Public sector pension schemes under review

With Lord Hutton's interim report on immediate cost savings in public sector pension provision imminent, we examine how the schemes under his microscope have already changed in recent years to reflect emerging issues such as rising member longevity and affordability.

On this page:
Election pledges on pensions provision
New-look pension scheme
Employer contribution capped at 14%
Changing pensions in a cost-neutral way
Governance issues
Tiered contributions aid cost sharing
Ill-health retirement
Focus on disability
Medical assessment
Our research
Guiding principles for public sector pension reform, 2005
Table 1: Public service pensions and recent changes in terms.

Key points Lord Hutton's current independent commission looking into public sector pension provision is the latest contribution to a long-running political debate around how to provide sustainable, affordable pensions to a disparate group of workers with very differing pension needs. Many of the schemes reviewed by Hutton are relatively new arrangements that are still bedding down - the local government and NHS schemes only admitted new members from 2008 following four years of wrangling. The new public service schemes introduced in the past five years were specifically designed to produce £13 billion savings to the public purse over the next 50 years. Some schemes incorporate new measures to share the cost of any unexpected rise in pension liabilities between employers and employees, and/or cap the amount employers will be expected to pay in the future. Members of most new schemes will see their normal pension age move towards 65, and experience a tightening-up of eligibility for enhanced ill-health early retirement.

Public sector pension provision has a long, and at times, troubled political history - the current schemes for civil servants and the armed forces have their origins in the mid-19th century, when the non-contributory provision on offer quickly became a benchmark for other groups in the public sector¹. Even then, with future funding in mind, the Treasury and local ratepayers' representatives were cautious about extending such relatively generous schemes to other workers. As a result, early local government arrangements usually involved a member contribution in return for lower pensions than those accrued by colleagues in the non-contributory central government scheme.

Pension provision for public sector workers has also been under the spotlight in the more recent past, even before Lord Hutton was asked to "conduct a fundamental structural review of public service pension provision and to make recommendations … on pension arrangements that are sustainable and affordable in the long term". As our table shows, all the schemes and provisions under Lord Hutton's microscope have been reviewed and, in many cases, quite significantly revised in the past five years, a fact widely overlooked in the current debate. Recent changes have focused on the same areas as Hutton's current review - including how to reflect in scheme design the rise in member longevity and changing working patterns, and funding sustainability.

As a result, normal pension ages for many public sector workers are already set to rise to 65 over time and ill-health early retirement benefits have been restricted. Cost-sharing mechanisms and contribution caps are also being developed to deal with future fluctuations in macro-economic indicators and membership profiles. We review how these significant changes in public sector provision are only really just beginning to bed down, raising questions for Hutton and the ministers to whom he must report about their appetite for further change.

Election pledges on pensions provision

The most recent wave of changes to public sector provision has its origins in a Labour Government pledge made before the 2005 election to tackle public sector pension reform, if re-elected, as a matter of priority. It was a very similar pledge to that made by the new coalition.

There then followed a period of intense discussions between politicians, public sector employers and trade unions, culminating in a set of framework principles governing future negotiations in some of the UK's largest public sector schemes (local government workers were covered by a similar, but separate, "stock-taking" exercise). The resulting framework agreement was designed to produce £13 billion savings in the cost of providing pensions over the next 50 years for three key groups - teachers, civil servants and NHS staff. Crucially, the principle was established that age 65 would become the normal pension age for new entrants to many public sector schemes. Also, all future negotiations on new schemes would have to take place in the context of a "cost envelope" signed off by the Treasury's Chief Secretary.

Optimistically, Alan Johnson, then Secretary of State for Trade and Industry, expected all parties to conclude detailed negotiations on new schemes by June 2006 in time for implementation "as soon as possible thereafter". Business leaders condemned the framework agreement and accused the Government of caving in to trade union pressure and, in terms with a familiar ring, of perpetuating the pensions gap between public and private sector workers. Below we explore the outcome of the subsequent discussions, which were designed to produce new schemes for the 21st century - some of which have only been admitting new members for a little over two years - and focus on two particular aspects of new-style provision - ill-health retirement and cost sharing.

