Flexible pensions could offer a way out of the public sector pay crisis

Kwasi Kwarteng faces a host of problems, many of his own making. Announcing a £43 billion tax cut without any evident plan for the public finances is going to constrain him, and his successors, for years to come.

The markets gave the chancellor his first headache, which millions of us will share as our mortgage payments rise. His next, and perhaps even more severe, headache is going to come from nearly six million public sector workers. I wrote here at the start of the year that the public sector pay round could prove the biggest challenge facing this government. With inflation running even higher, and likely to stay high for longer, and a chancellor who has given himself even less room for manoeuvre, it is looking like an even bigger challenge today.

The public sector pay bill, covering 5.7 million employees, amounted to more than £230 billion last year, representing more than a fifth of total government spending, a third of what government spends on delivering public services and almost 10 per cent of national income. That’s why decisions about public pay are economically and fiscally so important. They also have a direct effect on the standard of living of an awful lot of families.

Spending totals to which the government is committed were set out a year ago when inflation was projected to average less than 3 per cent over the spending review period. Well we all know what has happened since then. The government has responded by offering pay rises of about 5 per cent this year. That is a compromise, but one which is unlikely to satisfy anyone. It implies a big real terms pay cut for millions of nurses, teachers, and civil servants, a bigger pay cut than most in the private sector are experiencing. But it is still more than was budgeted for, and hence will mean perhaps 100,000 job losses, or other cuts to public spending.

With even the Royal College of Nursing balloting its members nationwide over strike action for the first time in its 106-year history, the next few months look set to be bumpy enough. But the problem will only get bigger. The Bank of England expects inflation to remain around 10 per cent for much of next year. What then for public pay? Is another big real-terms cut really feasible?

One doesn’t have to worry about industrial action to worry about the effects that “cut” might have. Pay cuts on this scale, coming after a decade of cuts, both in real terms and relative to the private sector, would surely worsen the already severe recruitment and retention problems faced in teaching, nursing and elsewhere. There is a limit to how much you can cut pay and still expect to deliver decent public services.

But with fixed budgets, even after this year’s below inflation settlements, raising pay in line with inflation next year seems likely to prove incredibly hard. It could imply the loss of well over 200,000 jobs to pay for it.

That creates quite a conundrum. By coming in all guns blazing with big tax cuts the chancellor has made it almost impossible to solve the conundrum by relaxing the budget constraint. Indeed, he has made it clear he wants to cut spending even more.

This will be an equally big conundrum, let’s not forget, for an incoming Labour government. It has committed to reversing less than half the recent tax cuts and have hemmed themselves in almost as much as has Kwarteng. If it wants to keep or increase the number of people delivering public services, and not accept large scale pay cuts, it too will have to tell us how it will pay.

Perhaps there is one way to square this circle. I have not yet mentioned pensions. Pay in the public sector may have fallen behind that in the rest of the economy. Pensions most definitely have not. Generous defined benefit occupational pensions, almost extinct in the private sector, remain ubiquitous in the public sector. Can it really make sense that more than a fifth of the total remuneration of the average public sector worker comes in the form of deferred pay — a pension — while pensions form only 7 per cent of the total remuneration of private sector workers?

As public pay has fallen behind, pension contributions, from both employer and employee, have kept on rising. It is not just pay restraint that has squeezed take home pay over the past decade.

Most public sector workers have also faced increased deductions from their pay to “fund” their pensions, as well as higher national insurance contributions (NICs). The latter followed the end of so-called “contracting out”, a change which led to higher NICs for those — almost entirely in the public sector — still in a defined benefit pension.

One can see why unions might be suspicious of offers to raise pay today in return for lower pensions. Pay can always be cut again tomorrow. But what about at least offering people some flexibility.

Why not let public sector employees choose to pay lower contributions themselves in return for lower pensions in the future? The current schemes are hopelessly inflexible, all or nothing, in or out. Some are also absurdly generous. It is actually possible for low-paid public sector workers, struggling to make ends meet as they bring up a family, to end up with more income in retirement, from their state pension plus, say, an NHS pension, than they ever earned during their working life.

With a bit of flexibility on both sides there is surely a win to be had here: a win for the workers and a win for the government.

With a cost of living crisis on the one hand and something close to a fiscal crisis on the other, both need it more than ever.