With many changes having taken place over the last few years, teachers should be aware of where they stand with their pensions. John Adams of the Pensions Policy Institute explains why.
The world of pensions has seen a number of big changes over the past few years. Some, but not all of them, may impact the retirement options and outcomes for teachers. Significant changes have been made to the Teachers’ Pension Scheme, but also there have been changes to the way that pensions can be accessed in the form of the Freedom and Choice initiative and also the new State Pension that replaces the current two tier Basic State Pension and Additional State Pension.
The Teachers’ Pension Scheme
The Teachers’ Pension Scheme (TPS), like other public sector pension schemes, is a Defined Benefit (DB) pension scheme. That means that the pension received is based on a formula that typically combines salary, service and a rate of accrual. However, private sector pensions schemes tend to be Defined Contribution (DC) schemes. DC schemes are pension saving schemes where a pre‑determined amount of contributions are made into a savings pot, which is invested on behalf of the member. The pot is subject to the volatility of the investment market, and whatever is in the pot at retirement is the pension fund that the member receives.
The perception of a growing divide between the pensions offered to public and private sector employees, combined with fairness and sustainability concerns, led the coalition government to appoint John Hutton to chair an Independent Public Service Pensions Commission in 2010. His brief was to ‘conduct a fundamental structural review of public service pension provision and to make recommendations to the government on pension arrangements that are sustainable and affordable in the long term, fair to both the public service workforce and the taxpayer and consistent with the fiscal challenges ahead, while protecting accrued rights’. The Commission reported in March 2011 with a number of proposals, which the government used as the basis for the scheme reforms that came into effect in April 2015.
In June 2010, separate to the Hutton commission, the government changed the inflation measure used to uprate public service pensions. From April 2011, public service pensions are uprated in line with changes in the Consumer Prices Index (CPI), instead of the Retail Prices Index (RPI) as had been the previous policy. The CPI typically rises more slowly than the RPI. This means that the annual increases to pensions when they are in payment are likely to be less than under the previous policy.
Teachers’ Pension 2015 Reformed scheme
The government implemented a form of Hutton’s recommendations for the TPS. Key features of the reformed scheme include: increase contributions paid by members of the scheme; switch from final salary, to Career Average Revalued Earnings (CARE); pre-retirement revaluation of earnings for CARE at CPI +1.6 per cent; accrual rate of 1/57th of salary; and linking of the Normal Pension Age with the State Pension Age.
The government announced that pension contributions made by employees to public sector pensions would be increased by, on average, 3.2 per cent of salaries, but protecting the lowest earners. This was achieved by making the employee contribution rate earnings related. In the case of the TPS, those earning below £26,000 a year faced a one per cent increase to their contribution rate, but higher earners would see increases of up to 5.3 per cent.
The switch from a final salary pension scheme to a Career Average scheme is the most fundamental change. Under a final salary scheme the amount of pension received is based on salary near retirement and the number of years of membership in the scheme. Under a career average pension scheme every year’s salary is included in the calculation of the pension. That means that it is more representative of the working life, and specifically of the level of contributions made by the employee.
Career average is seen as providing an element of fairness. For instance, it means that people who achieve promotions toward the end of their working life (leading to a higher, than otherwise final salary) are not in effect being subsidised by those who do not achieve such promotions.
The ‘Revalued Earnings’ part of CARE refers to the uprating of past years of earnings. When calculating the pension under the Career Average scheme all the previous years’ salaries are indexed up to retirement by CPI plus an additional 1.6 per cent. This is to allow for the fact that inflation erodes the value of previous years’ salaries, so taking an unadjusted salary from, say 30 years before retirement, would not give a reasonable measure of the average salary. Revaluation avoids this problem by setting all salary measurements on a more consistent footing.
The changes to the TPS only affect future pension being built up. For teachers with existing pension in the final salary scheme, that part of their pension is protected and will not be changed by the CARE scheme.
There are protections in place for some teachers. Those who are within 10 years of retiring will continue in the final salary scheme. Those who are within 13‑and-a-half years will continue in the final salary scheme but be transitioned in to the CARE scheme at a future date.
Freedom and Choice
In Budget 2014, the Chancellor announced plans to review the access that individuals have to their pension savings. The Chancellor has stated the intention of these plans is to give individuals more flexibility and trusting them to make their own decisions with their pension savings.
