Case study: Lesley is a 48-year-old head of department at a Manchester school. She had 24 years and 212 days of final salary service when the Teachers’ Pension Scheme changed to a career average structure on 1 April 2015. Although she will be able to access her final salary pension benefits at age 60, the benefits accrued in the career average scheme cannot be accessed on an unreduced basis until the higher age of 65 and her state pension age, which is 67.
If Lesley retires at 60, there will be a seven year “gap” between the age at which she can take only her final salary benefits on an unreduced basis and the age at which she can access all her benefits unreduced without an actuarial adjustment to the career average tranche. Lesley would still like to retire at age 60 and meets with her adviser to discuss her options.
Solution: Although she has moved into the career average scheme, her final salary benefits will continue to be linked to her salaries earned in the career average, as long as she does not have a gap in pensionable public service of more than five years ending on or after 1 April 2015. Her adviser must therefore make reasonable assumptions on Lesley’s salary progression over the 12 years to her retirement on 1 October 2027.
Lesley’s career average benefits will revalue by CPI plus 1.6 per cent, as long as she remains in active service, so her adviser will have to make an assumption on CPI over this period. This will also facilitate a lifetime allowance check.
The actuarial reduction to her career average benefits for the period between ages 65 and 67 will be a “standard” reduction of 3 per cent each year, whereas she will suffer a higher reduction for years 60 to 65.
Based on Lesley’s current salary of £55,000, her adviser calculates an expected final salary at age 60 of £64,787, based on an increase of 1.5 per cent per annum. This would give Lesley an expected final salary pension at 60 of £19,906.46, with an expected lump sum of £59,719.41.
Her unadjusted career average pension at age 67 would be £15,693.91 per annum but if she retires at 60 it would reduce to £11,359.25: an actuarial reduction of £4,334.66 per annum.
Lesley’s final salary benefits will not be increased if she takes them later than age 60. If she were to retire as a deferred member before age 67, her career average benefits would suffer the full reduction in respect of years 65 to 67. So her adviser counsels against deferral to age 67.
Instead, the adviser considers it might be most suitable for Lesley to take all her benefits at 60 and make up the career average reduction through additional money purchase or defined benefit contributions.
Lesley’s adviser considers all the options to increase the benefits she will get from her scheme on retirement at age 60. Looking first at the Teachers’ Pension Scheme, the adviser discounts a number of options. Lesley has missed the deadline for an actuarial reduction buyout election, which she would need to have made within six months of joining the career average scheme. The faster accrual option is also unsuitable on the basis that the dependants’ death benefits included are not required: Lesley’s husband has generous pension benefits through his employer and she has no eligible children.
Buying additional pension would allow Lesley to accrue additional self-only pension with no dependants’ pension. As this would also be actuarially reduced if taken early, she would need to buy £6,000 in additional pension to be left with a £4,152 per annum additional pension before revaluation. The gross cost of doing this would be £573.60 per month for 12 years.
Alternatively, if Lesley were to make a gross contribution of £550 per month over 12 years to a money purchase pension arrangement, assuming 5 per cent per annum growth and 1 per cent annual management charge, after 12 years she would have a fund value of £95,800. This would produce a level annuity with a five-year guarantee of around £4,330. Alternatively, Lesley could take one or more cash lump sums from her money purchase pension pot or use drawdown to provide additional income flexibility.
As Lesley anticipates having the greatest expenditure in early retirement and likes the flexibility of being able to increase her contributions when her cashflow allows, her adviser recommends she commences contributions of £550 per month to a money purchase arrangement.
By doing this, Lesley is able to mitigate the impact of the actuarial reduction which would apply to the career average portion of her benefits if she takes them at her previous final salary normal pension age and provide an income shape that meets her expected needs in retirement.
Moira Warner is public sector technical manager at Prudential