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CARE pensions - how do they compare to final salary
pensions?
CARE stands for ‘Career Average Revalued
Earnings’, a name which gives a clear indication of what
it entails
CARE like Final Salary is a type of ‘defined
benefit’ pension scheme i.e scheme members are promised a defined
level of pension when they retire or leave on a formula generally
related to their salary and years of service.
In calculating the pension the
‘Earnings’ you have in each year of your
employment, or ‘Career’ are taken into account and
an ‘Average’ of all of them is calculated
In order to maintain the value of pension
earned each year it is ‘Revalued’ up until the
time that you retire or leave, before being averaged. Revaluation
could either be in line with a measure of inflation or earnings
increases.
In a Final Salary scheme, by contrast, all
years of service are linked to a scheme-determined definition of
each members ‘final’ salary ’. Generally it is only salary just
before you retire that influences the pension
CARE pensions have been introduced by a
significant number of employers in the private sector in recent
years, generally to replace Final Salary pension schemes e.g by the
Co-operative Group, by Tesco and by RSA.
They have now attracted much greater attention
as the Government is consulting on proposals which could see CARE
introduced in the public service pension schemes schemes. If this
happened it is likely that they would spread more rapidly in the
private sector
An illustrative calculation of how a CARE
pension is calculated is provided in an Appendix to this
briefing
Revaluation rates
There are two critical things which determine
the quality of a CARE scheme, which are:
- the accrual rate (the proportion of earnings earned as pension
for each year of service) which might be 1/60 or 1/80
- the revaluation rate
A final salary scheme could be thought of as a CARE scheme where
pension once earned increased in line with each member’s future pay
rises. In practice the revaluation rate in CARE schemes is set at
one rate for all members.
In the private sector revaluation rates have
generally been set on a basis linked to inflation. Perhaps the
commonest rate, when schemes were first established was RPI (often
with a cap of 5% in any year). In recent times revaluation rates
have sometimes been worsened or established at lower levels e.g CPI
inflation capped at 2.5%
Actuaries generally expect that the earnings
of members of a pension scheme will rise faster than inflation,
usually by 1%-2% each year. These assumptions are based on historic
national trends though they are to an extent modified by factors
specific to the particular organisation involved.
The reason for these approaches to revaluation
is that CARE schemes have been introduced with the deliberate
intention of reducing cost . The other reason is that the
employer has wanted to remove the risk that future pay rises will
increase the cost of pension earned before the salary increase was
given.
A different approach to revaluation has been
suggested for the public service schemes. Revaluation in line with
average earnings increase has been suggested. Such a revaluation
rate is designed not so much to make savings as to make schemes
fairer to those members who do not have promotional careers.
In final salary schemes members whose salary
rises fastest during their careers get a better return from the
scheme, for their contributions, than those whose salary rises at a
slower rate
In a CARE scheme all members may get a pension
which is argued to be fairer as it better reflects the earnings and
contributions throughout the members’ careers.
A simplified ready reckoner of the potential
loss a member might suffer from a CARE scheme, relative to a final
salary scheme is that the loss would be :
Years of membership x difference between
pay rises and the revaluation rate x ½
So, for example, if a member had twenty years
membership during which their pay rose by 1% a year above the
scheme revaluation rate then the loss of pension as compared to a
final salary scheme would be around 10%
Effect on past service
CARE schemes are often introduced to replace
final salary schemes. In this event the value of past service
benefits may or may not be affected.
In some cases past benefits remain linked to
future final salary. This is what has been suggested may happen
with the public service schemes.
In other cases past service benefits have been
fixed by reference to ‘final salary’ at the point the scheme
changes to CARE and then increased each year of future service in
line with the revaluation rate in the CARE scheme.
This reduces benefits to the extent that pay
rises exceed the revaluation and has proved attractive to companies
as a means to reduce pension scheme deficits.
A simplified ready recliner for the loss to
members is that the loss would be :
Years of future membership x difference
between future pay rises and the revaluation rate
Other considerations
In final salary schemes it is often the case
that not all pay is pensionable. One reason for this is that
variable items of pay, such as shift or overtime, are excluded as
they may not still feature in ‘final ‘pay. In a CARE scheme this
argument does not apply and an argument can be made for all pay
being pensionable.
The amount of salary progression a person has
during their career is the key determinant of whether they would be
better served by a Final Salary or a CARE scheme, which delivered
the same total value of pension to all members. Those with short or
broken careers, many of whom may be women, may have as a result
less career progression and therefore tend to benefit from
CARE.
Also important is when during a career
promotions are achieved. If promotion is achieved at the end of a
career then a CARE scheme will not reward it very much relative to
Final Salary. If it happens at the beginning of a career then CARE
will not impact very much on the benefit which results from
it.
In designing a CARE scheme within a budget the
different levels set on the accrual rate, revaluation rate and the
increase in benefits when deferred will affect how benefits are
distributed between members of different ages, between those
who obtain promotions at different points in their careers and
between early leavers and those who stay to retirement.
A disadvantage of CARE is that it makes
pensions more difficult to calculate
and that the pension may not bear a
predictable relationship to the level of pay before retirement.
Individuals may or may not have a clear idea as to how their career
and pay will progress. At a collective level the Union, faced with
a CARE proposal, will need to form a view as to the likely career
movement of all of its members.
Some employers have in recent times offered
‘final salary’ pensions but with a cap placed on the growth of
pensionable pay. These will tend to be worse than a CARE scheme
would be as with CARE all pay remains pensionable.
Appendix
Illustration of comparative CARE and
Final Salary pension calculations
This is a grossly simplified calculation to
show how pensions are calculated under the two formats
Consider the following individual who has a
pension based on five years service.
In the final salary scheme pension is based on
the final year’s earnings
In the CARE Scheme pension is based on Career
Revalued Earnings. The revaluation basis used in this case is
inflation, which is assumed to rise by 2.5% p.a
Year
Earnings
Career Revalued Earnings
1
£20,000
£22,075
2
£21,000
£22,615
3
£22,000
£23113
4
£23,000
£23,575
5
£24,000
£24,000
The ‘final salary’ in the final salary pension
calculation is the Year 5 salary of £24,000 (note however that some
final salary schemes base pension on n average of salary in the
years before retirement)
In the table above, Year 1 Earnings are
revalued by 2.5% p.a for four years in order to give the Career
Revalued Earnings for that year. Year 2 Earnings are revalued for
three years (etc) through to Year 5 Earnings which are not revalued
at all.
The CARE salary used to calculate pension is
the Average of the five ‘Career Revalued Earnings’ figures in the
table – which is £23,075
This means that the pay figure used to
calculate pension is 4% lower in the CARE scheme than in the final
salary scheme, and that the pension would similarly be reduced if
the accrual rate in the schemes was identical.
