A recent Treasury technical notice has revealed that employer contribution rates for unfunded public sector pension schemes, such as the Teachers’ Pension Scheme and the NHS Pension Scheme, are likely to rise more steeply than anticipated from April 2019. 

However, while additional funding has been promised for 2019-2020, there is no such guarantee for future years. In a separate development, employee benefits may well rise because member-related costs have been lower than expected.

Rising employer contributions

Employer pensions contributions are set by reference to the cost of benefits being built up. The total cost of future benefits payments is discounted to reflect investment returns, on the basis that money invested today can be expected to generate a certain return and so there is no need for 100% of the future cost to be paid today. Although the Government doesn’t invest contributions received from the unfunded public sector schemes, the cost of future benefit payments is still discounted by the interest rate paid on index-linked government bonds (gilts).

The Office for Budget Responsibility’s forecast of lower long-term economic growth has led the Treasury to reduce the discount rate for public sector schemes. It had already decided in the 2016 Budget to reduce the rate from 3% to 2.8% from 2019. However, the Treasury has now decided that a further reduction to 2.4% is required to prevent a widening gap between what it receives in contributions and pays out in pensions.

This means that employers participating in the unfunded public sector schemes can expect higher contributions. The current employer contribution rate for the Teachers' Pension Scheme (TPS) is 16.48% of pensionable pay, while the rate for the NHS Pension Scheme is 14.3%. Early indications are that the employer contribution rate for the Teachers’ Pension Scheme will rise to 23.6%. The extent of the rise for the NHS Pension Scheme is not clear at this stage. This won’t affect the Local Government Pension Scheme as this is a funded scheme.

The Treasury has advised that public bodies will be supported in meeting unforeseen costs in the 2019/20 financial year when the changes first take effect. However, compensation beyond the first year cannot be guaranteed. Affected employers will, therefore, be forced to make costly changes without any certainty that government funding for front line services will be proportionately increased in years to come.  Of course, where employers have no access to government funding, they will bear the whole cost of any increase themselves.

Rising benefits

Reform of public sector pensions in 2014/2015 introduced a cost control mechanism to protect both employers and employees against unforeseen changes in member-related pension costs. A cost ceiling was introduced to protect employers against a significant unexpected increase in costs relating to assumptions about the profile of members such as life expectancy, growth in salaries or career paths. Alongside that, a cost floor was also introduced if there was a significant unforeseen decrease in costs relating to the same assumptions. Breach of the ceiling results in a reduction in benefits for employees and breach of the floor results in an increase in benefits or lower contributions. It should be noted that the cost control mechanism does not control “employer” costs – broadly these are financial or technical assumptions, such as the discount rate or actuarial methodology used – only “member costs”.

Alongside the lowering of the discount rate, the Treasury also indicated that at least some, if not all, schemes are expected to breach the cost control floor, as “member” costs measured by the cost control mechanism have decreased by more than 2% of pensionable pay. The fall in scheme costs has been attributed to the Office for Budget Responsibility’s reduced forecast for economic growth and short-term pay growth and the Office for National Statistics’ reduced life expectancy forecast meaning that pensions will typically be paid for a shorter period. In order to rectify the breach, an increase in future accrual rates is anticipated, to ‘balance out’ these cost downward pressures.

The Local Government Pension Scheme has an additional cost control mechanism which it needs to run before any assessment is made about whether there is any breach of the Treasury’s cost control mechanism. The Treasury has also made it clear that it will look to move LGPS valuations from a three-yearly to four yearly basis for consistency with the other public sector schemes, which is likely to see the next LGPS valuation postponed until 2020.

Commentary

In practical terms, the implementation of these proposals would mean that:

  • Public service providers would have to increase employer contributions to the Treasury with no guarantee that the additional monies would be compensated beyond 2019/20;
  • If public bodies are not compensated for the increase to contributions beyond the first year, this would mean an indirect spending cut;
  • It will become more expensive to hire workers who participate in public sector pension schemes;
  • Employee contributions will not be impacted; and
  • Workers in public sector pension schemes will receive improved pension benefits (or pay reduced contributions) from April 2019 until at least March 2023, after the next full assessment of public sector pension schemes.

Employers may wonder why benefits would be going up (or employee contribution rates going down) while employer contribution rates go up.  The reason for this is that the coalition government gave a commitment that there would be no rise in employee contribution rates for 25 years, and because “member” costs have decreased while “employer” costs have increased.  Under the cost control mechanism, this means a better deal for members, with no increased cost to them, meaning that employers will have to pick up the bill.  Criticism has already been levelled at the Treasury, with many concerned that the overall result of the changes would be backdoor spending cuts for already tightly-squeezed public bodies and those delivering public services.

While these recent proposals leave public sector employers and those delivering public services in a state of uncertainty, they should note that any changes would not be implemented before the 2019/20 financial year, and so no immediate actions are necessary. Employers should, however, be mindful that any changes are likely to squeeze budgets even further in the long term. Arrangements beyond the next financial year will likely be finalised after the 2019 Spending Review, which will set spending for the 2020/21 financial year as a minimum, possibly longer. In the meantime, public service employers and departments can comment on the draft proposals, which will not be finalised until later this year following a statutory consultation with the Government Actuary Department.

For more information

Please contact Douglas Mullen.

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