If you read nothing else, read this…

  • The coalition government has taken a tough cost-cutting stance on public sector pay and pensions, commissioning independent reviews in each of these areas.
  • It has also imposed a two-year pay freeze for all public sector staff earning above £21,000 a year. Staff earning less than this will receive a £250 rise in each of these years.
  • Trade unions fear the pay freeze will erode the powers of pay review bodies, which have previously proved fundamental in the settling of disputes.
  • Inflation adjustments will be lowered on public sector pensions, which will affect the overall value of retirement benefits.
  • High levels of staff engagement are still possible amid budgetary pressures and spending cuts.

The public sector is getting to grips with government demands to save money, but staff engagement does not have to suffer, says Nicola Sullivan

The age of austerity, which munched into private sector pay, reward and jobs as its first course, has now undone its top button before feasting on the public sector for dessert. A new coalition government is waiting at the table, keen to feed it with what it needs sooner rather than later, stressing the many cuts that are needed to deal with the country’s deficit. Already on the table are government plans to slash the budgets of unprotected public sector departments by 25%.

Dean Shoesmith, president of the Public Sector People Managers’ Association (PPMA) and head of HR for the London boroughs of Sutton and Merton, is concerned that Chancellor George Osborne has focused too much on cuts and not enough on growth.

In June’s emergency Budget, Osborne dished up a number of measures affecting public sector pay and pensions. One of these, a review to be conducted by economist Will Hutton, will investigate pay scales across the public sector as part of efforts to ensure that no public sector manager can earn more than 20 times the salary of the lowest-paid employee in the organisation.

A two-year pay freeze will also be imposed for public sector workers earning more than £21,000 a year. This will not affect the lowest-paid workers, who will receive a £250 pay rise in each of those two years.

But taking pay out of the equation is not likely to ease tensions between employers and unions. Rachael McIlroy, policy officer at the Trades Union Congress, says unions will look to negotiate on job security, policing Osborne’s promise that the pay freeze will result in fewer redundancies. “There will be negotiations on the relationship between pay freezes and job security,” she says. “Before the general election, unions for the NHS were already talking to employers about the trade-off between lower pay and job security.”

Reward packages up for negotiation

In the absence of pay rises, employees’ total reward packages will also be up for negotiation, with more being expected from employers in terms of training and development, and flexible working. Some local authorities are starting to push their total reward package, obtaining staff feedback on after-work clubs, workplace environment and working hours (see case study below).

“Local government has been pushing for the total reward approach for a fair number of years and the unions have pretty much resisted it,” says McIlroy. “But maybe the time will come when unions will be forced to negotiate on training and development, and flexible working, just to get something out of the bargaining agenda because there is no money for pay [increases].”

Another concern is that the pay freeze will erode the authority and powers of the independent public sector pay review bodies, which have been fundamental in settling previous industrial disputes. Setting pay rises for public sector staff who work in prisons, the armed forces, the NHS and the police, pay review bodies rubber-stamp the government’s pay policies after considering evidence from employers and unions.

“Pay review bodies take the heat away from long-drawn-out negotiations and they collect a massive amount of evidence on what is actually happening on the ground,” says McIlroy. “If there are recruitment and retention problems in particular [job] bands or areas, they will make recommendations.”

Employers need more autonomy

Duncan Brown, director of HR business development at the Institute for Employment Studies (IES), argues public sector employers have not been given enough autonomy over the way they reduce salary costs, which could restrict how they manage the challenges ahead. “Putting a freeze on pay costs is fine, but why is central government saying to those running a [public sector] department: do not give anyone a pay increase?” says Brown.

“After all, they could take 5% out of their cost base and still increase the pay of some people. Why shouldn’t they be able to do that? Why have a flat freeze? Employers should be able share some of the cost savings with staff in the same way that some deals were done in the private sector last year.”

Public sector pensions are also being targeted, with the government announcing a number of changes, including plans to switch the inflation index from the retail price index (RPI) to the consumer price index (CPI) for public sector and state pensions. This means inflation adjustments will be lowered on public sector pensions, which will affect the overall value of workers’ retirement benefits. Towers Watson estimates that, by 2016, a former public sector employee currently receiving a pension of £10,000 will be over £800 a year worse off because of the change.

John Prior, a principal at Punter Southall, says the subsequent reduction in members’ accrued pension rights will reduce organisations’ pension liabilities. “This change appears to be good news for employers that operate defined benefit or final salary pension schemes, but correspondingly bad news for the employees and ex-employees who are members of these schemes,” he explains.

“Not only has CPI tended to lag behind RPI in the past, but we fully expect it to do so in the future. Technical differences in the methods of calculation mean we would expect annual CPI to average about 0.5% less than RPI, even if they were both based on the same underlying price inflation.”

An independent review, chaired by former Labour pensions minister John Hutton, is to be carried into the affordability of public-sector pensions. But Karen McWilliam, head of public sector benefits consulting at Hymans Robertson, says the government should tread carefully because private sector-style solutions may not be the answer.

“It is critical that the government understands the implications of any decision it makes,” she says. “If it downgrades the pension scheme, then, in theory, it could be passing the problem on to the state. This means there will be more people with much lower pensions, who then might have to rely on the state for their retirement income.”

Care schemes offer lower-cost alternative

McWilliam adds a number of lower-cost alternatives could be offered to public sector employees apart from moving to a defined contribution (DC) pension scheme. These include a career average revalued earnings (Care) scheme, which bases an employee’s pension on their salary in every year of employment, not just their final year. One of the biggest advantages of Care over final salary DB schemes is the reduced cost for the employer because these schemes typically revalue in line with inflation. Care plans can be preferable for staff with variable earnings, particularly those who shed hours or responsibilities in the run-up to retirement.

