Final Salary Pensions

Final salary pensions are a very bad idea.

Perhaps that is not what a former UCU Branch President is expected to write, but I believe that final salary pensions are socially, and economically, very bad.

The social problem

Final salary pension schemes were invented by employers. Employers are not always known for their largess towards employees, so why did they do it? Quite simply, because they act as golden handcuffs.

Consider a model employee, retiring at 65 after forty years service on a pension of 40/60ths of final salary, and so enjoys a retirement still receiving two thirds of former salary. Then consider an awkward, disloyal, employee who keeps changing jobs, taking training with him, and repeatedly needing new training. Assuming the changes occur every ten years, the resulting pension will be something like one-sixth of salary at 35 (from first employer), plus one-sixth of salary at 45 (from second employer), plus one-sixth of salary at 55 (from third employer), plus one-sixth of salary at 65 (from final employer). This is likely to be less than the pension of the model, loyal, employee, unless the ship-jumper ends up on a very significantly higher salary. Indeed, until the mid 1980s there was no requirement for a deferred pension (i.e. one to which an employee is no longer contributing, but which is not yet being drawn in retirement) to be index-linked at all. It could simply be frozen. Given the high levels of inflation in the 1970s, this meant that changing jobs could be very expensive in terms of pension rights.

To look at it another way, as soon as you change jobs, your accrued pension benefits start being indexed at some form of inflation rate, rather than your own personal rate of salary increase. If your career is such that your personal rate of salary increase is above the inflation rate, you have an incentive for not leaving.

I don't believe that these sort of golden handcuffs are fair, particularly as employees may have to leave through no fault of their own, whether family circumstances, or involuntary redundancy.

From the employer's point of view, the handcuffs work well. If you believe that you will not be promoted further, then the handcuffs no longer apply, and your employer will probably be happy to see you depart. If you believe you are likely to be promoted, then your employer probably values you, and will be pleased that you have an extra incentive for not leaving.

It also fails to live up to the idea of equal pay for equal work. Consider two people who, having worked for ten years, face redundancy at the age of 35. One is lucky, is retained, and continues until 65. The other is dismissed. The one who is dismissed will have pension rights from those ten years based on the salary when he was dismissed. The other will have them based on a career-end salary, which may well be twice as high, or even more. Why should their pensions, a key part of their pay and reward package, relating to the period when they worked together be so different?

The personal problem

In some sense a final salary pension is not a defined benefit pension. One of the advantages of a defined benefit pension is that the employee can plan, knowing what pension has already been accumulated, and being able to guess fairly accurately what future pension might be gained.

Once one's pension is heavily dependent on one's final salary, such planning becomes hard. An unplanned resignation or dismissal, or simply being "unlucky" with the promotions system, can have a large unexpected impact. It reduces not just the value of future benefits, but also the value of the years of service one has already achieved.

The economic problem

The `final salary' for the purposes of calculating the USS pension could be simply one's average salary over the final three years of one's career. Many Departments were notorious for promoting people about three years before they retired so as to boost their pensions considerably. This was very bad.

It was bad because it gave the Head of Department huge influence. If the HoD you had just before retirement did not like you, it would cost you a fortune in lost pension. At the point in their careers when it might be expected that people could challenge bad HoDs, many could be tamed by promises of a late promotion.

It was bad because you never knew what your pension would be worth. If the Head of Department failed to secure promotion for you at the right point, it would be much less.

It was bankrupting for the pension fund. At the time the total contribution rate was around 20%. So suppose someone got a generous promotion three years before retirement which resulted in a £10k salary boost. The pension fund would then receive an extra £6k, i.e. £2k a year for three years.

Assuming forty years had been worked, the extra pension entitlement would be £5,000 per year, and the extra lump sum on retirement benefit would be £15k. This additional benefit of £15k plus £5,000 per year until death would being funded by an additional contribution of just £6k to the pension fund. Complete nonsense. It was funded by over-charging the unfortunate people who do not receive this sort of late promotion. In this University, this meant that, in very general terms, academic-related staff, along with successful academic staff who reached professorial grades early in their careers, and unsuccessful research staff who left the sector before gaining significant promotion, were subsidising those who got promoted to readerships and chairs just a few years before retiring.

Certain Departments quite routinely promoted people around three to five years before they retired, just at the point at which they would be forced to start winding down their research programmes as they would be becoming ineligible to apply for new grants or to take on new PhD students. Similarly the extra salary for being Head of Department for a typical five to seven year term was quite modest, until one worked out the extra pension benefits implicit in it.

If the USS had funding problems in, and before, 2011 this is one of the reasons. Some form of career average earnings scheme, in which what one gets out is more directly linked to what one puts in, is both fairer on employees, and easier for the pension scheme to manage. (The above theories were patiently explained to me by another former member of Cambridge's UCU Executive Committee. He probably wishes to remain anonymous.)