New-look pension scheme

An important aspect of the negotiations culminating in the establishment of new public sector schemes over the past five years was the need to share the cost of any future, unforecast, increases in pension costs between employees and employers. Several of the new schemes outlined in the table contain provisions for capping employer contributions, and/or sharing contribution increases in future, accompanied by the establishment of joint monitoring or auditing panels and committees.

A new-look pension scheme for more than 1.5 million local government workers went live on 1 April 2008, following four years of discussions around the principles of making provision financially sustainable and affordable given growing longevity and changing working patterns. The Government's stated aims during negotiations were to stabilise the costs of the local government scheme, to ensure equitable cost sharing between members and employers and to ensure that no additional costs were imposed on taxpayers.

Communities and Local Government, the government department with responsibility for local government, set up a policy review group to develop cost-sharing arrangements for the scheme in time for the 2010 valuation, and to monitor and assess trends and events that might influence the future affordability of local government pensions. In its submission to Lord Hutton's commission (external website), the Local Government Employers state: "The Local Government Pension Scheme already contains a cap-and-share mechanism whereby any underlying increase in the cost of the scheme going forward can be shared between employees and employers up to a certain level, with increases above that level all falling on employees."

Employer contribution capped at 14%

Employers' contributions to teachers' pensions are also capped, at 14% of salary. This was part of a package of radical changes to the teachers' pension scheme that introduced a new normal pension age of 65 for new entrants from January 2007 and a gradual increase in the minimum retirement age of existing teachers from 50 to 55 by 2010. The operation of the cap excludes any increase in costs arising from overriding legislative requirements, or from changes to the financial assumptions on which the scheme valuation is based.

An agreement between teaching unions, employers and government reached at the time recognised that protecting existing members' normal pension age and benefits, and securing improvements and flexibility for all members, was not possible within the old total contribution rate of 19.5% (6% from members; 13.5% from employers) and required an increase to 6.4% and 14.1% respectively.

Changing pensions in a cost-neutral way

Affordability and the need to change pensions in a cost-neutral way were at the heart of the new armed forces' scheme, introduced in April 2005. The new scheme retains a defined-benefit design, but with major changes to early retirement and dependants' benefits. Attention was also paid to addressing disparities in accrual rates between officers and other ranks. Headline improvements included an increase in death-in-service benefit to four times salary, a rise in the value of spouses' pensions and - in a move common to most of the other new public sector schemes - opening up dependants' benefits to unmarried couples, including same-sex partners.

These improvements are funded by changes in other areas of provision - for example, although the normal pension age for serving personnel remains at 55, the vast majority leave before this age and will not be eligible to draw a preserved pension and lump sum until 65, up from 60 in the old scheme. Big changes were also made to the pensions of those leaving the services before normal retirement age - immediate pensions are replaced by early-departure payments, a combination of a lump sum and income for those over the age of 40.

During parliamentary debates on the new armed forces' scheme the Government was accused of moving the goalposts by changing actuarial assumptions to inflate the cost of the old scheme. It was also accused of reneging on its promise to use savings in one area of provision to fund improvements in others - it responded that the new scheme costs 22% of the service paybill, the same as the old one, and that younger recruits should expect to share the cost of their own improving longevity. This is further proof that public sector pensions are always a political issue.

Governance issues

Plans leading to the formation of the newest civil service scheme, Nuvos, were built around a Cabinet objective to save £2.1 billion over 50 years on the bill for civil service pensions. In its plans for the scheme in 2007, the Government proposed that any increases in civil service pension costs arising from further improvements in member longevity or benefit changes would be split equally between employers and members. This new arrangement was planned to apply for the first time once the results of the 2010 scheme valuation are known. A 20%-of-pensionable-pay cap was also proposed for the employer's contribution.

The civil service trade unions were cautious about proposals to split future increases in pension costs, arguing that funding decisions need to be set in the context of the time at which they occur, and that it is not reasonable to anticipate the service's and members' needs in 10, 15 or even 20 years' time. However, they did welcome proposals for a greater involvement in the main civil service scheme through a new joint governance group, believing that this would mean a bigger role in determining future benefit and contribution changes after each valuation.