Hybrid pension arrangements are another money-saving alternative. Essentially, these are a half-way house between final salary and money purchase schemes. Such an arrangement might see an employer offer staff pension benefits based on defined benefits up to a salary cap of, say, £30,000 a year. For members whose salary is above that amount, additional money purchase benefits can be accumulated in a separate pot.

Hybrid schemes can also be structured so that the employer provides members with money purchase benefits until they reach a certain age, for example 45. After that, members accumulate final salary benefits.

Nigel Peaple, director of policy at the National Association of Pension Funds (NAPF), says public sector pensions could also be linked to conditional indexation. “This is when you index pensions and payment only in years when the fund is doing well,” he explains. “This is the model used in the Netherlands.”

In its report Reforming public sector pensions: solutions to a growing challenge, published in July 2010, the Public Sector Pensions Commission estimates that £10 billion a year could be saved if the retirement age was raised to 65 for state workers. Switching from a pension based on final salary to payments based on a career average salary would also save £10 billion a year, and a two-percentage-point rise in employee pension contributions would save a further £2 billion.

Unfunded pensions ‘Ponzi’ schemes

The report also likens the unfunded pension schemes enjoyed by civil servants to ‘Ponzi’-style fraud, in which future taxpayers have to stump up increasing amounts to stop the system collapsing. Ponzi schemes are destined to collapse because their earnings, if any, are less than the payments made to investors.

“People might think that with unfunded pensions, the money comes straight from taxation,” says Peaple. “It does in a way, but the individuals in these ‘unfunded’ pensions are often paying into them and making contributions of a varying degree.

“In some schemes, such as the fireman’s scheme and the policeman’s scheme, the employee contributions are actually quite high. Although it is paid on a pay-as-you-go basis and there is not actually a fund set aside, there is money coming in every year from the individuals who are saving.”

Ministers are also taking steps to cut redundancy benefits for 500,000 civil servants. These employees are currently entitled to severance payouts worth up to six years’ salary. The government is aiming to reduce these packages and bring them into line with those offered in the private sector, where the statutory minimum payment is one week per year of service.

These existing packages for civil servants are also inconsistent with those offered elsewhere in the public sector. IES’s Brown says: “In the NHS, payouts are capped at two years, so why is the government looking to cap payouts in the civil service at a year, which is probably less than in the private sector?”

As budgets are cut, and pay and benefits are carved up and reformed, it will be the most dynamic, creative and forward-thinking reward professionals in the public sector who will find ways to continue motivating staff with diminished resources.

Impact on engagement

Many reward professionals will no doubt be pleased to hear that money is not the only answer when it comes to engaging employees.

One of the most significant drivers of engagement for employees is finding work meaningful. Professor Katie Truss, director for the Centre of Research in Employment Skills and Society at Kingston University, explains: “I think this is very true across the whole of the public sector, where it is perhaps easier in many ways for employees to find their work meaningful and to see a connection between what they do and the greater good of society.”

Budgetary pressures and spending cuts do not necessarily have to lead to lower levels of engagement and staff morale. Nita Clarke, co-author of the MacLeod Review and director of the Involvement and Participation Association, says: “It is very important, as the budget cuts impact on the public sector, that staff are made the agents of change and not the victims of change. Staff in the public sector know how things could be done better and they know how services could be reconfigured.”

According to the review Engaging for success: enhancing performance through employee engagement, conducted by David MacLeod, organisations that are under pressure to cut costs can still improve staff engagement.

The MacLeod review cited the example of the Department of Work and Pensions, which managed to increase engagement levels following a 30% reduction in staff over three years.

Case study

BBC switches channels on pensions

The BBC is to close its defined benefit pension scheme to new joiners from December as part of efforts to tackle the scheme’s ballooning deficit.

Future salary increases for existing members will be capped at 1% a year from April 2011 and a defined contribution plan introduced for new joiners.

These changes follow the publication of the 2009 interim valuation by the broadcaster’s pension trustees, which showed the DB scheme’s deficit had jumped from £470m in 2008 to about £2bn. A 90-day consultation period on the proposed changes is underway with staff and unions. The National Union of Journalists has threatened to ballot its members for strike action unless the BBC guarantees that the value of pensions already earned will be protected and moves to cap pensionable pay are dropped.

The BBC is also taking steps to reduce the pay bill for senior managers by 25% in three years. Its strategy review stated: “The Trust recognises the scale of very senior pay within the BBC continues to be an issue for concern for the licence fee-paying public.”

Case study

Kent County Council rates staff for rewards

Kent County Council is in a strong position to deal with the effects of budget-tightening because of its private-sector-style pay and reward structure and focus on total reward.

After bringing the ‘benefits’ of working for the public sector together with conventional benefits in a single place, the council asked employees to rate the value of some benefits, such as homeworking or staff clubs. It can use these ratings as feedback to develop better benefits.

Earlier this year, the council removed the annual incremental pay points from its pay grades and introduced annual percentage increases linked to staff appraisal ratings.

In June, it rolled out a training programme to 1,500 managers to ensure they understood the new pay structure and how to harness employees’ full capabilities. Colin Miller, reward manager at the council, says: “Everybody with the same appraisal rating will get the same award, and that is the big switch in the changes we have introduced.

“Previously, people at the top of the pay grades, which applied to about a third of the population, would not have been able to benefit. Now they will get the same amount, albeit as a one-off payment rather than built into base pay.”