Audit Committee, 27 Jun 2006

Meeting date: Tuesday, June 27, 2006

Official Report 201KB pdf

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“Public sector pension schemes in Scotland”

For item 3, we will receive a briefing from the Auditor General for Scotland on the report "Public sector pension schemes in Scotland".

As I am sure committee members are well aware, there are six main public sector pension schemes in Scotland. As I say in the report, those schemes will provide retirement benefits for about 950,000 people. In other words, nearly one in five people in Scotland has some entitlement to a public sector pension. The report sets out the current funding position for public sector pension schemes in Scotland. It draws on information that is publicly available but has never before been pulled together into one public document.

Recent changes to the accounting requirements for pensions have resulted in clearer information about the likely future costs of public sector pensions. By setting out in one report the current assessment of the potential future cost of pensions to the taxpayer, I hope to provide a useful contribution both to a general understanding of the issues and to the debate on how best to meet future public sector pension obligations.

Before I outline the content of the report, I want to stress that pension provision is a long-term exercise. There will be short-term gains and reversals, and funds are managed with that in mind. The report provides a snapshot of a situation that changes with financial markets.

There are six main schemes in Scotland. All are what are called "defined benefit schemes", in which members' pensions depend on the salaries that they earn towards the end of their employment and on the number of years in which they have contributed to their scheme.

The local government pension scheme pre-funds its future liabilities by investing contributions from employers and employees. That funded scheme is administered by 11 separate administering authorities. For other schemes—covering national health service workers, teachers, police, firefighters and civil servants—the contributions made by employers and employees are not invested in the same way. Those schemes are often called pay-as-you-go schemes. They rely on in-year contributions and Government grants to meet pension payments if those payments exceed contributions.

Five schemes are administered in Scotland and the combined funding shortfall and unfunded liabilities of those schemes may be as high as £43 billion. The sixth scheme is the civil service scheme, which is administered at United Kingdom level. If we include an estimate of the unfunded liability for civil servants who work in Scotland, the total for all six schemes could be up to £53 billion.

The expectation that people will live longer is increasing the value of pension liabilities, because pensions will have to be paid over a longer time. The new accounting rules that I mentioned a moment ago are also having an effect, as the discount rates for valuing liabilities are reduced. To comply with the accounting rules for financial reporting standard 17, the discount rate for valuing the liabilities of funded schemes was reduced from 3.5 per cent to 2.4 per cent in real terms on 31 March 2005. That reflected lower investment returns of quality bonds at that date and it has the effect of increasing the value of pension liabilities. For the local government pension scheme, the change to the discount rate means that the average level of funding of the scheme fell from 89 per cent at 31 March 2004 to about 76 per cent at 31 March 2005. That is despite an average growth in investment assets of 14 per cent over the same period.

As the same discount rate does not apply to all the main public sector pension schemes in Scotland, they cannot be compared directly. Also, the liabilities that are shown in the accounts of the unfunded NHS superannuation scheme, the Scottish teachers superannuation scheme and the principal civil service pension scheme are valued at a higher net discount rate, which means that—relative to the liabilities of the local authority scheme—they are undervalued. The unfunded police pension scheme and the firefighters pension scheme are also valued at the local authority rate.

To keep employer contribution rates affordable, funded public sector pension schemes invest mainly in stock market equities that give a higher return than investments in bonds. However, when equity investment is compared with other forms of investment, it is found to be more risky and vulnerable to sharp drops in value. Contribution rates are not set with reference to accounting valuations; they are recommended following funding valuations by the actuaries that take account of the anticipated extra return from equities and are reassessed at each full valuation in response to actual fund performance. If some of those issues may appear to be technical, it is because they most certainly are.

In conclusion, I will repeat the remark that I made a few moments ago. The funding position of the pension schemes that are set out in the report represents a snapshot in time. The position will move with the financial markets. For example, market changes since 31 March 2005 initially increased the value of liabilities, but compensating rises in equities offset some of that. However, since March 2005, it is probable that net liabilities will have increased over the piece.