For example, during 2010, the Civil Service Pensions Governance Group (PDF format, 66K) (external website) planned to work with the actuary on preparations for the impending valuation and to meet to consider the actuary's initial findings on scheme experience. It is due to make recommendations to the Cabinet Office on the assumptions to adopt in valuing the scheme's liability, other than those set centrally by the Treasury.

Tiered contributions aid cost sharing

A final-salary basis was retained in the new scheme for NHS workers, launched on 1 April 2008, but with a higher accrual rate and no automatic lump sum (the old scheme remains open for existing members only). Standard member contributions are replaced by a new salary-related contribution structure, which in turn supports new mechanisms for cost sharing.

Arrangements for cost sharing are linked to actuarial valuations, and it is likely that the employer contribution to both the old and new NHS schemes will remain at around 14% of pensionable pay until 2016, in line with a final agreement between employers and the unions on funding and cost sharing. Any nominal actuarial surplus emerging from valuations in the period to 2016 (the latest scheme accounts relate to a valuation as at March 2004) will be used to cushion upward pressure on employee contributions in the 15 years after this date.

If valuations predict a deficit by 2016, the employer contribution will rise up to a cap of 14%, and any further cost pressures will be met by the members, in the form of higher contributions, benefit changes or a mixture of both. If the total cost of both schemes falls in the longer tem, savings will go to members until the overall combined employer/employee contribution rate returns to 20.4%. Any fall in funding requirement below this level will be shared equally between the two groups.

These cost-sharing principles in the NHS schemes apply only to factors that change the expected value of benefits as assessed by the Government Actuary, for example, demographic variables, and not to changes resulting from financial assumptions, for example, discount rates. In common with the civil service and local government, a new employer/union governance group was set up to advise the health departments and Treasury on strategic pensions issues arising from this new cost-sharing principle.

Ill-health retirement

The payment of enhanced pensions to those retiring early on medical grounds has long been a feature of public sector schemes, particularly those where employees are involved in stressful or physically demanding roles such as police officers and firefighters. However, these benefits are costly and difficult to monitor - and ill-health early retirement is a tempting, and less messy, option than redundancy for line managers faced with reorganising a department or service.

A second driver for changing the way public sector schemes paid ill-health benefits was the emerging workplace health agenda in the 1990s, which sought to debunk the myth that, if somebody was no longer fit to perform their normal duties, they were incapable of all work. Hence the move towards tiered ill-health benefits in the new-style schemes - typically, enhanced pensions will only be paid in cases where scheme members are permanently incapable of performing their normal job and are not likely to be able to undertake gainful employment before retirement.

In the new local government scheme, members have to be permanently incapable of performing their normal job, and to have a reduced likelihood of obtaining "gainful" employment before normal pension age, in order to qualify for an ill-health benefit. "Gainful" employment is defined as employment for 30 hours or more a week over 12 months.

Three tiers of benefit are paid: a pension based on full prospective service to the age of 65 if the member has no reasonable prospect of gainful employment up to this point; a pension enhanced by 25% of prospective service to 65 in cases where the member is not likely to gain employment within three years of leaving, but is likely to do so before normal pension age, and a pension based on membership at the point of leaving in cases where the member is likely to work within three years of leaving, but not immediately.

Payment of this third-tier benefit can be stopped after three years, or earlier, if the member becomes capable of work, or obtains employment - a provision that caused controversy during negotiations. The employers questioned whether or not the new ill-health provisions would save money, arguing that their complexity would give rise to more appeals. However, a regulatory impact assessment at the time suggested that the new arrangements were within the Government's "cost envelope" of 19.4% of payroll for future service.

Focus on disability

The three-tier model is also used in the new armed forces' scheme. Severely disabled personnel are entitled to a pension based on actual service plus 50% of prospective service to age 55, plus a lump sum of three times the value of this initial annual pension. Those whose prospects are significantly impaired are eligible for a one-third enhancement, and those who have reasonable prospects of other employment outside the forces receive a lump sum of 1/8th of pensionable pay per year of service and a preserved pension to be taken at age 65.

Before the introduction of a new scheme in April 2006, pension benefits for firefighters cost a whopping 37.5% of the paybill, making them the most expensive in the public sector. Government policy aimed at encouraging later retirement generally, and the need to curb the spiralling costs of ill-health benefits in particular, provided a keen focus for the redesign of benefits for this group.

