The fierce debate in the UK over public sector pension reform continues, as the Hutton report recommends phasing out final salary schemes for state employees. But could scrapping them have a negative overall economic effect?

Most UK firms chose to wash their hands of their final salary defined benefit pension schemes a long time ago, leaving its employees to cast an envious eye over the final salary retirement benefits that are still available to the country's public sector workforce.

This looks set to change however in the near future, after Lord Hutton's commission into public sector pension reform branded the final salary link as "inherently unfair" and called for a career average revalued earnings (CARE) system to replace the current status quo.

Hutton, a former pensions minister with the last UK Labour government, has not managed, however, to put an end to the debate with his final report.

Professor Andrew Oswald, Professor of Economics at Warwick University, a defender of final salary schemes, told Pension Funds Insider this week that he did not believe that Hutton's arguments made "much sense".

He argues that final salary pension schemes can be justified through the application of standard labour market economics, in both the public and private sector. The fact that they are now unaffordable, given rising longevity, should have forced an adjustment in DB formulae to reflect our greater lifespans, rather than wholesale radical change.

Hutton, claims Oswald, has failed to build a solid argument against final salary schemes in principle. He has also neglected to confront a major issue: the role of incentives within overall remuneration.

The behavioural economics expert says that final salary schemes can be used to encourage people to be productive in their later working lives. Under the present system, if someone in the public sector works hard to get another promotion, then their effort can be rewarded through a multiplier effect that is reflected in their retirement package. "The public sector needs people to be motivated in this way with final salary schemes. Productivity like that is not mentioned in the Hutton report. It appears to have forgotten that pensions play a vital role in creating incentives," he says.

"There's not nearly the same incentive under CARE. What incentive will university lecturers have to keep publishing research or delivering really good lectures?"

He also points out that the abandonment of final salary will mean that 'high flying' public sector employees will have to be paid a lot more; something that the general public will not like.

But doing that while restricting their pay through their pension, with a CARE scheme, doesn't make logical sense. "You might as well say that the pay packet of the chief executive should somehow reflect the wages of the factory worker. Well, the Soviet Union showed us that that was a disaster," he says.

Magic money

Ros Altmann, Director-General of the Saga Group, an insurance and travel group that focuses on the over-50s, has a very different view. She is adamant that final salary pension schemes "just don't fit in with 21st century capitalism".

In her view, there has been an air of unreality around final salary schemes for too long. Employers in the private sector were led to believe that the "magic" of the stock market would miraculously fill their huge funding gaps, while public sector retirement plans, unfunded as they are, have been subject to inaccurate assumptions, which have led to their true cost being hidden away.

"Pensions are not cost free," she says. "If someone is on a £100k salary, they don't know how much their pension actually is. Sometimes it's 30% extra salary over a lifetime."

There have also been cases of public sector services being outsourced to the private sector, where firms have had to meet pension obligations that have cost as much as 50% - or more - of total salary, she claims.

"If you need to pay people more money to do a good job, let's make it transparent. Some people appear to think that pensions are cost-free."

For Altmann, it is the uncertainty and negative effect on future financial planning that outweighs any positive effects that final salary schemes have on companies' productivity. 

Final salary schemes, she says, impose salary inflation risk as well as longevity risk, on firms and the government's resources.

"Every year that you keep your final salary promise it's an increase in cost, because life expectancy is increasing every year. So each year workers are getting a pay rise, but they don't know it or appreciate it."

She claims that old-fashioned 'vested interest' approaches to the debate will continue, but advocates of final salary ignore the fact that the majority of public sector workers will in fact have a better pension thanks to a CARE scheme.

Oswald, however, maintains that DB schemes have shown their value in helping protect the interests of the average human being. DC schemes, he believes, are suitable for individuals who are very well-off, financially literate and have self-control: which is not an accurate description for 90% of the UK's population.

"People have observed one problem and tried to solve it with a completely inappropriate method. DB schemes are expensive. But to go over to DC (in the private sector) and CARE is an unfortunate short-run reaction and human welfare is going to suffer as a result of it over the next century."

mhandzel@wilmington.co.uk 

First published 24.03.2011