Whatever we see in the short-term market changes, when we stand back from the technical details, the position seems clear: liabilities in the unfunded public sector pension schemes in Scotland are increasing. Almost certainly, unless the benefits that are provided by the schemes are adjusted, employee and employer contributions will need to increase. If that happens, it is likely that extra demands will have to be made on public spending to meet costs.

As always, I am happy to attempt to answer any questions. My colleagues will help me to do that.

Thank you.

I will attempt to ask a layperson's question—basically, it is what the person on the street would ask. Is the position sustainable?

Yes. It is important to emphasise that the liabilities will not all crystallise in the short term. We are talking about a period of many decades ahead. For example, if someone aged 16 were to join the public sector today, work until they were 65 and live into their 90s, we would be talking about eight decades of contributions and benefits. Certainly, there is not an immediate crisis in the scheme. However, the report confirms that financial pressures are building up across Scotland as a whole. Everyone needs to be aware of them when they are planning future public spending and the management of the pension arrangements.

Over a period of years, the private sector has experienced the same sort of pressures that the public sector has experienced. Many companies have shifted from final salary pension schemes to other forms of schemes, certainly for new entrants. Is that route necessary for private sector companies to take in the short term?

I prefer not to comment on policy aspects—first, and most important, because it is not my role to do so and, secondly, because this is a highly specialised area. There is no doubt that some of the changes to final salary schemes that we are seeing in the private sector and changes to the terms and conditions of schemes reflect pressures that are similar to those that we see in the public sector.

At the risk of asking you another question that you cannot answer—not because of your abilities but because of mine—one of the things that you have highlighted is the way in which the money in the local government pension scheme is invested in equities rather than in other forms of investment. Is there an argument for considering what local authorities do with their money?

There are different schools of thought on that. Some people, particularly the economists, argue that there should not be any equity investment and that everything should be in long-dated bonds that match the liabilities to the risks. That inoculates a fund against the risk because it is getting a set return over a long period. Equally, there are counterarguments in investment planning that equity investment is a relevant part of a balanced portfolio for long-term pension provision. Under that approach, better growth is sought in the early years of the employee's career through investment in equities. If one were planning for the pension requirements of someone who is joining a pension scheme now, one could encourage their funds to be invested in equities in the expectation that they would get a higher rate of return. As that person reaches the more mature years, the investment is shifted towards bonds and so on, where there is a secure return.

In practice, the idea of a wholly bond approach falls down because the volume of bonds required to match the liabilities is not available in the market. The recent abnormally low level of bond yields is in part due to funds switching to bonds as a result of the private sector exposure in equities, which in turn is pushing up prices and driving down the yields; in other words, funds need to pay more for the bond and therefore the real return that they are getting from that investment is falling. Funds can be pushed into a vicious cycle if that extreme position is taken.

In terms of what we might call prudence, the question is how closely the funds work to the matching principle for the liabilities close to maturity. A number of the funds, where a high reliance is placed on equities, are exposed to greater risk from market volatility, but a switch to bonds in the current market would not appear to be prudent. There is no simple answer to those questions, which is really why the administrative authorities need to get high-quality, professional advice.

My questions are mainly to do with the local government pension scheme and the lack of synchronisation of the scheme with workforce planning to anticipate when there will be greater demands on the scheme. There is a view around that the difficulties experienced in the local government pension scheme might be linked to employers in local authorities having taken a rather long holiday from making contributions. What are your views on that?

