COMPARISON OF AFPS WITH BEST PRACTICE OF OTHER SCHEMES
The review team established to review the Armed Forces Pension Scheme (AFPS) has requested, as background information for the review, a comparison of the AFPS with the best practice of other pension schemes.
A summary of the cost of providing benefits through the AFPS compared with other public service pension schemes has already been discussed in Grant Ballantine's paper of May 1999 "Comparison Of The Cost Of AFPS With Other Public Service Pensions Schemes". This showed that the average cost of providing benefits in the AFPS per year of service (22.0 per cent) was higher than for other normal accrual rate public sector such as the NHSPS (20.0 per cent). The cost was lower than for faster accrual schemes such as the Fire (34.75 per cent) and Police (32.0 per cent) service schemes.
Whilst the AFPS provides an above average overall level of benefits it is important to compare each element of the benefit package against that provided by private sector schemes to ensure that the Review team considers all areas where the AFPS may not match the best practice adopted elsewhere, or where the AFPS may be criticised as being inferior to the norm. This paper therefore focuses on a comparison of the AFPS with the approach adopted in large private sector schemes.
SOURCES OF INFORMATION
A comprehensive analysis of occupational pension schemes can be found in the annual survey by NAPF ("National Association of Pension Funds Annual Survey 1998") to which this paper refers. The survey is based on responses from 728 schemes across the public and private sector, (654 private sector schemes). The survey covers pension arrangements of approximately 2 million private sector employees. Amongst other items, the survey provides an analysis of the level of benefits provided by occupational pension schemes. The survey therefore provides valuable evidence of the approach used within private sector schemes.
It should be noted that this survey is biased towards larger schemes and hence larger employers. The benefits provided by smaller schemes are generally inferior or more frequently of money purchase (defined contribution) form.
3. NORMAL RETIREMENT AGE (NRA)
The NRA is the age at which members are able to retire from the scheme and receive their pension benefits without any reduction for early payment. Usually members are able to retire before or after the scheme's NRA with the agreement of the employer or trustees. Schemes may also have a range of ages at which members may retire. IR limits state that a scheme's NRA must be between 60 and 75, however, the rules do allow for benefits to be drawn before age 60 for certain occupations.
The normal retirement age in AFPS is 55 for all members, although early retirement is available from as early as age 37. Preserved benefits for AFPS members who leave service are payable at age 60.
Since the Barber judgement (17th May 1990), schemes have been required to provide equal treatment for both males and females in respect of service accruing from that date. NRA's have therefore been equalised such that the same NRA applies to both male and female scheme members.
Before the Barber judgement there was a tendency for a scheme's NRA to be at the same age from which state pension was payable, 65 for males and 60 for females. For low earners, state pension can form a significant part of post retirement income. Hence occupational pension schemes were designed so that benefits came into payment at the same time as state pension. NRA will also reflect the ages at which the employer may wish to encourage employees to leave service and also the ages at which members themselves wish to retire.
Post Barber, schemes had the option of equalising NRA at the lower or higher age, or at some age in between. The cheapest option would be to equalise at the higher age, as pensions are in payment for less time and the payments are deferred. In fact most schemes do seem to have taken this route. The NAPF survey shows that 60 per cent have an NRA of 65, with some 27 per cent of schemes having an NRA of 60.
The AFPS is therefore more generous than the norm in that it provides pensions below age 60 for those leaving with entitlement to an early immediate pension and preserved benefits from age 60 for those that leave service having completed at least two years' service.
4. AGE RETIREMENT BENEFITS
Benefits at retirement can be provided in either
the form of a pension with lump sum by commutation of pension,
or pension with separate accruing lump sum. Inland Revenue rules
specify the maximum level of benefits a scheme can provide in
order to retain its approved status. IR rules allow for a maximum
pension of 2/3 of pay to be provided, with a lump sum by commutation
of pension, using a factor of 12. There are restrictions on the
amount of lump sum that can be taken varying with length of service
up to a maximum of 1.5 times final salary.
