Public sector pension changes - what you need to know
Despite headline-hitting strike action against the government's new framework for public sector pensions, new research shows that one in ten (9%) public sector workers surveyed claim they aren't aware of any pension changes.
Even among workers who are aware of the future changes, there is still widespread misunderstanding about how public sector workers fare under the current pension scheme.
More than one in three (36%) have no idea how much they are currently due to retire on, and a further 38% have only a rough idea, meaning it's almost impossible for public sector workers to work out whether they are better or worse off under the new scheme.
Despite this, 64% believe the changes will result in them having a smaller pension on retirement. Over two in five (42%) think the changes are unjust and should not be implemented, with 26% either having joined or planning to join strike action to try and get the government to re-consider these changes.
Why are public sector pension schemes changing?
The government want to contain the cost of public sector pensions, which has been rising steeply, particularly as life expectancy rises. A report commissioned by the government found that a person aged 60 today lives 10 years longer than someone who reached 60 in the 1970s.
Who is affected?
The government has proposed a broad framework of changes that will apply to most public sector schemes, including the schemes for local government workers, NHS employees, teachers and civil servants.
Different changes may apply to firefighters, the police, judges and the Armed Forces, which are due to be announced later in 2012.
How public sector pension schemes are changing
The broad framework set out the following package of changes:
- Member contributions increasing in stages in April 2012, 2013 and 2014 - but no increase for the lowest earners. However, the thresholds below which contributions will not increase are based on full-time equivalent earnings, so if your pay is low because you work part-time, you may well see your contributions rise.
- From April 2015 (or 2014 in the case of the local government scheme), final salary schemes will be replaced by career average schemes (see below for more information on how these different schemes work).
- Pension rights built up before April 2015 are fully protected and, if they are final salary schemes, the pension will still be based on pay at retirement (or on leaving the scheme if earlier).
- The age members can take benefits from the scheme will increase in line with state pension age.
- Members can still choose to retire earlier, but their pension will be reduced.
- Members will still be able to swap some pension for a tax-free lump sum (called a pension commencement amount). The government recommends this should be on the basis of £12 cash for each £1 of yearly pension given up - which is a very poor deal, given that the £1 of pension is worth well over £25 at current values.
- The changes will not apply to members within 10 years of normal pension age on 6 April 2012. There may also be some partial protection for members within, say, 15 years of retiring and individual schemes are working out how they might do this.
Individual schemes can implement the changes in different ways to suit their workforce, provided the overall cost of the scheme does not come to more than a ceiling set by the government.
The ceiling varies depending on the scheme. In addition, for each scheme, there will be an absolute cap on the amount that the taxpayer will pay, with future cost increases beyond the cap being borne by the members.
How do final salary and career average schemes work?
Final salary schemes and career average schemes both promise a pension at retirement that is worked out as a proportion of your pay.
In a final salary scheme, this is worked out using your pay just before retirement. For example, the scheme might promise 1/60th of your pay for each year in the scheme, so, if just before retiring, you earn £36,000 and have been in the scheme 20 years, your pension would be 20 x 1/60 x £36,000 = £12,000.
In a career average scheme, it is based on your pay throughout the time you have been in the pension scheme. For example, in a 1/60th scheme, if your pay one year was £30,000, you would build up this much pension: 1/60 x £30,000 = £500. If the next year, your pay was £31,000, you would build up another 1/60 x £31,000 = £516.67 of pension, and so on. All these bits of pension are added together when you reach retirement.
A final salary scheme is better if you expect to get promotions throughout your working life and end your career on a high salary. Career average schemes tend to be better if you reach your peak earnings relatively early in life and earn less as you near retirement, for example, through switching to part-time work.
But career average schemes are not necessarily good for people - usually women - who take maternity and career breaks or part-time work to look after their family.
The fraction of pay you get as pension (1/60th in the examples above) is called the ‘accrual rate'. The actual accrual rate under the changes varies depending on the particular scheme.
Goodbye RPI, hello CPI
Public sector schemes provide pensions that are protected against inflation. The package of changes outlined above comes on top of a switch from measuring inflation against the Retail Prices Index (RPI) to the Consumer Prices Index (CPI). This came into effect from April 2011.
There are three ways that inflation is important for pensions:
- In a career average scheme, each year's earnings used to work out each bit of your pension are revalued by inflation (or inflation plus a bit more) between the time you earn the pay and the date when you start your pension.
- Once pensions are being paid, they are increased each year.
- If you leave the scheme before retirement - say, because you change job - the pension you have built up is increased between the time you leave and the time the pension starts.
It is estimated that uprating public sector pensions already being paid in line with CPI rather than RPI will save the government £1.8 billion a year by 2015-16. That's £1.8 billion less for pensioners.
This happens because the CPI - which, for example, excludes mortgages and council tax - tends to rise by around 1.4% a year less than the RPI. If a pensioner starts with a pension of £10,000, after 10 years, he or she will have received over £7,000 less pension in total under CPI indexation and this difference increases to nearly £37,000 after 20 years.
How the pension scheme changes may affect you
The way the whole package of changes may affect you depends on the particular scheme you are in, how your scheme adapts the package to its own workforce, and your own level and pattern of pay.
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.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).