Peter Tompkins: My solutions to the public pensions problem

The main conclusion is that public sector pensions typically cost the Government more than 40 per cent of salary, compared with around 20 per cent currently being paid in. The commission calls on the Government to be more transparent in explaining the costs in future, so that better decisions can be made about what we can afford to provide.

Private sector pensions are valued regularly and have shown large

levels of deficit in recent times. In other words, the funds they have invested are less than the liabilities to pay pensions in future – discounted to the present time at the rate of interest that they expect to earn on their investments.

One reason pension deficits abound is that returns on investments have been steadily falling but the main one is that people are living longer

and seem likely to continue living longer in future.

On the other hand, public sector schemes are "pay as you go" where pensions are paid with today's pension contributions. Apart from the Local Government Pension Scheme, there are generally no funds put away and invested, so you would not expect the future payments to be discounted based on the expected return on their investments.

But the Government does still discount future payments at a rate of discount 3.5 per cent higher than inflation (similar to what private sector funded schemes do), even though its own promises to pay inflation-linked payments to holders of index-linked stocks now earn only 0.8 per cent above inflation.

Using this artificial set of calculations, the Government says that if employees pay in 6 per cent (say) to the NHS scheme, then the employers need to pay in 14 per cent. Current pensioners are then paid out of the combined 20 per cent.

However, this is no longer enough and the Treasury has to pay in more than 4bn a year extra to meet pensions. An even bigger shortfall has emerged between the 20 per cent paid in and the true cost of providing pensions, which we have calculated are worth around 45 per cent of salary.

Hiding the true cost distorts the market for a number of reasons:

n Employees don't appreciate the full worth of their benefit package.

n Employers don't pay in the full value of what they are providing and are at risk of future large increases in contributions.

n Contractors cannot compete on an even playing-field for outsourced public sector contracts.

n Future generations of taxpayers will have to pick up the pieces for the balance of cost of paying out the pensions which employers are promising today.

n Maybe most importantly of all, the public can't make a proper

judgment of what the right level of pension should be.

Some of the choices for how pensions could be provided in future include:

n Raising member contributions by two per cent to bring in an extra

2bn a year.

n Increasing retirement ages for all staff, not just new joiners as the Labour government changes in 2005 did – that would save around 5bn a year.

n Changing from a final salary scheme to one where the pension is based on your average salary over your lifetime. This would hit high flyers hard and be fairer to the average worker but could save 10bn a year.

n Lower the benefit accrual rate, for example from 1/60th to 1/80th of salary for every year of service. This would also save 10bn a year.

We also looked at radical changes such as those that have happened for many private sector employers. This would involve setting up a defined contribution scheme where employees and their employers pay into a fund which is then used for buying a pension at retirement.

This would be a fairer regime but the problem with it is that we would be paying into people's pension funds straight away, while we still have to pay for all the pensions we have been promising in the past. In other words, today's taxpayer might end up paying twice.

A new commission has been set up by the Government with John Hutton leading it and we welcome this move.

We expect the solution to be a combination of changes but hope that it can examine increases in contributions, moving staff on to a single benefit scale for everyone and the possibility of a scheme based on employees' average salary replacing the final salary basis on which pensions have been provided in the past.

Peter Tompkins is the chairman of the Public Sector Pensions Commission which was set up by the Institute of Economic Affairs, the Institute of Directors and other organisations.