One of the recommendations made to the government by Lord Hutton was that public sector pension schemes should be altered from ‘final salary’ to career average. But what does this mean?

Final salary pension schemes are a form of ‘defined benefit’ arrangement. This means that the eventual pension available is based on an earnings formula, most commonly, one sixtieth, eightieth or hundredth of ‘final salary’ for each year worked. In practice, the final salary is usually averaged over the last three years prior to retirement, in order to avoid the pension being disproportionately boosted by a final year salary increase.

The responsibility for meeting the guaranteed payments – and any future indexation – is entirely on the employer, who sub-contracts the administration to trustees, often an insurance company. The member carries no financial risk at all, although in the event of the scheme running out of money and the employer not being available to make good any shortfall, a replacement income from the Pension Protection Fund may be limited for those with higher pensions.

How will career average (revalued) schemes work?

The difference with career average schemes will be that, instead of looking at the ‘final’ salary, each year of scheme membership will be considered individually and an appropriate proportion – the accrual rate – notionally set aside as a future benefit, to be revalued on an agreed basis, but probably in line with CPI inflation.

The accrual rate might be 1%, 1.5% or higher; for example, new entrants to the Civil Service are currently offered an accrual rate of 2.3%.

Will anyone be better off?

It has been pointed out that many high-flyers will be worse off, because their increased earnings later in their careers can currently result in disproportionately large salaries in the run up to retirement, which massively boosts their pension entitlement – and the cost to the employer. This is one of the problems that is exercising the minds of civil servants and BBC journalists, amongst others, who are concerned that the switch (which will only affect future earnings) will leave them much worse off.

The other side of the coin is, however, that those lower down the pay scale, whose incomes tend to rise only gradually over their entire career, could find that they are no worse off – and may even be better off, depending on the accrual rate and how inflation works.

What might you do, if you are affected

What this highlights is that nobody can really afford to ignore their pension planning, even if they are members of a defined benefit pension scheme – and most of us are not; employers have been closing these schemes in their droves, because they impose a massive financial liability on the business that many simply cannot afford to carry.

Consulting a professional independent financial adviser will enable you to determine how your pension arrangements are affected by any changes. Even if you are not directly affected by a switch to career average pensions – perhaps because yours is already a defined contribution scheme, where the benefits depend on what is paid in plus investment growth net of charges – you should take the opportunity to check whether your retirement plans are on track.

It is important to seek independent financial advice before making any decision regarding your finances. The value of investments is not guaranteed; you may get back less than you put in.

NOTHING CONTAINED IN THE ARTICLE SHOULD BE CONSIDERED AS GIVING INDIVIDUAL FINANCIAL ADVICE. PLEASE NOTE THAT THIS ARTICLE IS BASED ON OUR CURRENT UNDERSTANDING OF LEGISLATION, WHICH CAN BE SUBJECT TO CHANGE IN FUTURE; THERE MAY BE VARIATIONS FOR THOSE LIVING IN SCOTLAND AND NORTHERN IRELAND.