David Bell: Cost of tackling pensions crisis will worsen if we ignore it PUBLIC and private sector liabilities, an increased life expectancy and a shrinking economy are creating a perfect storm, writes David Bell Last night I conducted an experiment. I imagined that I was 65 and had £100,000 to invest in a pension. Based on my postcode and the fact that I am a non-smoker, the best offer I could find on the web would pay me £305 per month if I wanted to increase the pension each year in line with inflation. An annual pension of £3,660 hardly seems a very good return for my £100,000. Admittedly if I was prepared to forego any adjustment for prices, I could get £6,120 per annum, but this still seems a meagre reward. All of which goes to show that buying a pension in 2012 is very expensive. This is not good news for anyone close to converting their savings into a pension. The high price is partly the result of the weakness of the economy. Returns on investments in general, and government bonds in particular, are extremely low. Pension funds invest heavily in government bonds because they offer a relatively risk-free return and therefore provide a secure cashflow from which to pay pensioners. Unfortunately, the yields on UK government bonds are at historically low levels. The cost of pensions is also a real headache for governments because they are responsible for paying the pensions of public sector workers. The government funds organisations that make employer's contributions on behalf of their employees towards pension schemes. It also ultimately pays the workers themselves who make employee contributions towards these same schemes. In Scotland, the public sector accounts for around 23 per cent of the workforce. The potential cost of all of the UK government's public sector pension liabilities is an eye-wateringly large amount. Even back in 2008, the unfunded liabilities associated with UK public sector pensions were estimated to exceed £1.1 trillion. Scotland's share of this total is close to its 8.4 per cent share of the UK's population, and still a frighteningly large amount. Yet the story of public sector pensions is a little more complex than these headline figures suggest. Public sector workers contribute more to their pensions than do those in the private sector. Almost 60 per cent of both male and female public sector workers make pension contributions of at least 6 per cent of earnings. Only 22 per cent of females and 25 per cent of males working in the private sector make contributions in excess of 6 per cent. Around 20 per cent of employees in the private sector make no pension contribution at all. Employer contributions follow a similar pattern. Almost all employers in the public sector contribute more than 12 per cent of earnings towards workers" pensions. In the private sector, only 30 per cent of employers exceed a 12 per cent contribution. Employers in the public sector are far more generous in supporting employee pensions than those in the private sector. This partly explains why public sector pensions are typically larger than those in the private sector. Average weekly pensions range from £81.20 for ex-civil servants to £301.40 for ex-police officers. The low-level of civil service and local government pensions partly reflects large numbers of low-paying jobs. In such jobs, shorter hours and more opportunities to transfer to other sectors shorten average lengths of service and therefore pension entitlement. At the other end of the spectrum, police officers accumulate pension entitlement more rapidly and change occupation less frequently. Pensions for men are significantly higher than those of women reflecting higher career earnings among men, which then results in larger pensions. For women, career interruptions reduce their length of service, which reduces the value of their pension. Many public sector pensions are larger than the average total pension income of those with occupational or private pensions in Scotland. And there are many of pensionable age who have no pension other than the state pension. Public sector pensions are higher because wages are higher in the public sector: by 11 per cent on average. Thus, even if contribution rates were equal across the private and public sectors, public sector pensions would be greater. The public sector "wage premium" is increased if the hidden benefits of these more generous pensions are taken into account. The Institute for Fiscal Studies estimates that the value of the pension advantage enjoyed by public sector workers is equivalent to 12 per cent of earnings. So public sector workers and their employers put more into the pension system and they get more out. Where's the problem? The issue is that there is a relatively powerless third party in this bargain - the taxpayer. It is ultimately the taxpayer that pays for all public sector pension contributions. The taxpayer also pays directly when public sector pension funds run short of cash to pay current pensioners. In Scotland, such shortfalls are mainly met by the UK Treasury. These payments are outside the Scottish Government's main account and therefore do not mean that pension shortfalls have an immediate cost in reduced spending on roads, schools and hospitals. If Scotland became independent, these costs would fall on the Scottish Treasury. Their size wouldn't change, but the trade-off between pensions and other spending priorities would be more obvious. The taxpayer may also feel aggrieved because the quality of pensions offered in the public sector is generally better than those available from private sector employers or from investing in a private pension. All of the major public sector pension schemes in the UK are a defined benefit. Their value is set by rules reflecting job characteristics such as maximum career earnings, length of service etc. Most private sector pensions are defined contribution schemes where pensions depend on the investment return from the accumulated contributions of employers and employees. With these schemes, the employee takes the risk when these contributions are invested in the market. With defined benefit schemes, the pension fund takes the risk and in the case of public sector pensions, this ultimately means the taxpayer. Even large companies are no longer prepared to shoulder pensions" risk. Shell was the last FTSE 100 company to maintain a defined benefit scheme for all employees. It closed this scheme to new workers at the start of 2012. Changes in the way that pensions are dealt with in company accounts have also had a negative effect on the willingness of companies to accept pension risk. The other major risk issue for pension design is increasing life expectancy. Between 1950 and 2010, life expectancy for males and females in Scotland has increased by more than ten years to over 80 for women and 76 for men. Yet actual retirement ages have changed little. The length of working life has not increased but life expectancy post retirement has grown significantly. The inescapable logic is that if pension contributions do not increase, but life expectancy does, then the annual value of pensions must fall. Hence both the Labour and coalition governments have tried to raise employee contributions and/or increase retirement age. In addition to the problems raised by demographic change, a slowing economy means reduced returns for all savers, including pensioners. It also reduces tax receipts, making the competition for the use of these receipts even more intense. This increases the potential conflict over the costs of public sector pensions, particularly where they have a guaranteed value irrespective of the state of the economy and of the rate of inflation. The tricky issue of how to design an effective and fair pension system will not disappear if Scotland becomes independent or if, under a fiscal autonomy deal, it takes full control of pensions in Scotland. Perhaps a Scottish government would wish to start by prioritising private sector pensions and particularly those not making any provision for retirement. And even if private sector pensions can be improved, public sector pensions will still have to be funded, which will be a headache, whatever the constitutional settlement. What is clear is that this issue needs to be considered sooner rather than later: almost all members of pension schemes are involved in contracts that extend beyond 2014. They need to know how these will be managed and regulated. David Bell is Professor of Economics at Stirling University and Director of the Work and Wellbeing strand of the Scottish Institute for Research in Economics. Public Sector Remuneration in Scotland, from the David Hume Institute is available at www.davidhumeinstitute.com