If I understand it correctly, that is a two-part question. One question relates to whether greater account should be taken in workforce planning of the pension implications; the second question relates to how the local authorities have been managed in recent years. A couple of diagrams in the report highlight the difficulty of predicting what the pension liabilities will be in future. Exhibit 8 on page 13 shows an expanding range of possible funding levels, depending on a range of assumptions. It would therefore be unreasonable to have accurate figures about that going into the future. However, there is no doubt that there is one particular, important consequence, which is that if there is significant expansion and recruitment at a point in time, many years ahead there will be an issue. We are seeing an example of that in the fire pension scheme. Those of us of a certain age will recall a significant recruitment exercise in the fire service in the early to mid-1970s; those people are now reaching retirement, which is why the report indicates a great deal of pressure in that area.

On the second part of your question, in the early to mid-1990s the Inland Revenue required pension funds to take pension holidays. The requirement was introduced because there were concerns that companies, particularly in the private sector, were building up reserves that were not required. To prevent that from happening, the actuarial surpluses in funds were to be restricted to 5 per cent and any excess was to be disclosed and reduced over five years. Therefore, in the 1990s there was pressure from the Inland Revenue for pension funds—primarily in the private sector but also in the public sector—to reduce their surpluses.

It is certainly the case that pension funds took holidays. From my background in local government, I recall that the Scottish pension authorities tended to take a more conservative approach to pension holidays than did some of the English schemes. We know that the funding position of the English pension funds is generally poorer than that of Scottish funds. More recently, there has been a change in policy to allow authorities to retain surpluses against future market movements, so it has been recognised that the circumstances have changed.

The issues are complex—I am sorry about that—but I hope that my comments have helped the committee's understanding.

Scottish Enterprise is consulting on the transfer of Careers Scotland staff. What impact would a transfer have on the agency's budget, given the other budgetary issues that it is dealing with? The liabilities will have to be met, wherever the staff go.

My understanding is that Scottish Enterprise has a separate pension fund and that when staff transfer into or out of local government, for example, allowances are made. Unfortunately, I cannot help you with a detailed answer on the consequences of a hypothetical move of staff from the Scottish Enterprise payroll into local government.

Is it correct to say that it would not be possible to move the debt with the employees, so the pension scheme's current liabilities would have to be met in full?

I am sorry, but I will have to go away and find out the answer to your question.

You can come back to me.

I want to ask an overarching question about the interface between the Scottish and UK Governments in the context of discussions about pensions and powers to make decisions and legislate, if appropriate. That is one of the most complicated matters for MSPs, whether we are considering overall policy, as we are doing today, or the case of a constituent who is a member of the local government pension scheme and wants to know whether their MSP or MP is best equipped to address their concerns. Can you provide clarification on where the responsibilities lie? How might we improve dialogue to ensure that the appropriate decisions are taken?

Again, I must apologise. The answer is not straightforward, although the question is entirely reasonable. Funding for schemes other than the local authority scheme fall under annually managed expenditure, which is the responsibility of the Treasury and is outwith the Scottish block and the Barnett formula. The liabilities are at UK level because the contributions are taken at UK level and pension payments are made from the centre. In the past, when contributions exceeded costs, they went to the Treasury and were applied against other expenditure. It is very much a case of macroeconomic management at Treasury level.

To the best of my knowledge, there is no intention to alter any of those arrangements. The arrangements for the funding of pensions are backed up by statute, so the entitlement of employees to a pension is set in statute. The Treasury is obliged to ensure that funds are in place to pay pensions when they are due. In that respect, there is growing pressure but no immediate crisis.

The framework for public sector pensions is set at UK level, and that includes the local authority scheme. However, it is acknowledged that the Scottish position could diverge if unique differences warranted a separate Scottish approach. That is why there are separate negotiations with employers and unions in Scotland. However, a very strong case would have to be made for divergence from the UK position. For example, it would probably be difficult to argue for different fixed contribution rates from employees.

Theoretically, the local authority scheme is more flexible, as it is a funded scheme administered in Scotland, but the contribution rates for employees are fixed and the entitlement to a pension is laid out in terms of a final salary pension scheme.

What machinery is in place to facilitate discussion between the Scottish Executive and the UK Government—at ministerial or civil servant level—to ensure that the interface between Scotland and the UK is managed effectively?

