Public sector pensions information

Dr_Wu

Hi

Setting aside the rights and wrongs and strong opinions expressed on this forum and elsewhere over the last year or so, it does seem clear that there is a lot of confusion and mis-information over just what is being proposed in the public sector pension review and how this will impact on workers, leading to a great deal of anxiety.

There is an article on the BBC website as from today which I think spells out quite fairly, clearly and comprehensively just what is being proposed and how it will affect people:

http://www.bbc.co.uk/news/business-15475716

Obviously nothing (other than RPI to CPI) has been agreed yet (court case not withstanding), but I think it's a pretty good stab at what's likely to happen.

Hope it helps

hugheskevi

One of the better articles, although I have a few gripes with it:

Firstly and most importantly the author fails to mention or control for the private sector schemes he draws a comparison to being contracted-in, whereas public sector schemes are contracted out.

Secondly, the author fails to mention or control for many private sector schemes offering salary sacrifice (some with employer NICs savings being rebated to members), significantly reducing the cost to members. With employee contributions going into double figures for some employees this becomes significant.

If you further wanted to go into a detailed comparison, you could also control for the pension commutation lump sum in public sector schemes being so poor most shouldn't take it, meaning that the 25% tax free lump sum feature of pensions is worthless to them, whereas in (private sector) defined contribution arrangements it is valuable.

And the other differences worth mentioning are the lack of investment risk faced by members of public sector schemes, but with a higher political/policy change risk than that faced by a defined contribution scheme. With the NRA link to SPA there is longevity risk borne in both sectors, although the link is much less direct in the public sector.

There is a quote:

"Some staff will be better off in a career average scheme, argues John Wright"

It is undeniably true that Career Average schemes will give lower earners a higher pension than final salary schemes assuming the same level of scheme funding. But talking about this in isolation is wrong, because as the author acknowledges, it is the pounds and pence impact of the overall reform which matters, not talking about individual features of the reform in isolation.

Nonetheless, a decent article.

hugheskevi

Thought about this a bit more.

Take the example in the article of the LGPS scheme, and all the employer/employee contribution figures quoted and use tax and National Insurance system values for current year for a person earning £20,000.

I'd show the maths, but it be a very long and painful post. Those who could follow it should be able to replicate it easily enough anyhow.

You get:

LGPS scheme

Employee contribution - 8%
Employer Contracted-out rebate - 2.4%
Employer contribution - 6.9%
Total contribution - 17.3%

Compare this with a contracted-in private sector scheme offering full salary sacrifice and using values in article (ie employer cont=6.5%, employee=3.5 including rebate of employer NICs from sal sac)

Private scheme

Employer contribution - 6.5%
Employee contribution - 3.1%
Employer NICs refund (added to employee contribution) - 0.4%
State Second Pension accrual - 3.4% (sum of employer and employee contracted-out rebates)
Total 13.4%

Group all this together into contribution from employee and contribution from employer and State, and you get:

Public scheme - 8% employee, 9.3% employer and State
Private scheme - 3.1% employee, 10.3% employer and State

Now none of this means the public sector schemes proposals are bad, and definitely doesn't mean folk should opt-out. But they are not anywhere near as good as is often being made out...but then nor are they as bad as many seem to believe.

[note: there are also savings from National Insurance from being contracted out of £204 for the public sector worker, and of £74 from salary sacrifice for the private sector worker.]

datostar

hugheskevi wrote: »

One of the better articles, although I have a few gripes with it:


If you further wanted to go into a detailed comparison, you could also control for the pension commutation lump sum in public sector schemes being so poor most shouldn't take it, meaning that the 25% tax free lump sum feature of pensions is worthless to them, whereas in (private sector) defined contribution arrangements it is valuable.

I don't quite understand this statement. I commuted 20% (the maximum allowed) of my public sector pension on retirement for a 6 figure tax-free lump sum. The 50% Widow's Pension (should it ever come to that) will be paid on the basis of there having been no commutation and uprated by previous years' indexation. I didn't think that was a bad deal (and still don't).

Stargazer57

datostar wrote: »

I don't quite understand this statement. I commuted 20% (the maximum allowed) of my public sector pension on retirement for a 6 figure tax-free lump sum. The 50% Widow's Pension (should it ever come to that) will be paid on the basis of there having been no commutation and uprated by previous years' indexation. I didn't think that was a bad deal (and still don't).

Have you actually worked out what it would have cost you to buy (in the form of an indexed linked annuity) the pension you have given up? I doubt it, because if I was in your position and was wanting to persuade other people that my commutation was a good deal, the commutation rate would be the first thing I would quote. Without it, your assessment of value is just empty rhetoric.

Stargazer57

hugheskevi wrote: »

Now none of this means the public sector schemes proposals are bad, and definitely doesn't mean folk should opt-out. But they are not anywhere near as good as is often being made out...but then nor are they as bad as many seem to believe.

