Public sector pension changes: The winners and losers
The cost of pensions for Britain's public sector workers will double over the next five years to £16.2 billion - the equivalent of £1,500 per family, according to the Office for Budget Responsibility. This is equal to £1 in every £7 the government borrows. It is a truly massive burden for the UK taxpayer.
These will be the costs even after the government has implemented its plans to replace current public sector pensions with less generous schemes, as part of a raft of cost-saving proposals that will come into effect in 2015.
However, research shows that many of the UK's 5.7 million public sector workers are confused about the impact of the pension changes. A MoneyVista survey of teachers, for example, revealed that one-in-10 were not aware of the changes and one-in-three had no idea how much pension they will receive.
The main changes
The three main changes proposed under the Public Service Pensions Bill, which is still going backwards and forwards between the House of Commons and the Lords, are the closure of final salary schemes and their replacement by schemes that use average career earnings, the raising of each public sector scheme's normal pension age in line with the state pension age and the introduction of an employer cost cap to ensure future changes in costs are controlled. Generally, arrangements for death benefits, spouses' benefits and children's benefits remain unchanged.
The most important change in financial terms is the raising of the pension age. For example, NHS workers, teachers and civil servants will now have to wait until age 65 to pick up their pension, instead of age 60. Normal pension ages will also be raised for the police, firefighters' and armed forces schemes, from age 55 to 60.
The loss of pension benefits during this five-year period amounts to a sizeable sum. Furthermore, thousands more members will not survive to pick up their pension at all. The likelihood of a person dying at age 60 is 1,137 in 100,000, more than twice the likelihood of death at age 50 (521 per 100,000). That likelihood will continue to rise from age 60 to 65, amounting to an 8-9% chance of death in these five years.
Members will still be able to retire earlier than their new pension age, but will receive reduced benefits. If someone retires early in the current scheme then their pension is permanently reduced by approximately 5% per year, and a comparable reduction will apply in new schemes. This is likely to remain good value as the small-print in the new schemes' rules stipulates that early retirement provision must fairly reflect its true cost.
Workers within 10 years of pension age on 1 April 2012 will not suff er a change in their pension age, nor any reduction in the amount of benefits they receive. To prevent a cliff-edge, most schemes have also put in provisions that those with more than 10 years but less than 13.5 years before current pension age, may stay in their current scheme for a period beyond April 2015.
These are massive concessions from the government, because nearly 40% of the public sector workforce fall within the 10-year protection and taper arrangements.
The second change is that benefits in the new public sector pension schemes will move to a career-average basis. In general, a career-average structure benefits those with lower salary growth rather than higher earners, and workers who have a steadier increase in salary each year rather than those who enjoy big promotions.
Any pension accrued before 1 April 2015, when the government plans to introduce the new scheme, is protected and will be paid on the basis of the current rules, so benefits will be calculated and presented in two parts, as pre- and post-2015. This means benefits for workers up to 2015 will be based on final salary and benefits in the new schemes will be based on an average of a person's pensionable earnings between 2015 and retirement. Critically, benefits earned in the old schemes will be based on the member's final earnings at the date they retire (or leave state employment), not the salary at the point they move to the new scheme.
For each year in the new scheme, the pension accumulated is based on a fraction of earnings - for NHS workers it will be 1/54th of earnings, for teachers it will be 1/57th of earnings and for civil servants it will be 1/43rd. These accrual rates are much larger than in the legacy schemes.
One advantage of the new schemes over the old schemes is that these higher accrual rates mean members will get more if they take their benefits as pension rather than as a lump sum.
Public sector pension schemes have traditionally operated a separate pension and lump sum accrual. Typically for each year of service members have received a pension of 1/80 times final salary plus an additional lump sum of 3/80 times final salary. Under the new scheme there is no separate lump sum provision but members can apply to have some of their pension commuted as a lump sum.
Members of the NHS, civil service, teachers' and local government schemes can exchange some of their pension for a tax-free lump sum at the rate of £12 of lump sum for £1 a year of pension. Since it would cost more than £12 to buy £1 a year of pension at current market annuity rates, members who exchange pension for lump sum will typically receive back less than the value of the pension surrendered.
Clearly, a lot depends on the underlying salary, but the bigger pension accrual under the new scheme is much more attractive.
Those looking for a flexible retirement will at least find this feature of the new scheme attractive. Members of the pre-reform NHS, civil service and teachers' pension schemes were not able to draw their pension until they left their job, although they could leave their public sector employer and start work elsewhere while drawing their pension. The new schemes allow workers to draw a limited amount of pension while continuing in their public sector employment, provided they reduce substantially either their hours of work or their job level grade.
One of the government's major cost-saving measures is big increases in members' contributions and these started in April. Under its 2010 Comprehensive Spending Review member contributions will increase by an average 3.2% of salary, to raise £2.8 billion revenue, on a phased basis over three years. In some, but not all schemes, these increases are tiered so that higher earners pay the most. There is still uncertainty about how the increases in years 2013 and 2014 will be implemented.
Employer cost cap
The third main change to public pension provision is the employer cost cap of protecting the Treasury from unanticipated events that increase scheme costs, which will be formulated after each scheme has undergone an actuarial valuation. The government has promised that no more changes will be made to public sector pensions for 25 years, but it is almost alone in its confidence about this.
For example, when the new single-tier state pension is introduced in 2016, members of public sector schemes will have to pay additional contributions of 1.4% of their earnings between £5,564 and £40,040 (based on current figures) to compensate for the demise of the contracting-out rebate previously paid by the government.
"For some employees, the impact on take-home pay could be the last straw," says Steve Simkins, head of public sector pensions at KPMG. "It will mean some public servants will not take up membership even with the new auto-enrolment rules." Simkins believes the government should have offered a cheaper option with reduced benefit accrual for hard-pressed workers. Falling take-up could destabilise these schemes if contributions from active members fail to maintain a balance between cash in and cash out.
NHS swap scheme: How it works
As an example, NHS worker Peter retires after 20 years of service with an average salary of £25,000.
Under the pre-reform scheme, Peter would receive a pension of £6,250 (calculated as 1/80 x 20 x £25,000) plus a tax-free lump sum of £18,750 (3/80 x 20 x £25,000).
Under the new scheme, Peter would receive a pension of £9,259.25 (1/54 x 20 x £25,000) with no automatic lump sum.
Peter would be able to voluntarily commute pension for a lump sum at the rate of £12 of lump sum for £1 of pension.
This means he could receive the same lump sum in the pre-reform scheme (£18,750) if he gives up £1,562.50 of pension.
If he takes this option, his new pension is £7,696.75 (£9,259.25 - £1,562.50) and that is still 23% higher than his pension under the old scheme.
A catch-all phrase that can range from assessing the price of a property or vehicle before offering it for sale or the net worth of assets in an investment portfolio to the prices of shares on a stock exchange.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
Office for Budget Responsibility
Formed in May 2010, the OBR makes an independent assessment of the public finances and the economy, the public sector balance sheet and the long-term sustainability of the public finances. The OBR has four man priorities: to produce two forecasts a year for the economy and public finances, to judge the progress the government has made towards meetings its fiscal targets, to assess the long-term sustainability of the public finances and to scrutinise the Treasury’s costing of Budget measures.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.