The AFPS, in common with other public sector schemes, provides benefits on retirement in the form of a pension and separate lump sum. The level of benefit depends on the member's service and rank at retirement. The accrual rate is not uniform, but aims to provide a pension of 48.5 per cent of Representative Pay at retirement on full service (34 years for Officers and 37 years for Other Ranks). A separate lump sum equal to three times the pension is also payable.
The majority of private sector schemes provide a pension with lump sum being available through commutation of the pension. Only 5 per cent of large private sector schemes provide a separate lump sum. Because of this, schemes use a higher accrual rate than AFPS.
Most schemes (72 per cent) use an accrual rate of 1/60ths such that a target pension of 2/3rds of pay (IR max limit) is achieved after 40 years service. 12 per cent of schemes use a more generous accrual rate, so that a 2/3rds target is achieved before 40 years service.
The survey shows that an average commutation factor of 12 is commonly used at age 60, although there is variation by age. For females, the survey suggests that on average a higher commutation factor is used. For the same lump sum as in AFPS, this commutation factor would provide a higher initial pension (but see pension increases below).
5. FINAL PENSIONABLE PAY (FPP)
In the AFPS representative pay, rather than pensionable pay, is used in the calculation of pension benefits. The level of representative pay depends upon the rank of the member and can be more or less than the member's actual pay.
Occupational pension schemes tend to use a definition based on actual earnings (about half use basic earnings, half include some element of additional earnings eg overtime), averaged over the 12 months prior to exit. Longer averaging periods are common, particularly if earnings are volatile. 23 per cent of schemes use the year prior to exit and 25 per cent of schemes use best year out of last three.
Unless some element of revaluation is used, longer averaging periods tend to produce a lower FPP figure than short averaging periods, because earnings tend to increase with duration. Conversely, some see a longer averaging period as being more generous as a member may be unable to work full time prior to retirement, particularly for bonus or overtime, so FPP may fall immediately prior to retirement.
6. PENSION INCREASES
IR rules allow for increases to pension in payment increasing in line with the Retail Prices Index (RPI) (or 3 per cent if greater) to be provided.
In common with other public sector schemes, the AFPS provides increases to pension in payment which are guaranteed to increases in line with the increases in the RPI without upper limit. This is considered to be a valuable guarantee and one that most private sector schemes are unwilling or unable to replicate.
Following from the 1995 Pensions Act, all final salary schemes must provide minimum increases to pensions in payment in line with the increases in the RPI up to a limit of 5 per cent per year for benefits that accrue from April 1997. This is known as Limited Price Indexation (LPI). Indeed this is what most private sector schemes provide (48 per cent) with only 18 per cent of private sector schemes guaranteeing full RPI increases.
Within this framework, there is scope for additional discretionary increases to be provided in private sector schemes where funds allow. Just under half of schemes hold regular periodic reviews, although where discretionary increases are provided they are not guaranteed as they are in AFPS. It is doubtful whether such discretionary increases could be provided if inflation exceeded 5 per cent for a sustained period of time.
7. SPOUSES PENSION BENEFITS
Following the Barber judgement, schemes must provide equal benefits for widows and widowers for service accruing from May 1990. Benefits may also be provided to other dependants. IR rules allow for a pension of up to 2/3rds of the member's pension to be provided.
The AFPS, and the majority of private sector schemes (69 per cent) provide a pension equal to one half of the member's pension, with 19 per cent of private sector schemes providing 2/3rds. The vast majority, some 94 per cent of private sector schemes calculate the spouse's pension from the member's pension at retirement before any commutation.
Once in payment spouse's pensions are payable within the AFPS until the spouse dies, remarries or cohabits. This format of benefits is provided across the majority of public sector schemes. Within the private sector spouse's benefits are almost universally payable for life ( provided by 91 per cent of private sector schemes).
