In this final post examining the current pension landscape in the UK, we turn our attention to pension schemes for public servants such as teachers, doctors, nurses and civil servants.

Each government department has its own defined benefit scheme – members receive an income on retirement which is linked to their salary. In addition, both members and employers pay contributions into the scheme. 

But unlike defined benefit scheme offered by the LGPS, these schemes are unfunded. The contributions are not used to make an investment but instead to pay current pensions.

In other words, these public sector pensions, like state pensions, are pay-as-you-go schemes. As the contributions are based on the future value of the benefits earned rather than the current cost of the pensions to be paid, they are insufficient to pay current pensions and need to be topped up by each government department. 

Some argue unfunded pensions can be more efficient than funded ones as they rely on asset managers and investment consultants both of whom make profits from their service.

But just like state pensions, unfunded public sector can become more expensive for governments and tax payers when demographics become a potent problem. 

When a significant proportion of the population ages and birth rates fall then the dependency ratio rises. The burden on the working population increases and forces governments to either increase their tax revenues or increase their borrowings to fund these public sector pension promises.

Optimistic valuations

That’s not the only way public sector pensions can prove expensive for future generations. I’ve explained how private sector defined benefit schemes started to look like expensive liabilities when accountancy changes forced companies to value these schemes using a market-based discount rate.

In recent years there have been several discussions pointing out the mismatch between the discount rate used by the government actuaries when valuing public sector pensions and those used by the private sector.

As I discussed private sector defined benefit scheme pensions are valued using discount rates linked to current corporate bond rates which are currently at very low levels.

In contrast, the government actuarial department uses a discount rate which is inflation plus around 3%. That is much higher rate than the one used to value private sector pensions.

The government has argued as pensions are paid out of tax revenues the discount rate should reflect GDP growth. But covid has sharply constrained the UK’s economic growth rate making that current discount rate look overly optimistic.

If vaccination goes to plan, then an economic rebound should be expected later this year. But longer term growth prospects will be further constrained by the impact of Brexit. 

In other words, the combination of covid and Brexit make it harder for the UK to achieve a growth of rate of more than 3% over the short- to medium-term, which would make the current valuation of public sector pensions at £1.9trn look like an underestimate.

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