The government has been urged to consider shifting the UK's unfunded public sector pensions schemes from a pay-as-you-go model to a funded model, after a report from New Financial found that "there is an opportunity to be seized in reforming these sleeping giants".

The report, The radical option in UK pensions, argued that while much of the focus in recent years has focused on the funded part of the pension system, it has "largely ignored the elephant in the room: the giant unfunded public sector pension schemes".

However, it argued that shifting these schemes to a funded model could allow them to become “global investment powerhouses”, as well as providing cheaper finance for the Treasury, better outcomes for taxpayers, and a more stable international investment position.

Whilst the report clarified that the current system is not broken, despite “alarmist calls to the contrary”, it argued that moving schemes towards becoming fully funded would deliver a step-change in their political sustainability and address key macroeconomic vulnerabilities in the UK economy.

In particular, the report highlighted the fiscal case for change, pointing out that financing public service pensions on today’s market terms rather than the special discount rate used by the government would save HM Treasury over the next two decades around £70bn.

In addition to this, it found that channelling new employer and employee contributions into investments could save taxpayers over £600bn, or up to £1.5trn if the existing balance of these schemes were diversified into market assets.

This is not the only potential benefit, as the report suggested that funded pensions would also increase the stock of savings, deepening pools of capital that can be drawn on to enhance the capital stock and help finance the transition to net zero.

Higher national savings rates could also help address the UK’s chronic serial current account deficits and deteriorating net international investment position, so improving macroeconomic resilience, the report explained.

There is also a political case for change, as the report noted that, in the growing absence of private sector defined benefit pensions, public ones are increasingly portrayed as unfair and unaffordable, and public service pensions have become a political football.

Given this, it suggested that funding them would both put them on a level playing field with remaining defined benefit schemes and link them to substantial fiscal and macroeconomic benefits, as well as improving their political sustainability.

Whilst the report acknowledged that there is likely to be some pushback on this idea, with on-balance sheet government debt already high, and concerns around the ‘financialisation’ of public sector pensions and the politicisation of pensions more broadly, it argued that, on balance, the potential benefits offset the risks.

Commenting in the report, New Financial managing director, William Wright, stated: “These schemes are huge – the future pension liabilities sit off the government’s balance sheet but are bigger than the national debt – poorly understood, and complex.

“They have been criticised for being too generous compared to private sector pensions, too expensive, and unsustainable in their current form. But there has been a strong sense running through the policy debate on pensions that they could be part of the solution.

“While the potential benefits are clear, such a move would face significant opposition and would require bold political leadership. The best time to have started this transition would have been decades ago. The second best time is now.”

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