The Freedom and Choice reforms are only applicable to Defined Contribution pension schemes. These are the schemes mentioned earlier, where a pre-determined amount of contributions are made into a savings pot, which is invested on behalf of the member. Under the existing rules, up to 25 per cent of the fund could be taken as a tax free lump sum and the remainder would, in the majority of cases, be required to be used to purchase an annuity.
The main results of this review were that all members of defined contribution pension schemes would no longer be required to buy an annuity with their fund. From April 2015 there are no limits to how individuals over age 55 can access their DC savings. However, these reforms will have little impact on the pensions built up by teachers over the course of their teaching career.
The Teachers’ Pension Scheme is a Defined Benefit pension scheme, where the amount of the pension to be received is based on a pre-existing formula. So, because it is not a DC pension, the pension built up in the TPS is not subject to the freedom and choice reforms. The government have also put in place a ban on members of public sector pension schemes from taking a transfer from their pension scheme.
The reforms therefore do not affect the pension built up in the TPS, however, any other pension savings they have that are not in public sector pension schemes may be eligible to be used under the new pension freedoms.
New State Pension
The new State Pension is the replacement for both the current Basic State Pension and the Additional State Pension. It is only for people who reach State Pension Age after 5 April 2016. The base amount of new State Pension (nSP) will be £155.65 a week from April 2016, which is £36.35 higher than the level of the Basic State Pension in 2016 of £119.30 a week. However not everyone will receive the £155.65; some may receive less and others may receive more.
In April 2016, at the point when the nSP comes into effect, the government will calculate an individual entitlement level for everybody, called the ‘Foundation Amount’. This calculation compares the amount of pension built up under the current state pension system, with what the person would get under the new State Pension, adjusted for any period of being in a ‘contracted‑out’ pension scheme. Their Foundation Amount will be the higher of the two.
If an individual’s foundation amount is equal to the full nSP, they will not build up any further nSP up to their State Pension Age and will retire with an entitlement to the full level of nSP at retirement. If an individual’s foundation amount is higher than the full nSP, perhaps because they had a significant amount of SERPS or S2P built up, they will retire on the full nSP, plus a protected amount equal to the excess of their foundation amount over the full nSP.
People may receive less than the full amount if they have fewer than 35 years qualifying years of National Insurance contributions or credits. They may also receive less than the full amount if at some point in their working life they were a member of a contracted-out scheme.
The TPS is a contracted-out pension scheme. This means that members pay a reduced National Insurance contribution rate and in turn do not build up Additional State Pension. In effect, part of the pension from the TPS could be thought of as paying a pension that would otherwise be delivered by the state.
The default position for an employee in the UK is to be part of the Additional State Pension, so if the individual was contracted‑out, their State Pension is adjusted. This is to allow for the fact that reduced NI contributions were paid and lower Additional State Pension has been accrued. The adjustment is called the Contracted-Out Deduction. The calculation of the Foundation Amount takes into account the Contracted‑Out Deduction, so someone who has the 35 qualifying years required for the full nSP may have a Foundation Amount which is less than full nSP after taking account of the Contracted-Out Deduction. This may be the case for many teachers, because the Teachers’ Pension Scheme is a contracted‑out pension scheme. Many teachers may find that they have a Foundation Amount which is lower than the full rate of nSP as a result of having made reduced National Insurance contributions while in the TPS.
However, it is possible to fill the gap, because every qualifying year worked after 2016 builds up further entitlement to nSP. This means that by the time they reach SPA, many people who had a reduced Foundation Amount may have achieved entitlement to the full rate of new State Pension. Teachers may therefore have a higher state pension under the new State Pension than under the current system, but National Insurance contributions will no longer be on a reduced rate.
There have been many changes to the pensions world over the past few years, each affecting teachers to differing degrees. Changes to the Teachers’ Pension Scheme affect their current workplace pension. The Freedom and Choice initiative does not affect their Teachers’ Pension, but may affect any other pension savings a teacher has. The changes to the State Pension will likely affect all teachers retiring after 2016. The total pension income is a combination of all of these pensions, so all should be considered when a teacher thinks about their retirement planning.