The AFPS will only pay a pension to a legally married spouse. Inland Revenue rules permit schemes to pay spouse's form benefits to a financial dependant. Private sector schemes often take advantage of this wider definition often by using trustee discretion to pay such benefits. 18 per cent of private sector schemes pay such benefits to a partner and a further 57 per cent provide benefits at the trustees discretion.
8. EARLY RETIREMENT TERMS
8.1 Early retirement in normal health
It is common to allow members to retire before NRA. IR limits allow early retirement from age 50, or earlier for certain occupations.
The normal retirement age in AFPS is 55, although members are able to draw immediate unreduced benefits before then without requiring the employer's consent. Officers are entitled to retirement benefits once they have completed 16 years service (ie from age 37) and Other Ranks after 22 years service (ie from age 40).
Private sector schemes are usually reluctant to offer generous early retirement terms. The cost of providing benefits early can be prohibitive, so where terms are offered there is usually some reduction in the level of benefit. Trustee consent may be required to protect the security for the remaining members. There are also cost implications relating to preservation and transfer values. Provision for early retirement terms needs to be consistent with employment policy. An employer will want to make sure that the terms don't cause a conflict with the number of employees in service, hence eligibility can require employer's consent. Just over half schemes allow voluntary early retirement on reduced terms, but the majority require employer's consent.
8.2 Ill health early retirement (IHER)
Ill health benefits are usually held in high regard by the membership, to provide benefits (or continuation of income) should the member become unable to work. Following cessation of any sick pay, this may be the only source of income for the member while they remain unable to work. IR rules allow for the provision of a pension based on full prospective service.
Ill health pensions can take the form of accrued service payable immediately without reduction or accrued service with reduction to allow for the pension being brought forward. More generous arrangements can included some level of enhancement to service, with the level of enhancement depending upon the amount of service the member has already accrued in the scheme.
Additionally medical criteria have to be satisfied to assess whether the member is eligible for ill heath early retirement. Typically the level of benefits will depend upon the severity of ill health with more generous benefits payable if the member is expected to be unable to undertake work in any capacity. Sometimes monitoring of the condition continues throughout retirement and benefits may be reduced if the condition improves.
Income replacement schemes (private health insurance schemes such as permanent health insurance (PHI)) which provide a continuation of income and continued accrual of pension benefits following IHER are also becoming more popular. 16 per cent of schemes provide PHI.
In the AFPS all Ill Health retirement application are referred to the DSS War Pensions Agency. The AFPS provides an immediate ill health pension based on the total of accrued service and a small allowance for service enhancement for members unable to perform their own job. Further pension may be provided if the condition is found to be attributable to occupation.
For members of private sector schemes it is necessary to demonstrate ability to satisfy IHER criteria either to the trustees or sponsoring employer. Where the sponsoring employer has adjudication on IHER criteria, he is more able to control the number of members taking IHER and hence the cost of providing the benefits. 48 per cent of schemes have an own job eligibility criteria, 30 per cent have an any job criteria ( ie member is expected to be unable to work in any capacity).
Private sector schemes tend to be more generous in providing benefits on IHER. 41 per cent provide a pension based on full prospective service. 21 per cent provide accrued only, and 14 per cent something in between. For most schemes (64 per cent) no service requirement is necessary before IHER eligibility.
9. DEATH BENEFITS
Generally schemes provide benefits on death in service of a lump sum and spouses' and dependants' pension. Additionally a return of the members contributions may be payable. In some schemes the level of the lump sum may depend upon marital status.
9.1 Lump sum on death in service
Lump sum benefits on death in service tend to be highly regarded by the membership. Members may look to their pension scheme for life assurance cover, instead of having to obtain this through a separate arrangement. IR rules allow for a maximum lump sum of up to four times pensionable pay to be provided plus a return of the member's contributions with interest.
The AFPS provides a lump sum benefit equal to the greater of lump sum payable on ill health and twice the full career pension. This results in a lump sum of broadly 1 to 1.5 times salary.
