The public sector pensions ‘Ponzi’ scheme will soon be obsolete
Public sector pensions – the occupational pensions that public sector workers get (not the state pension which everybody can get) are in a mess.
The public sector pensions system is anything but sustainable, and hence it will collapse or disappear in its present form.
When exactly this will happen is anyone’s guess – my guess is within the next decade. Why?
The UK’s public sector has what is called a “defined benefit” pension system, which pays out pensions based on the career earnings of each employee.
Pensions are not affected by investment returns. This contrasts very sharply with all the UK’s current private sector pension schemes, which have abandoned the defined benefit model, and where a retiree’s pension now depends on the size of the pension contributions made during their working life, and the investment returns of that pot.
There are other factors (the prevailing interest rate and inflation) that also affect pension size.
So public sector employees enjoy a very good pension with no risk, while private sector employees have to fund and manage their own pensions, the size of which is subject to multiple risks, many of them unavoidable.
Click here to view this content.
All of this is now quite well known. What is less well known is that the public sector pension system, for which employees and employers make substantial contributions to HM Treasury, does not have a single penny invested.
This contrasts with legacy private sector pension funds, where all contributions have to be invested by law.
HM Treasury chose to spend the money it has received over the past 50 years or more by way of pension contributions.
So the pension promises – which are legally binding – are “unfunded”. This is a classic description of a “Ponzi” scheme – paying out investors not with the returns of investments, but with contributions from new investors.
Coming right up to date, the current annual bill for these pensions for 2024-25, according to the Government, will be a staggering £54.3bn – larger than the defence departmental budget.
The Government has chosen to be sneaky in its reporting of these pension costs, because in its accounts it deducts from the pensions bill all the contributions that current employees and employers are paying into the system (even though these should be reserved for their future pensions).
So instead of reporting a cost of £54.3bn for 2024-25, it will report a cost of £1.2bn. This is because these pensions contributions will be, according to the Government, about £53.1bn.
So each year, the Government borrows the contributions for future pensions and spends it instead of saving it.
That £53.1bn should be added to government borrowing. But for political reporting purposes, the Government can “cheat” like this, and pretend that it is borrowing £50bn or so less than it actually is.
Click here to view this content.
But there’s worse to come. Because the Government hasn’t invested the money it has received for pensions over multiple decades, it also hasn’t had (and won’t have in the future) any investment returns or interest.
So each year, the pension payments due get closer and closer, and as a result, what the Government says it owes in future pensions payments rises by the interest foregone.
This cost (in effect the “lost interest”) may sound esoteric, but in 2024-25, the Government estimates this amount will be £62.5bn. In 2023-24, it was £54.9bn. Think of these enormous numbers as the interest on the pension debt.
Like with the pensions costs, the Government is also very sneaky in reporting this number. I quote them from official publications, but nowhere does this figure appear in a “debt interest” line of government borrowing.
It simply disappears by being rolled up into what the Government owes in total on its public sector pension system.
And what does it owe in this pension system? Today, assuming that no new pension promises are made, and assuming future price inflation of 2pc per year, and future real salary increases of 1pc a year, the Government will have to pay about £4.9 trillion in pension payments until the last current employee dies.
This is such an enormous amount of money that it is hard to conceive. It represents a capital commitment of about £73,000 per man, woman and child in the UK, or some £173,000 per household. And this is to pay the pensions of only about 20pc of the UK workforce.
How did we manage to get ourselves into this disastrous position, and how will it end?
First answer: fixing the public sector pensions system is difficult, requires painful conversations with more than five million employees, and generations of politicians have looked at this and thought “why not do nothing, and the next PM or Chancellor can sort it out?”. I think this remains the current thinking in Whitehall and Westminster.
Second answer: in my opinion, there will be two pressures on the Government to finally bite this bullet. One will be the evident and highly visible difference between the income and lifestyles of retired public servants compared to their private sector counterparts.
The other will be that it will begin to prove impossible to cover the rising pension costs with contributions, so the Government will begin to really feel, and have to report, the cost burden of their pension promises.
What should the Government do? An orderly solution would be to offer all public sector employees the option of taking their and their employers’ contributions as a huge pay rise (over 30pc) in return for each employee leaving the pension system.
Employees would retain pension rights already earned, but accrue no new ones. I think many workers (but not all) would find this attractive.
It would hit the Government finances hard, however, as the hidden borrowing that the Government is doing at the moment would become visible.
A much more contentious solution would be to forcibly close all the schemes to new accruals, offering additional pay by way of compensation.
This is what the private sector have done with much difficulty and effort over the past two decades.
Finally, and ethically suspect, the Government could start subtly reneging on its pension promises. At the moment, public sector pensions are fully index-linked. Legacy private sector defined benefit pensions tend to have either a 3pc or 5pc annual cap on inflation indexation – the Government could follow this lead.
There are other even more subtle adjustments that the Government could make to worsen the position of their retirees, like changing the revaluation indices of career average revalued earnings schemes. These possible depredations of the pension promise risk industrial strife and a serous loss of confidence in Government.
I don’t approve of finding technical ways of reducing the pensions promised, but I fear that Government might find this the path of least resistance.
The Government has created an unsustainable pensions system through laziness and negligence of the interests of taxpayers, and in due course Government will have to face the music. It won’t be pleasant.