could also potentially enhance value for money for taxpayers. In particular, it reinforces Lord Hutton's view that final-salary arrangements "benefit long-stayers more than short-stayers and are much more generous to those who receive pay increases towards the end of their career than those who do not".

The IFS makes the point that pensions are part of total remuneration, but that any attempt to compensate individuals for pension cuts through pay increases is likely to prove unattractive. However, the alternative of cutting pensions with no compensation requires a judgment that the total reward package is "unnecessarily generous". "Addressing what level of compensation for any pension cuts is appropriate will be one of the most important and difficult questions Lord Hutton should address in his final report," the IFS concludes.

The public sector unions' response to the interim report is typically bellicose, and provides an indication of the rough political and employee relations ride to come for those given the job of implementing Lord Hutton's long-term recommendations. "We do not accept the need for further review, which clearly forms part of the Government's wider assault on the low-paid, the public sector and the welfare state. These plans are being drawn up on behalf of a Cabinet of millionaires and seek to make working people pay for an economic crisis they didn't cause," according to Public and Commercial Services Union general secretary Mark Serwotka.

This feature is based on the interim report of the Independent Public Service Pensions Commission and on comments from pensions specialists and other stakeholders.