How public sector pension schemes are funded

Most people assume all public sector pensions work the same way, but how public sector pension schemes are funded actually splits into two very different models.

Some, like the NHS and Civil Service schemes, are paid straight out of today's taxation, while others, like the LGPS, hold genuine invested assets behind every member's pension.

What "funded" actually means for a pension scheme

There are two types of public sector pension schemes: funded ones, built up through invested assets over decades, and unfunded ones, paid for by the younger working generation through today's tax receipts and borrowing.

• NHS Pension Scheme — unfunded
• Teachers' Pension Scheme — unfunded
• Civil Service Pension Scheme — unfunded
• Police pensions — unfunded
• Firefighters' pensions — unfunded
• Armed forces pensions — unfunded
• Local Government Pension Scheme (LGPS) — funded
• Universities Superannuation Scheme (USS) — funded
  
  

These unfunded schemes work the same way as the state pension: today's working taxpayers, or government borrowing, pay for today's pensioners rather than money being drawn from an invested pot.

Unfunded, pay as you go schemes

The NHS Pension Scheme, the Teachers' Pension Scheme, and the Civil Service Pension Scheme are all unfunded. There is no investment fund sitting behind them, growing quietly in the background.

Instead, today's employee and employer contributions go straight to the Treasury. Today's pensioners are then paid from that same pot, alongside general taxation if the numbers fall short.

This is often called a pay as you go model. It works as long as there are enough working taxpayers to support the people already retired.

The Local Government Pension Scheme: the exception

The Local Government Pension Scheme, or LGPS, breaks the pattern. It is a genuinely funded scheme, meaning contributions from council staff and their employers are actually invested.

Those contributions sit in real assets: equities, bonds, and property, managed by regional pension funds. Members' future pensions are paid from the growth and income these investments generate, not directly from current taxation.

In practice, advisors qualified as Pension Transfer Specialists, meaning they hold the additional qualification required by law to advise on defined benefit transfers, are rarely willing to recommend a transfer out of the LGPS or USS to a private sector DC scheme. Most will conclude the guaranteed inflation-linked income is worth more than what a transfer could offer.

This is mirrored in what we see at Regulated Advice. Since 2013, we have never come across an advisor, even one specialising in defined benefit transfers, who recommended a transfer out of an LGPS or USS scheme.

Local government pension scheme transfers

Technically, it is possible to transfer out of the LGPS or USS to a private sector defined contribution scheme, due to their funded nature. In practice, financial advisors are rarely willing to recommend a transfer out of an LGPS or USS scheme to a private sector DC scheme.

Who pays in, and how much

Employee contribution rates vary by scheme and salary band, typically running between 5% and 12% of pensionable pay. Employers contribute considerably more, often 20% or higher, reflecting the generosity of these defined benefit promises.

For unfunded schemes, the Treasury effectively underwrites any shortfall. For the LGPS and USS, investment performance and employer contributions must cover it instead.

What this means for members today

Benefits in unfunded schemes are not dependent on stock market performance, which offers real stability. However, they remain exposed to political and fiscal decisions, since future governments set the rules on contribution rates and indexation.

LGPS and USS members carry investment risk collectively through their fund, but each scheme's funding position is publicly reported and independently valued. Consequently, members can see exactly how well funded their pension actually is.