Worlds Apart

The Economist

June 11, 2009

United Kingdom

Britain’s pensions apartheid looks unsustainable

Company final-salary schemes were set on the path to extinction earlier this decade following a wave of closures to new recruits. Now BP, one of a handful of big firms that stood apart from the crowd then, is following suit. Even more strikingly, Barclays is planning to close the bank’s scheme for its existing members. 

Corporate Britain is abandoning final-salary plans because they have become too expensive and risky. By providing a defined-benefit (DB) pension based on end-of-career earnings and years of service, employers pay for investment shortfalls and rising longevity. By contrast individuals shoulder this burden under the alternative arrangement of defined-contribution (DC) plans, in which they build up a fund to purchase a pension. Employers generally pay much less into these than they do into DB schemes.

If any one British company seemed to be in a position to defy this trend and maintain final-salary pensions, it was BP. In deciding to close its scheme to new members from April 2010, the oil behemoth cited in particular its concern that liabilities were being driven up by greater life expectancy. Instead, new staff will receive a “flexible allowance” worth 15% of basic salary, which can be used either for a DC plan or for other purposes (such as paying off loans). 

Yet it was the move by Barclays that workers should find more ominous. Until now most big employers closing their schemes to new recruits have kept them open for staff who had already joined. This meant that they continued to accrue extra pension for additional years of service. Rentokil, a business-services firm, announced in December 2005 that it would close its plan for such workers, but it was the exception. Now Barclays is proposing to stop future accruals for its 18,000 existing members from December.

The effect will be to freeze retirement benefits already earned, since they will be based on current salaries uprated for inflation. That will typically produce lower pensions than if the payout had remained linked to final salaries, which would incorporate wage progression from general pay rises and promotions. Staff are being offered the same alternative for their future pension provision as new recruits, a “hybrid” plan that combines a DC component with a promise to pay a guaranteed sum of money into the account at retirement. Despite this, it remains a money-purchase arrangement and is much less generous than the final-salary scheme, says John Ralfe, a pensions consultant. 

The accelerating demise of final-salary schemes provided by companies contrasts with their rude health in the public sector. As recently as 2000, there were more employees building up pension rights—“active members”—in private occupational schemes than in the public sector (see chart). Four years later the tables had been turned, even though public workers make up only a fifth of total employment. By 2007 the number of active members in the private sector had fallen to just 3.6m, of whom 2.7m were in DB schemes; of these just 1.3m were in schemes still open to new recruits. By contrast there were 5.2m active members in the public sector, overwhelmingly in DB plans that remained open. 

As the Pensions Commission pointed out in 2004 when it was investigating the general health of British pensions, public schemes are collectively far more generous than those available to private-sector workers. It estimated that the public sector’s share of occupational and personal pension wealth was double its share of total earnings in the economy. Grumbles about this disparity sparked some half-hearted reforms to trim the big unfunded public schemes. The retirement age for new workers was raised to 65 but, crucially, was left untouched for existing employees. 

This pensions apartheid may change, however, as worries about the government’s finances intensify because of supersized budget deficits. A report on June 11th from Policy Exchange, a right-of-centre think-tank, puts the cost of unfunded pension obligations to public-sector staff at £1.1 trillion, equivalent to 78% of GDP and higher even than Britain’s ballooning public debt. Such valuations are sensitive to the choice of discount rate used to convert future pension payments into today’s money. But even official government estimates have put the cost of these off-balance-sheet liabilities at around 50% of GDP. 
Whatever the precise worth of the pension promises, the arrangements in the public sector are manifestly more generous than what is now generally available in the private sector. The row over expenses has obscured the fact that MPs themselves enjoy an extraordinarily lucrative pension package. An austerity budget is looming after the general election due within a year, whoever wins it. Public-sector pensions are an obvious target.

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