Daniel Herring: Time to think how we defuse the ticking debt bomb that is public sector pensions

Daniel Herring is Researcher for Fiscal and Economic Policy at the Centre Policy Studies.

The UK government’s financial position was precarious even before war in the Middle East blew up Treasury borrowing forecasts.

We have not run a budget surplus in over 25 years and debt is now approaching 100 per cent of GDP. But the situation is even worse than it looks on the surface, not least because of a big hidden debt on the government balance sheet: public sector pensions, which add £1.4 trillion – equivalent to 45 per cent of GDP – to the national debt.

Thankfully, there are some politicians and public figures who are taking action.

The Pensions Schemes Bill is currently being taken through Parliament, and the Lords have voted in favour of an amendment by Conservative Peer Baroness Neville-Rolfe that would require the government to conduct and publish a review of public sector pensions. This is an excellent amendment as a review of public sector pensions is urgently needed.

Public sector pensions are incredibly generous. Most private sector workers have defined contribution schemes, where the employee carries the risk and must manage their retirement pot throughout their retirement. In contrast, public sector pensions are defined benefit schemes, meaning a guaranteed, inflation-protected retirement income for as long as someone lives. And unlike private sector pensions, where you might get as little as 3 per cent of your salary as an employer contribution, public sector workers usually get 25-30 per cent from the government.

However, the main problem is not the generosity, but the fact that these pensions are entirely unfunded. Unlike a private sector defined benefit scheme, where the money is set aside in a managed fund to pay for future costs, no money is set aside for public sector pensions. This means that contributions made for employees’ future pension provision are spent on current pensioners.

The numbers are big. The pension schemes cover three million active members in the civil service, NHS, schools and the armed Forces (local government employees are in a separate funded scheme). There are also 2.2 million deferred members and 2.8 million pensioners. Contributions to the scheme are currently £57.3 billion and pensions paid are £56.8 billion.

It’s not helped by the obscure (some might say dishonest) way this is presented in the public accounts. A quick look at the OBR’s website will tell you that net public service pension payments are in surplus.

Nothing to worry about then!

Not so fast – ‘surplus’ just means that the employer and employee contributions are larger than what is being paid out to retired public sector workers.

This is perverse – it means that if the government were to vastly increase the size of its workforce, current contributions would increase, and the surplus would grow. This might look better today, but it would create a much larger bill for future taxpayers. This is already happening – increased contributions since 2020 have been driven in part by a growing NHS workforce.

This is irresponsible: like the national debt, future taxpayers are being forced to pay for our choices today. In contrast, our goal should be that each generation of taxpayers pays for its own choices.

There’s plenty of challenges to reforming the system. The biggest fiscal challenge is that moving public servants onto autoenrollment will mean the government continues to pay for current pensioners and make an employer contribution for current employees. That will be costly in the short-term, so the government would have to find savings elsewhere.

The second challenge is how to convince employees and trade unions of the reform. It is undoubtedly true that many public servants work hard and deserve fair compensation. However, public sector workers are paid, on average, similar wages to private sector workers (before their employer pension contribution is taken into account).

For many public servants, a promise for a pension in 30 or 40 years’ time is just not worth that much, and they might prefer a higher salary today so that they could afford a house or start a family. We could increase take-home pay for public servants and still save the government money in the long run.

Reform will be hard and should not be rushed. But a review that sets out the actual costs to future taxpayers is a good place to start.

We need an open debate about how much these pensions are costing the taxpayer, otherwise our children and grandchildren – probably on far less generous pension schemes themselves – will pay the price for £1.4 trillion worth of political convenience today.