Tomorrow vs Today: swapping future pension income for higher take-home pay

Written By: Tim Domanski
Principal Consultant, ISIO and member of The Society of Pension Professionals Public Sector Group

Tim Domanski explores the option of offering employees a choice between higher pay today for lower pension tomorrow, and what can be done to minimise the risk of employees making a choice that prioritises short-term reward over long-term financial stability

Rising living costs and changing priorities are reshaping how individuals think about their financial future. Defined Benefit (DB) pensions are a key element of public sector reward, offering a guaranteed income for life, free from investment market risks. These pension schemes have long been seen as highly valuable – but are times changing?

For some, the appeal of higher take-home pay today may outweigh the value of a more secure retirement tomorrow – but how should public sector employers respond? Should employees be empowered to tailor their reward package to their immediate needs? Or will uninformed decisions undermine their future financial security?

A choice already exists – but is it understood?
The choice to trade future pension benefits for higher take-home pay today is already available in some public sector pension schemes:

  • The Local Government Pension Scheme offers members a 50:50 option – employees can choose to halve their contributions, but their pension will build up more slowly (half the normal rate).
  • Civil servants in the Civil Service Pension Scheme can choose between a DB scheme (known as Alpha), or a non-contributory DC scheme (known as Partnership), with employer contributions of between 8% and 14.75% based on an individual’s age.

Take-up of these options has historically been very low. Between 2018 and 2022, analysis covering 73 of the 86 LGPS Funds in England and Wales shows that fewer than 20,000 members took the 50:50 LGPS option.

Why is this? There are many different factors, including:

  • A lack of awareness or understanding of the choices available – coupled with a fear of making “the wrong choice”.
  • An insufficient increase in take-home pay to justify the trade-off.
  • A presumption that DB pensions are more valuable than their DC counterparts – without really understanding the pros and cons of either option.

Do the current options go far enough?
Some near-public sector employers, such as academies and universities, are introducing a new – and often controversial – pension option. They are offering employees a substantial increase in their take-home pay in exchange for switching to a different pension scheme.

Some view this as empowering, allowing employees to make decisions that best suit their needs. Others see it as encouraging short-term thinking that could lead to long-term financial challenges.

What is the benefit of offering a choice?
Most employees choosing higher take-home pay today will be responding to their current financial needs. While inflation has begun to stabilise after reaching its highest levels in decades (exceeding 10% in 2022), living costs remain high, and many public sector employers do not have the flexibility to increase pay.

Employees may prioritise saving goals that feel more urgent than saving for retirement – and perhaps for good reason. The Joseph Rowntree Foundation notes that pensioners renting their home are twice as likely to experience poverty compared to those who own their homes outright – so prioritising saving for a home, for example, may positively impact an employee’s financial future in a similar way to saving into a pension.

Employees may also feel that public sector pensions, designed many decades ago, no longer meet their needs. Younger employees might not prioritise the dependant’s pension that is provided, or those nearing retirement may find the rules around taking their benefits too rigid.

Comparing DB and DC pensions does not need to be a zero-sum game. Providing access to an alternative DC scheme, alongside a DB option, could be seen as giving employees the best of both worlds: more flexibility, alongside the security of a guaranteed defined benefit income.

What could go wrong?
The biggest risk underpinning any conversation about introducing a choice is that employees simply do not save enough for retirement.

DC schemes typically have much lower contribution rates than public sector DB schemes. The average contributions (both employer and employee) to the LGPS are 27% – most DC schemes offer much less than half that.

Whilst the benefits of a DB scheme are guaranteed, poor investment returns in a DC scheme could leave individuals with a smaller retirement fund.

Understanding the full implications of a decision made today on an individual’s long-term financial future can be difficult. It is not just their own pension benefits that individuals need to consider, but also the impact on related benefits such as ill-health provisions. Similarly, opting for higher take-home pay may impact the individual’s tax position and eligibility for other benefits. The complexity of these choices increases the chances of individuals making poor or uninformed decisions.

Help employees make the right choice
There are three key steps that an employer needs to consider if they want to provide an alternative to their existing DB options.

Stage 1: Getting the design right
Any alternative pension offering should be designed to provide a suitable level of contributions. For example, the Living Pension standards set out minimum pension contributions that are higher than statutory minimums, in order for employees to receive an adequate income in retirement.

Employers can go further and explore adding additional savings flexibility relevant to their employees’ needs: For example, a 12% non-contributory scheme combined with access to Lifetime ISAs could provide employees with both support to get on the housing ladder and long-term financial stability.

Stage 2: Empowering informed decision making
Engaging, personalised communications will help employees understand the options available to them and decide what is right for their circumstances. Personalised illustrations or modellers can help employees understand the financial impact of their decisions.

Effective communications should involve multiple channels, combining written communications and videos with opportunities for face-to-face engagement. For example, group webinars or individual guidance sessions.

Stage 3: A process that allows employees to change their mind
An employee’s needs will change over time. For example, when an employee has a baby, the life assurance provided by their DB pension scheme may be seen as more valuable. This should not be a one-off choice.

Allowing employees to revisit their decision acknowledges that financial priorities change. This flexibility also reduces the pressure of a making a one-time-only decision.

 

Choice today does not have to be at the cost of future financial wellbeing. When paired with appropriate safeguards, employees can address their immediate needs without sacrificing long-term security. Providing employees with flexibility is not about playing down the value of a DB pension – quite the opposite, it is an opportunity to explain just how valuable these benefits are.

By embracing flexibility, public sector employers can continue to attract talent and safeguard their workforce’s financial resilience – both today and tomorrow.

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