The new firefighters' scheme incorporates a two-tier model of ill-health benefits - a lower level of benefits is paid to firefighters who become incapable of performing firefighting duties, but are capable of some regular work (defined as at least 30 hours a week). The pension paid is a simple unenhanced benefit of 1/60th of pay for each year of service at the date of early retirement. A higher-level benefit enhanced up to normal pension age is only awarded when a firefighter with at least five years' service is unable to undertake any other regular employment.

Medical assessment

Often, arrangements for ill-health benefits in the new public sector schemes are accompanied by systems for medical assessment, monitoring or occupational health support, especially in those schemes where a higher level of benefit is paid on the basis that a member is assessed as incapable of their normal duties or any other regular work. For example, firefighters' employers are required to review the entitlement to ill-health early retirement pensions of those members who have been receiving them for less than 10 years but who are under pension age.

During reviews, employers consider whether or not an individual's condition has improved to the point where they could return to a role as a firefighter. If a member receiving the lower level of ill-health benefit is offered a firefighting role, but chooses not to take it, the ill-health benefit can cease and the service on which it is based counts towards a deferred pension at age 65. Those receiving higher-level benefits who become capable of some work, but cannot to return to normal firefighting duties, transfer to the lower-level benefit.

The new arrangements for NHS workers in both old and new pension schemes are complex. In addition to a tiered system based on incapacity, there are special abatement arrangements in circumstances where a member in receipt of these benefits is re-employed by the NHS or elsewhere. Medical advisers have the option to defer a decision about whether or not to award a member a higher-level pension by proposing a review after a suitable period of time.

For example, an occupational health doctor may be satisfied that the member meets the criteria for a lower-level benefit (ie they may be able to undertake some meaningful work before normal pension age), but believes that the nature of the health condition precipitating the early retirement makes it difficult to assess the longer-term prognosis for fitness for work. In these circumstances, a lower-level benefit could be paid and a review conducted after a limited period to determine entitlement to the higher benefit.

As in other new public sector schemes, controlling the cost of ill-health benefits was an issue for the NHS - in the old scheme, the cost of such provision was met directly by the pension scheme with no recharging back to employers. The Government presented options for transferring the cost to employers during the consultation exercise in the hope that this would lead them to "recognise the cost impact of ill-health retirements … and should instigate a change in behaviour that recognises the cost benefits of proactive interventions". No such provision, however, was implemented, although the Government maintains that the new ill-health arrangements are designed to use financial incentives to encourage employers to manage long-term sickness absence more proactively.

Our research

This feature is based on information from individual scheme websites, official sources including consultation documents, and previous features published in Occupational Pensions.

1. "Inventing retirement: the development of occupational pensions in Britain", Leslie Hannah, CUP, 1986.

Guiding principles for public sector pension reform, 2005 A framework agreement reached between the then Labour Government and the large public sector trade unions in 2005 set out guiding principles for negotiations over new public sector schemes: 65 will be the normal pension age for new entrants to schemes, although this group should have the right to retire at 60 in return for an increase in member contributions; new schemes should continue to guarantee a pension linked to an employee's earnings, and pensions should continue to be index-linked; all changes should be equality-proofed; new schemes should reach out to previously under-covered groups of workers, such as part-timers; new schemes should allow phased retirement; the Government to make 1% of payroll available for improvements in scheme design, for example for better survivors' benefits; and negotiations should take account of the specific physical and mental demands of much public sector work, and recognise the importance of ill-health retirement provisions. Source: Former Department of Trade and Industry.