You are right to draw attention to how contracting out narrows the apparent gap between public and private sector schemes.

But do you know how the contributions for the public sector schemes are to be calculated? At present they include nothing for the cost of the guarantee (in the form of a defined benefit) because they assume an investment return of RPI plus 3.5%.

From memory I think the costing basis for public finance purposes is cutting the assumed investment return to CPI plus 3%. This includes something for the cost of the guarantee, but falls far short of what it would cost to reproduce the value of the guaranteed benefits using investments available in the market, such as index-linked gilts that yield something like RPI plus 0.5%. I reckon the benefits could cost about 10% of salary more on this basis, completely dwarfing the impact of contracting out.

Unless the guarantee is properly priced into the cost of the benefits, a DB scheme will always represent unbeatable value for money.

Andy_L

Stargazer57 wrote: »

You are right to draw attention to how contracting out narrows the apparent gap between public and private sector schemes.

But do you know how the contributions for the public sector schemes are to be calculated? At present they include nothing for the cost of the guarantee (in the form of a defined benefit) because they assume an investment return of RPI plus 3.5%.

I was under the impression that, for the employers contributions (not necessarially other costing estimates), they used historical investment returns and a notional investment pot to work them out

Stargazer57

4.48 Valuations for most public service schemes are calculated using the SCAPE discount rate which has historically been 3.5 per cent above RPI inflation but is currently under review by the Government. The process of setting the parameters for a cost ceiling would need to consider the interaction between the eventual choice of discount rate and the calculated scheme costs.
4.49 For the Local Government Pension Scheme (LGPS), valuations are carried out separately for each fund with the choice of discount rate also set at the fund-specific level. Consistency of approach across the schemes would require the cost of pensions accruing within the different schemes to be calculated on a consistent set of assumptions (e.g. by applying the SCAPE discount rate to the LGPS valuations).

http://cdn.hm-treasury.gov.uk/hutton_final_100311.pdf

Stargazer57

2.13 Discount rate for public service pensions – Following a full public consultation, the Government has decided that the appropriate discount rate for calculating unfunded public service pension contribution rates should be based on the long term expectation of Gross Domestic Product (GDP) growth. This will ensure that employment decisions made today take into account the costs passed to future taxpayers on a fair and sustainable basis. The latest OBR forecast for long-term GDP growth is 2.2 per cent above the assumed GDP deflator, equivalent to a discount rate of 2.9 per cent above the Consumer Prices Index (CPI).
Given the range of uncertainties inherent in these calculations, the Government believes that a rounded figure should be used. A discount rate of 3 per cent above CPI will therefore be adopted under this methodology for future valuations. The Government proposes to review the level of discount rate every five years, and the methodology every ten years. The Government has confirmed that this change in the discount rate will not lead to an increase in member contribution rates beyond those already announced at Spending Review 2010.

http://cdn.hm-treasury.gov.uk/2011budget_chapter2.pdf

Stargazer57

Having done the homework and found the figure that will be used to calculate the assumed investment return underlying the cost ceilings specified for public sector pensions (CPI plus 3%) you need increase the quoted total cost of the benefits by at least a half to find what it would cost an individual to reproduce those benefits on a guaranteed basis.

So if the LGPS combined contribution cap is 17.3% of which the employee pays 8%, contracted out rebates provide 2.4% and the employer 6.9%, the real value of the benefits is around 26% of which the employee pays 8%, contracted out rebates are 2.4% and the employer provides the remaining 15.6% either in contributions or by underwriting the guaranteed benefits.

hugheskevi

to find what it would cost an individual to reproduce those benefits on a guaranteed basis.

Taking such an approach gives a different cost of provision of the pension to the benefit of pension, with the cost of provision being lower than the gain of the pension benefit to the individual.

That is probably likely, as you would expect individuals to have different risk preferences to the State, and hence the perceived benefit should be more than the cost of provision (although reading recent posts you have to wonder).

But in practice, about 75% of defined contribution investments are in equities, and 25% in fixed interest.

That suggests individuals prefer to take on risk rather than purchase guarantees at prevailing market prices, and hence valuing the benefits at the risk free rate would overstate the actual value to individuals (assuming that individuals in DB schemes exhibit the same risk preferences as those in DC schemes, which seems likely).

So I'd say we know the cost of provision of the benefits (assuming the measure of CPI+2.9% is accurate, which given there has been an extensive recent consultation is reasonable), and the figures in your post give an upper-end estimate of the value to individuals, using market rates.

One of the other big differences in these sort of comparisons is how costs/charges are factored in, particularly cost of annuitisation, which usually has a load factor of around 10% (ie expected value of annuity is about 10% lower than pension pot annuitised, to account for insurer profit, admin costs, etc). In a DB scheme, that loss of 10% of value doesn't happen.