The sheer cost of gold-plated public sector pensions is today laid bare. Analysis for The Sunday Times reveals that unfunded inflation-proof retirement deals have saddled future taxpayers with a bill of £1.3 trillion — nearly half the national debt.

It shows a stark divide between the retirements of public and private sector workers, with one able to rely on the taxpayer while the other contends with investment risk and relentless tax threats.

Most workers in the public sector have generous defined benefit (DB) pensions, also known as final salary schemes, where your income in retirement is guaranteed and inflation-linked. They have all but disappeared in the private sector because they are too expensive to run.

As fears mount over the possibility of further tax hikes in the autumn budget to fill a multibillion black hole in the country’s finances, we reveal that:

• Public sector workers are annually gaining pension benefits worth as much as 82 per cent of their salary.
• Taxpayers will pay £57 billion this year to fund retired public sector worker pensions.
• Even if public sector pensions closed today, the yearly bill for funding existing pension promises would surpass £100 billion by 2050.

Neil Record, a former economist at the Bank of England who did the analysis, said: “Public sector pensions are one of the most damaging, and least understood, of the government’s long-term policies.

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“They are incredibly generous — way more generous than equivalent jobs in the private sector — and are set up like a Ponzi scheme, where today’s contributions are paying for today’s retirements and leaving the kitty empty.

“This is all taxpayers’ money. No wonder the fiscal position is so dire if successive governments have been content to allow this damaging policy to continue.”

The divide

Each scheme works slightly differently, but DB pensions typically pay an income until you die. It is normally inflation-linked and based on your salary and length of employment. The onus is on the employer to ensure that these pensions can be paid.

In 2006 3 million private sector workers and 5.1 million public sector workers were paying into DB pensions.

By 2019 the number in the private sector had dropped to 900,000 (and some of these are “quasi-public sector”, such as university and rail staff). Large companies such as BT, Marks and Spencer, Tesco, John Lewis, Rolls-Royce and BP have all closed their DB pension schemes. Hundreds of private schools have left the teachers’ pension scheme because of affordability fears.

In the public sector, however, the number of workers with a DB pension has grown to 6.6 million — even though the workforce has shrunk 11 per cent since 2006.

Private sector employees now typically save into defined contribution (DC) pots instead. These are “pot of money” pensions, where how much you get in retirement depends on how much you pay in and how your investments fare. They have the generous benefit of being held outside your estate for inheritance tax purposes, so can be passed on free from the tax, but from April 2027 this will no longer be the case, unless left to a spouse or civil partner.

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Importantly, in a DC scheme the onus is on you to ensure that you have enough in your pot to fund your retirement.

The cost

With DC schemes, the cost is easy to calculate. Under auto-enrolment rules, employees pay a minimum of 5 per cent of their salary and employers contribute a minimum of 3 per cent. Most private sector companies follow these minimums, but about a fifth of workers have an employer who contributed between 4 and 8 per cent, according to the Office for National Statistics.

With public sector DB schemes, the cost is more complicated. The government publishes the overall cost of matching the pension promises for unfunded public sector schemes, which stands at £1.3 trillion, but there is more to it.

Workers pay in more of their salary than private sector workers — NHS employees pay between 5.2 and 12.5 per cent, civil servants between 4.6 and 8.05 per cent and teachers between 7.4 and 12 per cent, for example — and employer contributions are certainly higher. The employer rate for the NHS pension scheme is 23.7 per cent of a worker’s salary, for the teachers’ pension scheme it’s 28.7 per cent and the civil service contributes 28.97 per cent.

But these contribution rates do not necessarily match up with the true cost of funding the pension benefits that are being offered. The true cost is what is known as the “current service cost”, a complicated sum calculated by the government. It is sensitive to wider economic circumstances, such as interest rates.

When interest rates were low, the cost of matching the pension benefits that were being promised was staggeringly high. For example, official documents for the teachers’ pension show that in 2021, teachers built up pension benefits worth 65.8 per cent of their salaries. In 2022 it was 77 per cent and in 2023 it was 82.3 per cent. This year, because interest rates are higher, it’s 22 per cent.

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John Ralfe, a pensions consultant, said: “Over the course of the last few years, the cost of new pension promises has gone down a lot because interest rates have gone up a lot.

“But the cost of servicing these pensions could go back up again. While at the moment the contributions match how much the pension is actually costing, it may not always be the case. The cost has been as high as 80 per cent of someone’s salary.”

Then there is the cost of paying today’s retired public sector workers. The forecast for the 2025 bill is £56.8 billion — the highest yearly cost yet.

And according to Record the annual cost to the taxpayer is only going to grow. He estimated the cost of meeting the public sector pension promises that have already been built up (so if the schemes were closed to new members and any new pension promises today) and found that the yearly bill would surpass £100 billion in 2049.

In fact the cost would peak in 2061 at £132 billion and the taxpayer would only stop paying pension promises by the year 2106.

The future

In an interview with this paper three years ago the pensions minister at the time, Guy Opperman, said that public sector pensions “should be reformed” and that the present system was “not sustainable” on a long-term basis.

The problem for any government is how to change tack — both practically and politically.

“While the pensions apartheid between public and private sector workers is pretty glaring, reform is incredibly difficult if not practically impossible. Most obviously, any attempt to reduce pension entitlements, even in return for higher pay, would almost certainly lead to another wave of strikes,” said Tom Selby from AJ Bell, an investment platform.

“The other side of the huge cost of public sector pensions is, of course, massive value to public sector workers. Any conversation about public sector remuneration needs to take account of these gold-plated pensions.”

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Then there’s the fact that any shake-up would probably cause cashflow trouble for the Treasury. Public sector pensions are operated on a pay-as-you-go basis, so contributions made today fund the incomes of retired members.

If it switched to a DC system, the government would need to pay employer contributions to the existing workforce (straight into those employees’ pension pots) and find the cash to pay the pensions of retired workers.

Record suggests offering all public sector workers the choice of leaving their pension scheme for a permanent boost to their pay. Anything their employer paid into their pension would simply be directed to their payslip. The government should then set up an NS&I-style pension scheme, which would be available to public and private sector workers.

Other options include a public sector “superfund”, a pension scheme consolidator that would aim to make a profit and take pension liabilities off the taxpayer. When they were in power the Conservative government said a superfund was not the best option for public sector schemes, however.

There are also collective defined contribution schemes, or CDCs, which have been trialled by Royal Mail. They are a bit of a halfway house between DB and DC schemes, but would still be a serious downgrade from the security of final salary schemes for public sector workers.

Selby said: “In short, there are very good reasons why politicians are nervous about grasping the public sector pensions nettle. And I very much doubt Rachel Reeves is in the mood for getting stung given where Labour currently sits in the opinion polls.”