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Report – The radical option in UK pensions

February 2024 • Rebooting UK capital marketsby Toby Nangle

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This paper analyses the potential political, fiscal, and economic benefits of shifting the huge unfunded public sector pensions schemes in the UK from a pay-as-you-go model to a funded model. Such a move would enable them to be global investment powerhouses, driving long-term sustainable outcomes for public servants, cheaper finance for the Treasury, better outcomes for taxpayers, higher levels of investment, deeper capital markets, and a more stable international investment position.

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The active debate on the future of pensions in the UK is vitally important for the long-term prosperity of the UK and its citizens: what should the pension system look like if it is to deliver better retirement outcomes for millions of people across the country and – simultaneously – drive more long-term investment in every corner of the UK?

Most of the debate over the past few years on the reform of pensions has focused on the funded part of the system: private sector defined benefit pensions, defined contribution pensions, and the Local Government Pension Scheme. All of these pensions are funded in the sense that the pension contributions paid by employers and employees are invested in a range of assets to generate returns (how and where they are invested has been one of the key topics of debate) and these assets are used to pay the future pensions of members.

But it has largely ignored the elephant in the room: the giant unfunded public sector pension schemes for around nine million current and former NHS workers, teachers, civil servants, and other public sector workers. These schemes are unfunded in the sense that the (generous) pension contributions paid by employers and employees each year are not invested but instead used to pay the pensions of retired members of the schemes (known as a ‘pay-as-you-go’ model).

Part of the solution?

These schemes are huge – the future pension liabilities sit off the government’s balance sheet but are bigger than the national debt – poorly understood, and complex. They have been criticised for being too generous compared to private sector pensions, too expensive, and unsustainable in their current form. But there has been a strong sense running through the policy debate on pensions that they could be part of the solution.

That is why we commissioned Toby Nangle, former senior asset manager and financial expert, to explore the case for transitioning these schemes to a funded model. The paper makes a strong political, fiscal, and macroeconomic case for reform, and explores how Canada successfully shifted its pensions system to a funded model over the past 40 years. He argues that:

  • Shifting to a funded model would enable these schemes to become global investment powerhouses – the NHS scheme alone would be the third largest pension scheme in the world.
  • They would become more politically sustainable, driving better long-term outcomes for public servants and setting an example for the rest of the UK pension system to follow.
  • The cost of funding these schemes would be lower for the government, providing a better deal for taxpayers.
  • Transitioning these schemes would lead to higher levels of investment and deeper capital markets in the UK, and a more stable international investment position.

While the potential benefits are clear, such a move would face significant opposition and would require bold political leadership. The best time to have started this transition would have been decades ago. The second best time is now.

Here is a short summary of this report:

1) The elephant in the room: the UK is a a world leader in private pensions with the second largest pool of pensions assets after the US. Private defined benefit schemes are well-funded, and auto-enrolment defined contribution pensions have increased the proportion of UK citizens with a private pension. But the largest pensions schemes in the UK are unfunded public sector schemes. They are poorly understood sleeping giants and have been largely absent from the debate.

2) A question of scale: these unfunded schemes for public sector workers in the NHS, teachers, civil servants, and other sectors are roughly the same size as all private sector defined benefit pensions combined, with notional assets of around £1.3 trillion. The five largest schemes are comfortably in the 20 largest pension schemes globally.

3) A different model: unlike private sector pensions, these schemes operate on a pay-as-you-go-basis, with payments to retired members of the schemes paid each year out of employer and employee contributions with a top up from central government, instead of through investments.

4) The current system is not broken: despite alarmist calls to the contrary, reforms delivered since 2013 have left the system fiscally sustainable. But moving schemes towards becoming fully funded would deliver a step-change in their political sustainability and address key macroeconomic vulnerabilities in the UK economy, and they could save taxpayers hundreds of billions of pounds.

5) The political case for change: from the perspective of the recipient, an inflation-linked defined benefit government guaranteed pension cannot be improved upon. But in the growing absence of private sector defined benefit pensions, public ones are increasingly portrayed as unfair and unaffordable. Public service pensions have become a political football, and funding them would both put them on a level playing field with remaining defined benefit schemes and link them to substantial fiscal and macroeconomic benefits. This would improve their political sustainability, increasing the security of millions of scheme members.

6) The fiscal case for change: public service pensions are an integral, large, but unscrutinised form of public sector financing. Financing them on today’s market terms (through the gilt market instead of the current system) would save HM Treasury over the next two decades around £70 billion; channelling new employer and employee contributions into investments could save taxpayers over £600 billion.

7) The macroeconomic case for change: funded pensions would increase the stock of savings, deepening pools of capital that can be drawn on to enhance the capital stock and help finance the transition to net zero. Higher national savings rates would help address the UK’s chronic serial current account deficits and deteriorating net international investment position, so improving macroeconomic resilience.

8) A model to follow: Canadian provincial public service pensions began to transition from unfunded schemes at the end of the 1980s. They offer lessons as to how to integrate independent governance, professional in-house investment management, substantial scale, and comprehensive geographic and asset-class diversification. Other markets such as Sweden also provide a potential example to follow.

9) The likely pushback: on-balance sheet government debt is already high; choosing to bring off-balance sheet liabilities on-balance sheet, even if this results in fiscal savings, increases balance sheet risk for the government, and potentially reduces consumption. Shifting to a funded model would increase the ‘financialisation’ of public sector pensions (generating huge fees for greedy bankers and asset managers) and the ‘politicisation’ of pensions, with bad investment decisions made for political ends. We address all these critiques and argue that on balance the potential benefits offset the risks.

10) Seizing the opportunity: the huge unfunded public sector pensions have been largely absent from the recent active political debate on the structure and future of pensions in the UK. At a time when the UK economy and UK citizens need all the help they can get, we think there is an opportunity to be seized in reforming these sleeping giants.

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