Sorting out public sector pensions: Reduce future benefits and increase the level of personal contributions.

Graham Duckett, pensions specialist and partner at Chartered Financial Planners Wardour Partners LLP looks to the emergency budget on Tuesday to clear up the misunderstandings around public sector pensions in order that the Government can have a more transparent view of the UK’s finances.

 Private Sector Defined Benefit schemes

Most employers in the private sector would love to wind up their DB schemes for a number of reasons, amongst which are:

•    Volatile investment markets and the recession
•    FRS17 reporting obligations
•    Increasing life expectancy of members
•    Increased taxation of pension funds
•    Additional pension contributions impacting on dividends paid to shareholders
•    Increasing regulatory focus on the role of pension scheme trustees
•    Increasing levies payable to the Pension Protection Fund (PPF)

A main consideration for employers wishing to close DB schemes is the conflict of interest for Finance Directors (FD) and other directors. In many smaller companies the FD is also a trustee of the pension scheme, and with the role of the trustee nowadays demanding an increasingly more aggressive stance to pursue adequate funding levels from the employer, managing both roles has become impossible.

In reality, winding up DB schemes is somewhat harder to do. Since June 2003, schemes are obliged to offer a full buyout pension to every member upon wind up in the form of a 'non-profit deferred annuity' (NPDA). This guarantees to pay the precise amount of entitlement promised by scheme rules. However, the lack of competition between insurers in this market has led this to being an unnecessarily expensive exercise and therefore made it more impractical to close a DB scheme.

Consequently, the winding up process is complex and can take several years to complete.

But if an employer wishes to close the scheme, there is a step-by-step procedure to do so:

1.    Close scheme to new joiners
2.    Amend benefit shape for future accrual for existing active members
3.    Cease all future accrual for active members and replace with a money purchase scheme
4.    Conduct an Enhanced Transfer Value Exercise for non-retired members
5.    Secure any remaining benefits via an NPDA

Employers with more than 50 employees are required to undertake a formal consultation with staff and scheme members prior to ceasing accrual in the scheme, which can lead to communication sensitivities. S67 of Pensions Act 1995 also determines that no benefits already accrued by members can be reduced without the agreement of the entire membership. The process therefore needs to be carefully managed with legal, actuarial and independent financial advice an essential.

Public Sector Defined Benefit Schemes

Whilst many employers in the private sector have been forced to start the process of winding up their DB scheme, employees in the public sector are still able to enjoy the luxury of preferentially or even fully index-linked benefits. With government action to curb the nation’s current account deficit, there is a growing expectation that this could be about to change. If so, it will be interesting to see if the restrictions applicable to private sector schemes will apply in the public sector. For example, why is a private sector employer required to disclose an FRS17 amount which reflects the deficit in its pension in its accounts, when there is no obligation for the government to do so?

Many public sector pension schemes are “unfunded,” meaning benefits to retirees are paid directly from tax revenues in a similar way to state pensions. This means the UK taxpayer in the private sector is inadvertently funding the generous pensions of their public sector counterpart. It is therefore crucial that tax advantages and reliefs are not tinkered with any further to avoid the majority of the population giving up on private provision altogether and relying on the state.

The lack of transparency in the cost of the public sector’s pension schemes has led to a complete misunderstanding of the effect on the UK’s finances. It is top priority and must be tackled in this week’s budget. It can be achieved by reducing future benefits and increasing the level of personal contributions.