Career average pensions: How do they work?

Pensioner couple Working out a prospective pension in a career average scheme will be difficult

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Millions of staff working in the public sector have had a new piece of jargon thrust at them - the career average pension scheme.

Or, to give them their ghastly full title, Career Average Revalued Earnings (CARE) pension schemes.

They are designed to provide generally lower pensions than traditional final-salary schemes.

That is why Lord Hutton thinks they are a good idea to cut the government's rising bill for pensions in the public sector.

So, how do career average schemes work?

As before, both employees and employers pay in contributions.

But how much people will eventually receive depends entirely on the design of the scheme.

Accrual rates

Each year, a percentage of a member's salary is notionally put aside.

The precise percentage can vary depending on just how generous or meagre the employer wishes the scheme to be.

It might be 1% of salary each year, or 1.5% or 2%. This is known as the accrual rate.

For instance, the Nuvos civil service scheme, the only one now on offer to new recruits to the civil service, has an accrual rate of 2.3% of salary each year.

On retirement the cash value of all these annually calculated percentage pots is added up and that is the annual pension.

"Accrual rates in a career average revalued earnings scheme could reduce to as low as 1.11% (1/90th)," warned the accountancy firm KPMG.

"If accrual rates have to be reduced to cut costs it will come as a big shock to the system."

Inflation protection

To protect the accumulating pension against inflation, each individual's notional pension has to be uprated each year.

Pension schemes explained

  • Final-salary scheme: Guaranteed pension based on earnings at end of your career and length of service
  • Career average scheme: Guaranteed pension based on your average pay over your career
  • Defined contribution scheme: Determined by contributions and investment returns. Usually worth less than final-salary pensions

Again, how this is done can vary.

The annual uprating might be in line with inflation (based on the Retail Prices Index or the generally lower Consumer Prices Index) or it might be in line with earnings growth.

That is Lord Hutton's suggested approach.

"As earnings are normally expected to increase faster than prices, particularly the CPI measure of price inflation, this is a good result for the public sector," said Michaela Berry, of pension lawyers Sackers.

John Ball of actuaries Towers Watson said: "For people who don't get pay rises on promotion, career average benefits that are uprated with average earnings growth will be no less valuable than a final salary scheme."

The annual uprating might even be set above inflation.

For instance, GPs and NHS dentists have their earnings, for the whole of their career to date, uprated by RPI plus 1.5% each year while they are still contributing.

When they retire, their annual pension is set at 1.87% of the final uprated lifetime sum.

As you can see, calculating a pension in a career average scheme can be very complicated and involves a number of key variables.

Another important factor at the discretion of those designing the scheme, in this case the government, will be the extent of inflation-proofing once a pension is in payment.

The greater the protection, the more expensive the scheme will be, and the higher the contributions that will be required.

From April 2011, inflation-proofing across all public sector schemes is going to have the current link to RPI replaced by the slower growing CPI.

Undefined

Other elements contributing to the cost of a career average scheme will be the extent of other features, such as a pension or other benefits for dependents, spouses and partners, both before retirement and after.

"[We are] concerned at the degree to which the proposals require further detailed announcements by government and negotiation, scheme by scheme," said the Association of Chartered Actuaries (ACA).

So, career average schemes are very different to final-salary schemes, despite the continued practice of the pensions industry in describing both of them as "defined benefit" schemes.

It would be much better to describe career average schemes as undefined benefit schemes.

That is because it is very hard indeed for anyone to calculate in advance how much pension will be generated for them on retirement.

By contrast, in final-salary schemes, the eventual pension is a straightforward factor of how many years you have been paying in, and your salary in your final year of employment.

Winner and losers

The most important fact to grasp though is that unless a new career average scheme has a more generous accrual rate than the final-salary one it replaces, then almost no-one will be able to accrue a higher pension then before.

Many members will, for the same number of years and the same level of annual contributions, receive a much lower pension.

That is because of the obvious reason that most people experience their peak earnings in their last few years of work after starting off with relatively low earnings while young.

In a career average scheme low wages or salaries in the early years directly affect the pension calculation; in a final salary scheme they do not.

"The changes are likely to have an even greater impact on higher paid employees and those who receive above-average salary increases in future," said John Prior of Punter Southall.

Retire later

Although the government is planning to introduce an average increase of three percentage points for public sector employee pension contributions, this is aimed at cutting the government's contributions, not at raising the level of benefits.

Perhaps even more important than the new basis of calculating the pensions will be the proposed higher retirement age.

Some existing staff who retire at 60 under their current rules will be told they must now work to 65 for a full pension.

And that normal pension age, it is now proposed, should rise even further, to 66, 67 and eventually 68, in tandem with the government's existing plans for the state pension.

The effect of this will be just as profound as changing the underlying method for calculating someone's pension.

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