The chasm between public and private-sector pensions is already marked, but the inequality is set to widen.
Final salary pensions – the most generous sort, which pay a retirement income linked to employees’ wages and length of service – are all but extinct for those of working age in the private sector.
But these guaranteed pensions remain a key benefit for public-sector workers and a source of growing envy for everyone else. In the private sector, most schemes have been replaced with so-called “defined contribution” pensions, into which staff save a percentage of their salary, plus a contribution from their employer. But the overall amount saved has fallen dramatically. The benefits received at retirement depend on stock market performance, and there is no guaranteed level of income.
How much more generous are public-sector schemes? Analysis by Tilney Bestinvest, a financial planning firm, shows that on average the income provided by public-sector schemes is five times more generous than a defined contribution pension in the private sector.
Using the NHS pension scheme from 2015 as an example, a fully qualified nurse aged 25, earning £21,692 and joining the pension scheme today, will typically contribute 7.1pc of salary each year to fund their retirement. If they work for 40 years, stay in the same band of earnings throughout and attain 4pc annual increases in pay, they could retire on an annual salary of £45,500 in today’s money.
When they stop working, they will have amassed a pension worth £30,700 a year in today’s money, equating to more than two thirds of their final salary. This income is guaranteed by the state and will also increase each year in line with inflation, protecting its value over time. Taking into account the fact that retirees typically have lower outgoings and pay no National Insurance contributions, this is a significant pension income. So how does that compare with pension provision outside the public services?
Taking into account current annuity rates, if someone wanted to purchase the same level of income for life at the age of 65, they would need a defined contribution pension fund worth £2.2m. This would involve the nurse contributing 43pc of her gross salary into a pension, assuming her fund grows by 5pc a year excluding charges. Assuming the nurse saved 9pc of her salary throughout her life and achieved 5pc net investment growth a year, she would end up with just over £458,000 in her pension at retirement. This could provide an increasing income of £6,366 a year at age 65 – around a fifth of the final salary pension.
Pension limits: one rule for public and another for private sector. The lifetime pensions limit, against which savings are tested when you take your pension benefits and on certain other key events, allows savers with defined benefit pensions – the vast majority of whom are in the public sector – to build up larger pensions without breaching it. Savers who exceed the lifetime limit, which is reducing from £1.25m to £1m in April, will be charged 55pc tax when they withdraw pension money above this level. The disparity is created because the limit is calculated differently depending on which type of scheme you are in.
For savers with final salary pensions, the lifetime limit is calculated by multiplying the expected income at retirement by 20. This means someone with a £50,000-a-year pension income would still fall within the new £1m limit and could avoid penal tax. For savers with defined contribution pensions, the lifetime limit is simply compared with the overall fund value.
But currently low annuity rates mean even large pots of £1m or more buy relatively little annual income. According to Legal & General, the insurer, a £1m pot would buy a 65-year-old man a retirement income starting at just £29,000 a year, assuming the income would rise by a modest 3pc a year and that his spouse would receive a half-share of the pension if he died first.
So are public-sector pensions running on borrowed time? One of the main reasons final salary schemes are rapidly disappearing for staff of private companies is that their workplaces are suffering from a pensions hangover from the Eighties and Nineties. Since life expectancy has risen unexpectedly, young workers are now helping to pay the price for their older colleagues’ longer retirement.
Wages have fallen from 87pc to 83pc of total employment costs over the past decade, according to research by Towers Watson, an actuarial firm. By far the most important explanation for this is increased employer pension contributions, as companies have been forced to plug growing deficits in their final salary pension schemes – which have promised to continue to pay older workers’ generous guaranteed pensions until the day they or their spouses die.
Taxpayers who fund public-sector pensions face the same pressures, but because workers are backed by strong unions and their benefits are protected by special government powers, they remain generous.
But this doesn’t mean that the disproportionately generous pensions public servants enjoy today won’t be scaled back at some point in the future. In fact, some experts say that this is inevitable.
For example the Intergenerational Foundation, a think tank, has estimated that Britain faces a £1.3 trillion liability for pensions, equivalent to a £45,000 burden per household. It argues that this is an “unaffordable” cost for younger generations, who are struggling with high housing costs, unemployment and students debts.
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