Most private sector schemes tend to provide a generous level of benefits to reflect their perceived worth by the membership and because they are relatively cheap to provide. 50 per cent of schemes provide a lump sum of four times salary and 36 per cent provide three times salary. 44 per cent also provide a return of contributions.
9.2 Death in service
The pension payable to the spouse on death in service
tends to be consistent with the pension provided ill health. IR
limits allow for 2/3 of the member's potential pension to be paid.
AFPS provides a pension equal to 50 per cent of the member's ill health pension ( accrued service plus small enhancement). Private sector scheme benefits tend to be more generous than this. 65 per cent of schemes provide a pension based on accrued plus some potential service, so pension is independent of age at death. Often it is the youngest members, with low levels of accrued pension where the benefits are needed most. Only 8 per cent pay a pension based on accrued service. However, it should be noted that for attributable death-in-service under the AFPS, the rate of pension is dependent on rank only (not length of service) and is approximately 90 per cent of the full career pension for the rank.
10. EARLY LEAVER BENEFITS
Across most schemes, members with less than two years service at exit receive a refund of their contributions, which extinguishes liability of the scheme.
Members with more than two years service have the option of preserving or transferring their pension benefits on leaving the scheme. All members who leave service are required to have their preserved benefits revalued by the lesser of 5 per cent per year and the RPI from date of exit to date of retirement. Members must be entitled to take their benefits in an unreduced form at the same age as they would have been entitled to had they remained in the scheme (or age 60 if later).
Within the AFPS members leaving service with at least two years service (and not entitled to an immediate pension) are provided with preserved benefits payable from the age of 60. These preserved benefits are calculated for each year of service as 3 per cent of full career pension for officers and 2.75 per cent for other ranks. Preserved benefits within the AFPS carry full RPI indexation.
11. MEMBERS CONTRIBUTION RATE
In meeting the cost of the accruing benefits, members are usually required to pay a fixed contribution to the scheme with employers meeting the balance of the cost. The higher the level of member contributions, the lower the cost of providing the benefits to the employer. This must be offset against setting contributions at a level which discourages membership.
The AFPS is a non-contributory scheme, ie the members are not required to contribute to the cost of providing benefits. The value of the scheme is considered as a factor when setting pay levels.
In private sector schemes, the average member contribution is 4.7 per cent where members are required to contribute and 3.1 per cent including non-contributory schemes. 33 per cent of schemes are non contributory.
For money purchase arrangements, the contribution rates are 3.4 per cent and 1.7 per cent respectively.
12. MONEY PURCHASE SCHEMES
As an alternative to a defined benefit pension scheme, defined contribution or money purchase schemes are becoming increasingly popular in the private sector as a means of providing pension benefits. 16 per cent of occupational pension schemes are money purchase in nature or are GPP's (group personal pensions), with a further 3.6 per cent of schemes being a final salary/money purchase hybrid.
Depending upon the investment returns achieved through the fund, average benefits at retirement may be greater or less than those available under a defined benefit arrangement. The benefits available following death in service or ill health can compare unfavourably with those available through defined benefit arrangements.
Essentially the benefits that can be purchased are bought out through the fund at the time of death or ill health. Frequently additional insurance is purchased in addition to the money purchase plan to provide a higher level of benefits on these contingencies.
The APFS and other occupation pension schemes provide pension benefits on a range of contingencies. When compared to best practise in the private sector, AFPS provides some benefits which are more generous, and some which are less generous than best practise. Overall the scheme can be considered as generous and compares favourably with the majority of private sector arrangements.
There are some areas where the AFPS may appear poor, in particular the benefits payable on death in service and under ill-health. These areas should be considered as part of the review process.
1 It should be noted that since this draft
paper was written, the position on some issues will have moved
on. It is provided as background to inform the Committee of the
earlier work done to assist in developing the Department's proposals.