Does the increase in pension contributions for government workers matter intergenerationally?

Angus Hanton looks at the proposals for meeting the gaping liabilities in public-service pensions

In the UK we are saving too little, according to the experts such as Martin Weale of the Bank of England. This ties up with personal observations: people expect to live longer, they expect to spend more, and they retire at about the same stage, even taking account of small increases in retirement ages.

The period of dependency while growing up is about 18-20 years, working life is about 45 years (a bit more for those who don’t go to university), and retirement is now likely to be about 25 years. Low savings rates will not be enough to finance retirement if this pattern is continued, and this should be a concern for younger generations.

Housing and Pensions as principal savings vehicles

The two big ways of saving for retirement in the UK are pensions and housing. Both are treated very generously by the tax system, but pensions have great advantages over housing: they are liquid and designed for the task, whereas housing wealth cannot be so easily cashed in. Paying off a mortgage leaves you with a house to live in, but no ready cash.

Pension contributions for government employees

As a result, the government has encouraged pension contributions, and especially so with their own employees. These number over 6 million workers and, with retirees and dependants, there are 12 million people covered by government pensions (as the recent Hutton report says).

In the past, the government has required very low contributions from its employees, so that almost all have joined the pension schemes. Contribution rates are as low as 0% for soldiers, 1.5% for many civil servants and about 6.5% of salary for the bulk of state employees.

The Hutton report made it clear that these contributions need to rise sharply, so they are now being increased by 3% for most government workers. These pensions are still a bargain for employees – it is suggested that to buy such pension entitlements in the market the total contribution would have to be about 40% of salary (employee and employer contributions combined).

Assuming that the pension payment is to be made half by employer and half by employee, then the employees “should” perhaps be paying as much as 20% of salary so that the 10% now being required actually looks quite modest.

How many will choose to opt out of the pension schemes?

The problem being considered in the Treasury is whether the 3% rise in contribution rates will make people opt out in large numbers. Certainly some hard-pressed government workers will choose to opt out of their pension schemes altogether. This is worrying government and is creating some speculation and research about how people will respond, and what the numbers will turn out to be.

Very recent Freedom of Information requests have revealed that the Treasury is estimating that many thousands of workers will opt out, and what is particularly worrying is that it is the lower-paid government workers who are expected to opt out in the largest numbers; according to Treasury figures, 8% of those earning less than £21,000 per year may opt out. Some pension consultants think the figures could be even higher. For example John Wright, of pension consultants Hymans Robertson, has suggested that the government estimates are too low.

Are those who opt out of government pension schemes really acting irrationally?

Although financial projections may show clearly that it is rational to stay in these pension schemes, there are currently enormous pressures on the income of many households. Most staff are facing a pay freeze, and inflation is running at almost 5%, so opting out of pension payments is one way to deal with the resulting cash squeeze.

From an intergenerational viewpoint, there are two serious concerns: first, that even with the 3% increase, government employees are still contributing too little for their pensions; and second, that there will be large numbers of government retirees with inadequate pensions.

But maybe those who opt out are smarter than we assume, and are in fact acting rationally. Perhaps they doubt whether the pensions promised to them will ever be paid. They may know that government liabilities on these pensions are already over £1 trillion (about the size of the official national debt), and that these pensions are mainly “unfunded”, meaning there isn’t money there to pay them.

This means that they would be paying now and depending on the ability and willingness of future taxpayers to pay the promised benefits.

It may also be that some regard these unfunded pensions as “Ponzi” schemes because of their unfunded and potentially unaffordable nature. If that is how people are thinking, it should be the younger workers who are most likely to opt out – as with all such schemes, it is the last into the scheme who are least likely to receive any return.

Posted on: 23 June, 2011

2 thoughts on “Does the increase in pension contributions for government workers matter intergenerationally?

  1. SamDes

    A 3% increase in government pension contributions is purely to fill Treasury coffers to undo the deficit that local government workers did not cause. The increase is not overly punitive a requirement, yet it still forces the younger generation to make a choice between providing for their future and handling heavy costs of debt repayment and housing costs. As someone in their early 20s with an interest in working in government, I’m considering learning some sort of skill so I can be self-employed when I’m older.

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