Switching to a career average revalued earnings plan would solve funding problems for those employers finding it difficult to maintain final salary schemes, by allowing them to cap the open-ended liabilities
Companies struggling to maintain final salary schemes in the light of FRS17 accounting rules should switch to a career average revalued earnings (Care) basis on a modest accrual rate, according to Richard Stroud, chief executive of the Pensions Trust.
This, he argues, is a much better benefit than a money purchase scheme.
Employers following Stroud's advice should see two immediate benefits. First, their funding problems would be over because the more modest career average basis for the pension calculation allows employers to cap the open-ended liabilities of final salary schemes, where the senior employees pensions' can rocket in the pre-retirement decade as earnings peak.
At the same time, if the scheme switched from sixtieths to an eightieths accrual rate, this would make the funding for future pensions far less onerous.
The second benefit is in securing continued employee loyalty. Arguably, given the skills shortage, employers need to be able to offer attractive pension schemes that can deliver a definable benefit rather than a pension linked to stock market returns.
Employers that close a final salary scheme but base future pension rights on career average revalued earnings would not make employees feel so short-changed as they would, understandably, when switched from final salary to pure money purchase.
Like other industry commentators, Stroud is concerned that the general trend away from salary-linked pensions to money purchase could prove disastrous.
'The pensions panacea to shut down final salary schemes and dump people in money purchase arrangements sounds like a potential time bomb with a 20-year fuse,' he says. 'It begs the question of whether we are going backwards.'
Pensions terminology is confusing for members so advisers involved in setting up Care schemes should ensure the communications material is first class. Employees need to understand that final salary schemes are just one type of defined benefit arrangement and care is another.
What Care schemes do is link the value of the pension to the member's average earnings over the entire period of service. Final salary schemes, on the other hand, base the value of the pension on earnings either at retirement or in the last few years prior to this date.
In both cases, the proportion of salary, whether this is fixed at retirement or averaged over the employee's career, depends on the number of years of service.
A typical final salary accrual rate assumes that for each year of membership the member will earn a pension worth one-sixtieth of his or her salary at retirement.
Under Inland Revenue rules, the maximum pension is two-thirds of salary ' that is, forty-sixtieths (capped for many higher earners).
So, how does the Care pension build up? Under the Pensions Trust scheme, the member earns a pension of one-eightieth of gross earnings each year. This means that instead of, say, forty-sixtieths of final salary, the member will end up with forty eightieths, where each segment has a different value and is revalued by RPI up to age 65.
The same result is achieved by revaluing the salary each year in line with RPI, adding all the revalued salaries together and dividing by 80.
The Pensions Trust provides industrywide schemes for the voluntary, charity and not-for-profit sectors.
Historically this has proved a tough market to penetrate given the comparatively low wages and, in the charity sector at least, the uncertainty over funding from one year to the next.
This is the clearly the market the Government is hoping to reach with its stakeholder schemes but Stroud believes we can do better with Care.
The design of the Pensions Trust industry-wide scheme, which is based on an accrual rate of eightieths, includes full RPI revaluation rather than the more typical RPI capped at 5% (Limited Price Indexation). An important feature of this Care plan is the profit-sharing element.
'We recommend companies fund on a higher basis than eightieths so they can distribute excess profits to scheme members,' Stroud explains.
'The over-funding of the scheme is deliberate and a fundamental part of the design. However, the bonuses are discretionary. If investment markets are volatile, as is the case at present, the liabilities are only linked to eightieths so, even under FRS17, there should not be a funding problem.'
Surplus is directed into the members' accounts. Stroud recommends a transparent with-profits contract for this purpose in order to reduce volatility. The account could also be used for additional voluntary contributions (AVCs).
There are other ways of including discretionary increases. Colin Singer, an actuary and partner with the consultant Watson Wyatt, says: 'The career average revalued earnings scheme could guarantee revaluation at RPI, possibly capped at 5%, but offer a discretionary bonus of up to 2%. This would bring the revaluation up to the level of wage inflation, which typically runs at 1.5%-2% above RPI.'
Stroud's third way is not new but simply the combination of contracts that have been around for many years.
In an influential article in the Pensions Management Institute's newsletter earlier this year, Stroud set out his recommendations.
'It just requires a bit of imagination coupled with unbiased thinking,' he says. 'Or, to put it more bluntly, people need to get out of the box and think about real solutions that meet customers' needs.'
Stroud's scheme includes a 50% dependant/partner's pension. This is calculated as 50% of accrued benefit plus 50% of projected future service to age 65, based on current earnings.
Scheme leavers would secure a deferred benefit that is revalued by RPI in the same way as for those who remain in employment.
Based on an average membership age of 45, Stroud estimates that the cost to the employer of this type of Care scheme would be about 10% of total salaries. This contribution is fixed and does not vary according to age.
Contributions are based on all earnings except P11D items. The member pays at a rate of age attained divided by 10, calculated each year.
For example, a 20-year-old would pay 2% on joining, 2.1% after one year, 2.2% after two years and so on, with an upper age limit of 64. The maximum employee contribution would be 6.4%.
From the employer's point of view, the career revalued average earnings basis is still a cheaper option than a final salary formula because it avoids having to pay a pension linked to what is traditionally an employee's year of peak earnings ' that is, the salary at retirement.
From the employees' point of view, as with any change in pension scheme, there are winners and losers. Clearly, those whose earnings rise according to age and seniority will do less well under a Care scheme than they would under a final salary arrangement. However, many employees will be better off.
For example, manual workers who include a lot of overtime in their early career can benefit from a career average earnings formula.
So too can those whose earnings peak mid-career or who actively seek a lower paid and less stressful job in the years preceding retirement.
Career average revalued earnings schemes represent a fair third way for pensions.
Employers can reduce costs further by lowering the accrual rate.
A profit-sharing scheme or discretionary additional revaluation is an integral feature of some Care schemes.
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