The retirement bill for pensions is growing fast but steps can be taken to turn the tide

Successive governments have cooked the books to hide the truth about these gold-plated benefits. Rather than being worth around the 20 per cent of wages budgeted for, they require an annual contribution of more than half an individual's annual salary, it has been revealed.

Without significant reforms, taxes will have to rise substantially or services be cut, according to a report from the independent Public Sector Pensions Commission.

The Commission has called for pensions to be realistically valued so taxpayers, staff and employers can evaluate public sector salary and pension packages properly. Moreover, these costs should be met directly by those involved such as employees, schools and hospitals, without taxpayer bailouts.

The rising cost of public sector pensions was already ringing alarm bells. Earlier estimates put the bill at 1.2?trillion, or an eye-watering 45,000 per household.

But this report paints an even bleaker picture. The Commission claims successive governments used inappropriate measures when calculating the cost to minimise public concern and postpone confrontation with unions.

Using more realistic equations, it says a civil servant's pension is worth around 58 per cent of salary, an NHS worker's or teacher's pension 51 per cent, a soldier's 74 per cent and a local government employee 48 per cent.

Yet, typically, staff are only contributing 3-6 per cent, leaving taxpayers to pick up the shortfall and costing 18 billion a year - a bill set to rise substantially.

The Commission, chaired by independent actuary Peter Tomkins, and comprising, among others, Professor Philip Booth of the Institute of Economic Affairs, Corin Taylor of the Institute of Directors and independent actuary Dr Ros Altmann, says: "The government's approach makes the cost of public-sector pension benefits look only a fraction of their real cost to taxpayers.

"There is an unavoidable trade-off. Either public sector pensions will have to be reformed further to manage the cost, or taxes will have to rise and/or other government spending cut."

Tomkins added: "We are not saying pensions must be cut. First we want transparency. Once the pensions are properly costed, it may be that the employer and employee together are happy to fund them through their own budgets. But if not, then we suggest a range of alternatives. We do not make the case for any of them. ."

The impact will be draconian, though, if costs are to be cut by, say, 20 per cent. In the NHS, for example, rather than nurses receiving half their salary plus a big lump sum at 60, they might have to wait until 70 with no prospect of an additional tax-free nest egg.

Whatever is decided, the Commission believes it vital reforms should only impact the pensions employees earn in the future. Existing benefits should be safeguarded. So what are the alternatives?

Increased contributions

Asking employees to make a 2 per cent higher contribution of salary would cut government costs by 2bn. Many private sector workers have been asked to pay more into their pension, and in Ireland the government introduced a levy which cut state employees' salaries by up to 9 per cent.

Removing index linking

In the private sector, full index linking is now very unusual. An inflation cap of 2.5 per cent is common. A similar cap could be introduced to public-sector pensions, which have risen in line with the Retail Prices Index. The coalition government has already broken this link. From next April they will climb in line with the Consumer Prices Index ,which is generally lower.

Pegging annual rises to 2.5 per cent could save up to 20 per cent on the pensions bill, or 10 per cent with a 5 per cent cap. An alternative might be to offer no uprating until inflation reached a certain level, and then compensate on top.

Lifting pension ages

In 1951, most men would have died before collecting state pension at 65. Now many state employees begin work at 21 or 22, work for 38 years and then retire at 60.

Increasing public-sector pension ages in line with the rise in the state pension would save a considerable sum. If employees had to wait until 70, the cost of public sector pensions falls to around 34 per cent of annual salary (see table below).

Accrual rates

Most state employees accrue either 1/80th of their final salary each year as a pension or 1/60th. If they work 40 years on the first, they get a pension of half their final salary, and on the second two-thirds. Those on the 1/80th schemes also qualify for a tax-free lump sum of up to three times their pension, so both arrangements are broadly equivalent.

If they lower the rate of accrual, employees either have to work longer or accept a lower pension. Teachers and nurses, currently on a 1/60th scheme, would have to work 45 years to earn a two-thirds pension if the accrual was changed to 1/67.5ths a year. But pension costs could be halved if pensions accrued at 1/100th of salary a year.

Career average

Instead of earning a pension based on final salary, these are calculated on the average you have earned throughout a working life, which tends to be lower and so cheaper. New entrants to the civil service are already on a career average scheme after recent reforms. However, the change also included an improvement in the accrual rate, so the benefit was largely unchanged.

The cost of a teacher or nurse's pension on a career average scheme would fall to 28 per cent of salary on a 1/60th accrual rate, 20 per cent with a 1/80th accrual rate, and 14 per cent with a 1/100th accrual rate.

Switch to new pension

Defined contribution or money purchase plans provide no guarantee about the future pension. Retirees receive an income based on the contributions, investment performance and annuity rates at retirement. From the taxpayer perspective, costs and risks are cut and transferred to the employee.

Furthermore, most annuities bought when such schemes mature do not offer any index linking or widows' benefits, which leaves pensioners facing falling income and dependants without support.

In the private sector, such schemes have largely replaced salary-linked pensions, and the coalition's savings scheme Nest will operate along these lines.

However, such a change presents the coalition with a problem. As its pensions are largely unfunded "pay-as-you-go" schemes, the Treasury relies on today's contributions to pay today's pensions. There is no kitty. If staff contributions were switched to a funded investment-linked scheme, there would be no money to pay today's pensions, causing a short-term crisis.

There is a way round this. The government could set up a "notional scheme" into which the money was theoretically paid, and which guaranteed a certain investment return.

This scheme has been adopted by Sweden, Germany, Austria, Italy and Poland to help the state off the final-salary hook. At retirement, the fund is converted into an annuity.

Salary ceilings

Capping pensions at say 50,000 would not save much money, the Commission believes, but pegging the amount of pay on which pension accrues could have an impact.

The BBC is already going down this route, having announced that in future pensionable salary will only increase by 1 per cent each year. If employees' pay rises faster, the increase cannot be used to calculate their pension.

End NI contracting out

Some pension funds are contracted out of the state's salary-linked top-up pension, and pay lower National Insurance contributions as a result. This is because private companies have taken on the responsibility for paying the Serps, as the top-up is known, or S2P on behalf of the state, which saves the taxpayer money.

Public-sector employees are also contracted out of Serps, allowing them and the employer to pay lower levels of NI, even though the taxpayer remains liable for this cost.

Ending contracting out and forcing employees to pay full NI would slice 8 per cent off pension costs.

However, staff would pay 11 per cent of salary in NI contributions rather than 9.4 per cent as at .