I am sorry, but I cannot answer that question. Our report did not consider that relationship.

The pensions issue is extremely complex and we are looking at it through the fog of war, trying to understand it. To laypeople, it is about as clear as global warming or holes in the ozone layer, or as uncomplicated as quantum mechanics. Could you give us some perspective—free of the financial gobbledegook about markets and so on—on the gap of £43 billion to £53 billion to be filled? That figure could go up a bit or down a bit, but should we be panicking?

It is important to use language properly. The word "shortfall" can be applied to the overhang that is evident in the local authority scheme. Figures to 31 March 2005 show an unfunded overhang. The local authority scheme is designed to take contributions from employers and employees and invest them in such a way as to cover liabilities. Technically speaking, there is a shortfall in that scheme.

For the other five schemes, I would encourage you to think in terms of unfunded liabilities rather than a shortfall. In those schemes, the Treasury is underpinning people's entitlement to a pension. For the first time, this report puts a figure on the total obligations—for the unfunded element in the local authority scheme and for the pension liabilities in the other schemes. The snapshot in the report shows that the figure is £53 billion. However, that liability will crystallise only as people retire over the coming decades. The funds will also benefit from contributions from new employees coming into schemes.

The overall situation is that, if we stand back from the technicalities, we can see ample evidence that the funding pressures are increasing in the six pension schemes. In the case of the local government pension scheme, evidence comes from the unfunded overhang. In the case of the other unfunded schemes, we think that the liabilities are likely to carry on increasing.

Is it fair to say that we have a long-term problem but that pressures are increasing in the short term?

There are no immediate short-term pressures. We have a situation in which there needs to be an awareness of the build-up of pressures over a number of years.

The usual solution is to increase the contributions of employers and employees and to require later retirement by making everyone work longer. Would such a solution be satisfactory in meeting the problem?

There is a remorseless logic to this, as only a number of things can happen: the retirement age will need to increase to reflect greater longevity and the fact that people will draw pensions for a longer period; employee and employer contribution rates will need to increase; or the benefits that people enjoy will need to be adjusted. Only one or more of those three measures can happen as we go forward, but some of the measures have greater implications for public sector spending than others.

Given that the Scottish block that comes from London may increase or decrease, how does that affect the situation?

As I may have remarked earlier, the financing of the unfunded schemes falls under annually managed expenditure, which is managed by the Treasury and is outwith the Scottish block and the Barnett formula. The local government pension scheme—which is a very large scheme indeed—is funded. There are possible implications for local taxation levels because of the element of that scheme that is not covered by investments.

Will that need to be covered by council tax?

That is one possible outcome.

You mentioned the need to use language carefully, but I notice that you used the word "underpinning" rather than "underwriting". I am not sure whether there is a clear difference between those terms. You also mentioned the overhang in the local government pension scheme. Given that the liability in that scheme will need to be funded either by council tax payers or by the Scottish Executive and given that the liability in the other schemes will need to be funded through, or underpinned by, the Treasury—which will still be a call on public funds—the public fund liability, wherever it might lie, is clearly of interest. Does the evidence tell us that the funded approach—that is, investing in equities or other portfolios—is more advantageous than the pay-as-you-go approach in reducing the exposure of public funds?

It is fair to say that one of the benefits of the funded scheme—both in theory and, I think, in practice—is that over a number of years the actuarial valuations can help to smooth out the fluctuations that take place. Clearly, that is more difficult to do for the unfunded schemes. As I think I said in answer to an earlier question, we have not looked in detail at the Treasury's management of the unfunded schemes or the Scottish Executive's interaction with the Treasury in influencing how those schemes are managed, so I cannot help much more on that issue.

Clearly, there is a great deal that needs to be addressed, although the committee cannot easily delve into the issue given that it involves local authorities. We will discuss the issue again under item 7. I thank the Auditor General for dealing with the issue in such detail.