Table 1: Public service pensions and recent changes in terms
Scheme basis	Main terms	Recent changes/scheme history
ARMED FORCES PENSION SCHEME
Statutory, unfunded, contracted-out, final-salary scheme.	Non-contributory scheme. Accrual rate: 1/70th of final pensionable earnings. Normal pension age: 55 for those still serving; 65 for those with preserved benefits. Automatic lump sum of 3/70ths of final pensionable pay per year of service. Ill-health retirement: three-tier system of payments, based on degree of impairment.	New scheme introduced April 2005 offering improved survivors' benefits but reduced options for early retirement.
CIVIL SERVICE: NUVOS SCHEME
Unfunded, contracted-out, career-average revalued-earnings scheme.	Member's contribution: 3.5% of pensionable pay. Accrual rate: 2.3% of pensionable pay. Normal pension age: 65. Ill-health retirement pension.	New scheme introduced July 2007.
CIVIL SERVICE: PARTNERSHIP SCHEME
Funded, contracted-in stakeholder scheme.	Non-contributory scheme. Benefits may be taken between 55 and 75, through purchasing an annuity. Ill-health retirement lump sum.	New scheme introduced October 2002.
CIVIL SERVICE: PREMIUM SCHEME
Unfunded, contracted-out, final-salary scheme.	Member's contribution: 3.5% of pensionable pay. Accrual rate: 1/60th. Normal pension age: 60 Ill-health retirement pension.	Introduced October 2002, closed to new entrants.
CIVIL SERVICE: CLASSIC SCHEME
Unfunded, contracted-out, final-salary scheme.	Member's contribution: 1.5% of pay towards a spouse's pension. Normal pension age: 60. Automatic lump sum, plus option to commute some pension as well.	Operated 1972-2002, with name change to "classic" in October 2002. Now closed to new entrants.
CIVIL SERVICE: CLASSIC PLUS SCHEME
Unfunded, contracted-out, final-salary scheme.	Hybrid of classic and premium schemes.	Open to existing staff from October 2002, now closed to new entrants.
FIREFIGHTERS' PENSION SCHEME
Statutory, unfunded, contracted-out, final-salary scheme.	Member's contribution: 8.5% of pensionable pay. Normal pension age: 60. Accrual rate: 1/60th. Ill-health pension: two levels of benefit, based on degree of incapacity.	New scheme from April 2006 - standard accrual replaces accelerated accrual for those with more than 20 years' service; minimum pension age of 55, up from 50.
LOCAL GOVERNMENT PENSION SCHEME
Statutory, funded, contracted-out, final-salary scheme, administered locally.	Member's contribution: earnings-related, ranging from 5.5% to 7% of pay. Normal pension age: 65. Accrual rate: 1/60th. Ill-health pension: three levels of benefit, based on degree of incapacity.	New scheme from April 2008 - automatic lump sum on retirement, and "rule of 85" governing early retirement phased out. Payment of enhanced ill-health pensions restricted.
NHS PENSION SCHEME (ENGLAND & WALES)
Statutory, unfunded, contracted-out, final-salary scheme.	Member's contribution: earnings-related, ranging from 5% to 8.5%. Normal pension age: 65. Accrual rate: 1/60th (1.87% for GPs in a separate career-average revalued earnings scheme). Ill-health pensions: two levels of benefits paid based on degree of incapacity.	New scheme introduced from April 2008, but old scheme survives with some revisions (eg, introduction of salary-related contributions and tiered ill-health benefits).
NEW POLICE PENSION SCHEME 2006
Statutory, unfunded, contracted-out, final-salary scheme.	Member's contribution: 9.5%, but lower for those assessed as ineligible for ill-health benefits. Normal pension age: 55, but older for very senior ranks. Accrual rate: 1/70th of pensionable salary. Ill-health pensions: two levels of benefits paid based on degree of incapacity.	New scheme from April 2006.
TEACHERS' SUPERANNUATION SCHEME
Statutory, unfunded, contracted-out, final-salary scheme.	Member's contribution: 6.4%. Normal pension age: 65. Accrual rate: 1/60th for new entrants; 1/80th plus lump sum for pre-2007 members. Ill-health pensions: two levels of benefits paid based on degree of incapacity.	Old scheme significantly reformed from January 2007, incorporating a higher normal pension age, removal of automatic lump sum in favour of higher accrual rate and increase in member contribution.
UNIVERSITIES' SUPERANNUATION SCHEME
Funded, contracted-out, final-salary scheme.	Member's contribution: 6.35%. Normal pension age: 65. Accrual rate: 1/80th of pensionable salary plus automatic lump sum of three times pension at retirement. Ill-health pensions: two-tier system, based on capability.	Scheme under review: proposals for reform published summer 2010 for implementation from April 2011.