Public service pensions: Less for more?

The Government announced in September that public service employers would have to pay more towards their employee’s pensions from April 2019. At the same time, public service workers would get better pension benefits. This has led to some head-scratching. Why is the Government proposing to increase pension benefits only three years after introducing reforms to reduce costs?

This Insight will explore the two mechanisms driving these changes: a reduction in the SCAPE discount rate and a target cost for pension benefits, linked to members’ life expectancy and earnings.

The first mechanism will force employers to pay more, while the second will entitle employees to better benefits.

The SCAPE discount rate

The main public service pension schemes (other than for local government) operate on a pay-as-you-go basis, which means that contributions from employers and employees are paid to the government department, which meets the cost of pensions in payment.

The schemes are subject to four-yearly valuations so that contributions are set at a level that reflects the costs of the benefits being built up. These valuations are done based on assumptions set by HM Treasury, including the ‘SCAPE discount rate’ (used to convert a future stream of pension benefits into a single figure, in today’s terms). Following a review in 2010, the Government decided to link the SCAPE discount rate to long-term expectations of GDP growth. It would review the discount rate every five years and the basis on which it was set, every ten years.

A reduction in the discount rate will – all other things being equal – increase the contributions employers are required to pay. That is because the rate ‘discounts’ future pension costs to a figure in today’s terms. A lower discount rate means a smaller discount for the employer.

The Government announced a reduction in the SCAPE discount rate, from 3% to 2.8% in the 2016 budget, which it expected would cost public service employers £2bn in 2019/20. On 6 September 2018, it announced a further reduction – from 2.8% to 2.4%. On the basis that a reduction of 0.2% costs £2bn, the cost of a 0.4% reduction has been put at £4bn.

The Government said that the increase in costs anticipated at Budget 2016, would need to be met in full by Government departments and the devolved governments. It would compensate them for the increase in costs resulting from the further reduction for the first year (2019/20) and would consider whether to do so beyond this as part of the spending review. The exact employer contribution rate from 2019 will be set at valuations of the scheme as at March 2016, results of which are due later this year. Concerns have already been expressed about the potential impact on schools and the health service.

The employer cost cap mechanism

The Coalition Government expected its reforms to public service pensions under the Public Service Pensions Act 2013 to significantly reduce the cost of public service pensions (from 2.1% of GDP in 2021–22 to 1.3% in 2066–67, according to the Office for Budget Responsibility in 2017). It said it was a long-term deal – to last for 25 years – that would keep costs sustainable and under proper control and set a ‘high bar‘ for future governments to change the design of the schemes.

At the same time, it introduced ‘an employer cost cap’, to protect the taxpayer from significant unforeseen increases in cost. The cap applies to costs relating to members of pension schemes (such as assumptions about their life expectancy or earnings growth) – on the basis that members should pay for ‘significant’ increases in costs from which they will benefit. But it does not apply to costs that arise from changes to financial assumptions, such as the discount rate. Costs must remain within a margin of two per cent either side of the cap, otherwise, action must be taken to return them to target.

Ironically, given that the legislation refers to a ‘cost cap’, initial results from first post-reform valuations, show that the cost of the schemes has fallen below the target. As a result, public service workers are to get improved pension benefits for employment over the period April 2019 to March 2023. Discussions will take place on how to do this, with an increase in the rate at which benefits build up being the default if no agreement is reached.

The Chief Secretary has asked the Government Actuary’s Department to review the cost cap mechanism to ensure it was “working as intended and delivering the Government’s objective to protect taxpayers and workers from unforeseen increases in cost.” The trade union Prospect objected saying that, “the Treasury should accept the results which simply reflect the reality that the reforms to these schemes have worked and the costs have fallen.”

Therefore, at the same time as pension benefits are increasing because they are costing less than expected, employers are being asked to pay more due to a change in the technical assumptions used to estimate future costs.

Further reading

 Djuna Thurley is a Senior Library Clerk at the House of Commons Library, specialising in pensions.