MYTH #2. Savings could be made by replacing final salary (defined benefits) schemes by a defined contribution scheme
REALITY. Scrapping defined benefit pensions would mean increased public spending on public sector pensions in the short and medium term
What are the Facts?
David Cameron has proposed replacing defined benefit schemes with defined contribution schemes in order to save costs. In defined contribution (DC) schemes (also known as money purchase schemes) the pension payment depends on the value of the investment in the individual’s pension pot upon retirement. Most public sector pensions are final salary schemes (also known as defined benefits schemes) which guarantee a pension based on the number of years worked for the organisation and the final salary upon leaving.
If new or existing staff were switched to DC schemes, then spending on pensions would increase. This is because most of the cost of paying pensions at any time is covered by using the contributions paid by or on behalf of current employees. If those contributions are instead paid into members’ own DC pots then they could not be used to pay for the pensions of already retired public employees.
In other words tax payers would be paying at the same time for the pensions of those who have already retired and to build up funds to pay pensions in the future for staff currently working – a double whammy.
If the quality of public sector pensions is substantially reduced this could also lead to many retired public employees becoming reliant on means tested benefits. This is because many public sector employees are low paid workers, already on quite low pensions. Increased spending on means test benefits would offset some of any saving on pension contributions in the longer term.
Public Sector Pensions – Definitions
Defined Benefit and Defined Contribution Schemes
A Defined Benefit (DB) scheme (also known as a Final Salary scheme) offers a defined or predetermined level of pension benefit. The benefits are expressed as a fraction of the final salary for every complete year worked for the organisation or as a scheme member of the final salary pension.
In a Defined Contribution (DC) scheme (also known as a Money Purchase Scheme), a pension fund is built up using employee and employer contributions. The pension available at retirement depends on the level of contribution paid, investment returns earned over time and the cost of purchasing the pension at retirement. These things are not known in advance. Therefore the pension it produces cannot be known. The contribution is defined, but not the pension.
Public Sector Pensions – Definitions
Funded and Unfunded Schemes
The terms funded and unfunded do not relate in any way to the contributions made by employees. Public sector scheme members contribute between 3.5% and 11% of their salary annually to their own pensions.
The Local Government Pension Scheme and the Universities Superannuation Scheme are ‘funded’ schemes, in which the funds required to pay future pensions are built up over time. This separate fund allows resources to be planned and managed over time to meet pension liabilities, as occurs with private sector DB schemes. There are around 4.25 million active, deferred and pensioner members of public sector funded schemes
Other public sector schemes such as those for civil servants, health workers, teachers, firefighters and uniformed police officers are ‘unfunded.’ Current pensions for staff are paid directly from central government’s current revenue (made up of contributions paid by civil servants, teachers, fire fighters and uniformed police officers in employment, and their employers). There are over 5.5 million active, deferred and pensioner members of unfunded schemes.
The significance of the difference between funded and unfunded schemes is often misunderstood or misinterpreted. Contributions are calculated and paid in unfunded schemes in much the same way as in funded schemes. The main difference between the two is that while unfunded schemes, in effect, lend contributions directly to the Government and receive a designated rate of interest in return, funded schemes keep control of their contributions and invest them in a range of assets.
When benefits are paid by the unfunded schemes, it is portrayed as public expenditure. In reality it is largely repayment by the Government to schemes of the invested contributions with the money being passed on as benefits to scheme members. Deficits (and surpluses) are identified at scheme valuations in both funded and unfunded schemes and addressed in the same way by adjustment of contributions and/or benefits.