Out come the Bolsheviks

30 November 2011
So the hard pressed stakhanovites known as public sector workers have decided to go on strike over their well-deserved pensions. Although there is grievance over increased employee contributions and later retirement, is it really a move from final salary to career average pensions. It is protection of a perk that the people who actually have to pay for the upkeep can only dream of having.

Final salary?

Public sector workers enjoy a class of pension known as defined benefits, which is when how much the future-pensioner gets per year is defined. In most cases this is a final salary scheme, where the annual pension is some fraction (typically two-thirds for a life-long employees) of salary at time of leaving the company. Using an average of an employee's entire employment rather than their last-year salary is basically intended to reduce overall cost, particularly for those who have big promotions late in their career.

The other class of pensions is defined contributions, which is where the contribution employers' pay is fixed, and actual pension returns depend on underlying investment performance. This is discussed later, but it will suffice for now that these schemes are vastly inferior to defined benefits as far as the recipient is concerned.


Despite what public sector unions claim, public sector workers pensions are not compensation of lower salaries compared to the private sector, as is revealed in Lords Hutton's report. The claim that such pensions are only circa £5,000-7,000 for most former employees is because most of them do not do the job for a large chunk of their lives. While public sector pensions are not exactly gold-plated, they are still substantially better than what is available in the vast majority of the private sector. In fact the deals available in the private sector are now so poor, only about 35% of workers subscribe to pensions, unlike the 85% uptake rate in the public sector.

Public sector only perk

I have heard on the news some union PR man state that they think the private sector should have this deal as well. One problem: the funding arrangement is illegal in the private sector.

To understand this, one needs to understand pension liabilities, which very roughly is how much money would be needed to pay someone's pension, assuming they left the job immediately. For defined benefits schemes, this liability is approximately their annual pension amount multiplied by a post-retirement life expectancy. In the private sector there is a legal requirement for money to be specifically set aside to cover this liability, and it is protected from other credits should a company go bust.

In the public sector, with the exception of universities, the liabilities are unfunded, on the assumption that future tax revenues will be able to pay for the pensions. The problem is that the cumulative liability is in the region of £1trillion, and since these pensions are index-linked they cannot be paid off by printing money.

How private pensions became extinct

Although increased life expectancy is part of the story, it is not the main reason why defined benefit schemes disappeared from the private sector. Private sector pensions have to be funded via ring-fenced funds, but there is still a lot of leeway in how this is funded. Typically pension funds involve investment, and the book value of these investments is used for funding evaluations.

Problems came when Nigel Lawson regarded over-funded pension funds as a source of tax avoidance, and introduced policies that encouraged companies to reduce their surpluses via actions such as contribution holidays. Then came Gordon Brown's own pension raid in the form of removing tax relief on dividend payments held by pension funds. The loss of slack followed by the loss of a significant portion of relatively stable dividend payments jeopardised the funding requirements, and when stock markets turned sour they then found themselves having to top up their pension funds.

At this point the attraction of defined contribution schemes to companies becomes obvious. The company knows exactly how much it has to pay, and the employer is landed with the risk that the underlying pension fund screws up. Considering how badly managed funds have performed in the last decade, it is of little surprise uptake is low.

How schemes are closed

I am not sure how the rules work for employees who are fired for misconduct, but leaving those cases aside pensions are a contractual obligation. That means there is no way for the company to avoid paying a pension that is already built up. However they can curtail further build-up, which is done in one of two ways:
Closing to new members
Fairly straight-forward. Any new employees are simply not allowed to sign up to the pension scheme, as the contract they are offered specifies a different pension scheme (if any at all).
Closing to existing members
This is where for the purpose of the current pension scheme, the employees' employment has ended. In reality it is implemented as a change of contract terms which pretty much state that any further employment will not affect how much pension they will ultimately get. Not always straightforward, as Kraft found out the hard way.

Workers sold down the river

This is the real killer. Since existing workers were not affected, the closure of final salary schemes to new workers in the early 2000's was largely unopposed by unions (one notable exception was Ford, but that had more to do with it being a precursor to the whole scheme being closed than concern for future workers). This is why public sector workers fobbing off the private sector with remarks about being non-unionised is actually extremely offensive.

and then house of cards comes down

The problem now is that anyone younger than about 30 is not likely to have anything remotely like the pensions the public sector enjoys, and yet they are the ones who will have to sustain their payment before long. Real trouble is going to start when this cohort starts to touch 40. To make matters worse those under about 25 are the ones who were sold the illusion of ever-increasing university attendance being the holy grail of social mobility. Loaded up on debt but kept unemployed by business taxes, they are going to be even less forgiving.