How public sector pension schemes are funded

Most people assume public sector pension schemes work the same way. In reality, they use two very different funding 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.

How public sector pension schemes are funded

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 public sector pension schemes work in a similar way to the state pension. Today's working taxpayers, or government borrowing, pay for today's pensioners rather than money coming from an invested pot.

Unfunded, pay as you go schemes

The NHS Pension Scheme, Teachers' Pension Scheme, and Civil Service Pension Scheme are all unfunded public sector pension schemes. These schemes do not have an investment fund sitting behind them and growing in the background.

Instead, today's employee and employer contributions go straight to the Treasury. The government uses that money to pay today's pensioners. General taxation covers any shortfall.

People often call this 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, Pension Transfer Specialists rarely recommend moving an LGPS or USS pension to a private sector DC scheme. These advisors hold the additional qualification required by law to advise on defined benefit transfers. Most will conclude the guaranteed inflation-linked income is worth more than what a transfer could offer.

This matches what we see at Regulated Advice. Since 2013, we have never come across an advisor who recommended transferring out of an LGPS or USS scheme. This includes advisors who specialise in defined benefit transfers.

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. They typically range from 5% to 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 covers any shortfall. For the LGPS and USS, investment performance and employer contributions must cover it instead.

What public sector pension schemes mean for members today

Benefits in unfunded public sector pension schemes do not depend on stock market performance. This offers members 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.