NHS PENSION SCHEME PENSIONS REVIEW COSTINGS OF CHANGES TO SCHEME ACCRUAL STRUCTURE FOR NEW ENTRANTS

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1 NHS PENSION SCHEME PENSIONS REVIEW COSTINGS OF CHANGES TO SCHEME ACCRUAL STRUCTURE FOR NEW ENTRANTS NOTE ON THE RESULTS OF THE COSTINGS AND THE ASSUMPTIONS UNDERLYING THEM This paper has been produced by the Government Actuary s Department at the request of the Technical Advisory Group (TAG) to the NHS Pension Scheme review. It sets out the results of our costings of possible changes to the accrual structure of the NHSPS for new entrants currently under consideration by the TAG, and describes the most important underlying assumptions adopted in costing these potential changes. Important background notes to this paper are set out in TAG00. As requested, the paper examines, in particular, the effects of 1) i) retaining the link to final salary, but moving to a 1/60ths accrual with retirement lump sum taken by of pension, with s (independent of age and gender) of a) 9 of lump sum for each 1 a year of pension or b) 12 of lump sum for each 1 a year of pension or c) 15 of lump sum for each 1 a year of pension; ii) retaining the link to final salary with pension accruing at a 1/80ths accrual and lump sum with a 3/80ths accrual, but with an option to commute part of the pension to obtain a higher lump sum using a of 12 of lump sum for each 1 a year of pension (independent of age and gender); 2) as 1)i), but with the accrual for spouses pensions also increased from 1/160ths to 1/120ths; This paper concents on the cost impact of the proposed changes for future new entrants, both in a scheme assumed to have a Normal Pension Age (NPA) of 60, and in one assumed to have an NPA of 65. (A sepa paper covers costings for possible changes to the existing scheme.) In both cases, the costings have been undertaken allowing for projected future improvements in pensioner longevity. The standard joint contribution for new entrants (which may be taken as a baseline for each costing) is 18.2% with an NPA of 60, or 16.9% with an NPA of 65, based on a scheme with the existing 80ths accrual structure see GAD paper TAG02/new/baseline.

2 At this stage, we understand that the TAG s immediate objective is to agree on perhaps two or three possible packages of benefit improvements, each of which might then be costed in its entirety. In order to avoid the need to set out a large and potentially confusing array of results, we have at this stage set out the results mainly in building block form, that is treating each possible change as being introduced independently. Additional costs/savings resulting from packaging of benefit changes will be identified as appropriate at a later stage. As with earlier costings, the results are quoted to a rounding limit of 0.05% of pensionable pay. Generally (but with the exception of the pensioner longevity assumptions), the costings have been based as far as is practicable on the 1999 valuation assumptions. However, for the purpose of costing structures under which retirement lump sum is provided by means of of pension, it has been necessary to adopt a further assumption on the extent to which members would take advantage of the option in a 1/60ths scheme (allowing for the expected changes in the tax regime governing occupational pension schemes which are scheduled to come into effect from April 2006). 1. i) Final salary scheme with 1/60ths accrual and lump sum by Under the current tax regime for occupational pensions, the maximum retirement lump sum that may be taken is in most cases restricted to 3/80ths of final remuneration for each year of service. However, in a 1/60ths scheme where lump sum is taken by, the new regime expected to apply from April 2006 will in effect allow a lump sum of one quarter of the value of the total benefits to be taken, where the value of the pension is determined by multiplying its annual amount by a factor of twenty. Under the scenarios investigated in this paper, the maximum lump sum allowed under such an approach varies between about 3.8 and 4.6 times the annual amount of the pension before, depending on the. Following discussion, the TAG has agreed that the central assumption for the amount of retirement lump sum expected to be taken should be equal to the amount if one half of members opt to take the maximum available under the new regime, with the remainder taking an amount equal to the current limit of 3/80ths of final pay for each year of service. In practice, a degree of uncertainty will attach to the average amount of lump sum that members may opt to take, particularly as there is little or no evidence available as to how pension scheme members are likely to react to the Inland Revenue s increased upper limit for retirement lump sums from April The limited evidence available suggests that, on average, members of occupational pension schemes in the UK which have a option commute a fairly high proportion of the maximum pension permitted, but less than the maximum possible. The costings have therefore been undertaken on three variant assumptions for the amount of lump sum to be taken, as follows: I) maximum take-up: all members opt to take the maximum lump sum permissible under the new regime ; II) central take-up: 50% of members opt to take the maximum lump sum permissible under the new regime, and 50% opt to take a 3/80ths lump sum as permitted under the current regime; III) low take-up: all members opt to take a 3/80ths lump sum as permitted under the current regime; 2

3 In considering the take-up assumption, the following should be borne in mind: (i) (ii) (iii) the low take-up assumption does not represent a lower limit on the possible extent of (this would be zero in theory), whereas the maximum take-up assumption does represent an absolute upper limit, which as such is very unlikely to represent the outcome in practice; whilst there is considerable uncertainty about the extent (if any) to which members might take advantage of the increase in the scope to commute, the remaining pension after commuting to obtain a lump sum of up to 4.6 times the pre pension will in many cases appear very small, so discouraging members from taking full advantage of the increased scope to commute; based on the available evidence, the low take-up assumption would represent a higher level of than that currently experienced (on average) in UK occupational pension schemes. The results of the costings for 1)i) a), b) and c) are set out in Tables 1(A) and 1(B). Note that it is assumed here that contingent spouses pensions continue to accrue at a of 1/160ths (which would be equivalent to 37.5% of the member s 1/60ths pension prior to ). Table 1(A): change to a 60ths scheme with lump sum by : NPA 60 Low Central Maximum take-up* 1) a) 9 for 1pa 0.00% -0.70% -1.45% 1) b) 12 for 1 pa 1.15% 0.80% 0.40% 1) c) 15 for 1 pa 1.90% 1.80% 1.70% Table 1(B): change to a 60ths scheme with lump sum by : NPA 65 Low Central Maximum take-up* 1) a) 9 for 1pa 0.00% -0.60% -1.20% 1) b) 12 for 1 pa 1.05% 0.80% 0.50% 1) c) 15 for 1 pa 1.70% 1.70% 1.75% * changes from the baseline cost, expressed as a percentage of payroll Note that with a of 9 for 1, the costs are negative on all but the low assumption because the extra pension assumed to be given up to obtain the additional lump sum is, in purely actuarial terms, more valuable to the average member than the lump sum so obtained. At higher s, less pension needs to be given up to obtain this additional lump sum. Note also that the extent to which members are likely to take advantage of the option is likely to depend at least partially on the attractiveness of the terms available. If, therefore, the central (50:50) assumption is viewed as appropriate for a scheme with a 12 for 1, it might be expected that more lump sum would be taken (on average) in a scheme with a higher, and conversely that less would be taken where the was less than 12 for 1. Notwithstanding this, the central results set out in Tables 1(A) and 1(B) have been based on the 50:50 assumption irrespective of the. 3

4 For any set of actuarial assumptions adopted, there exists a theoretical cost/value neutral at which the extent of take-up of the option appears (on the face of it) irrelevant to scheme costs and value to members. For the NPA60 costings, this theoretical is about 16.0, and for the NPA65 costings about However, it should be borne in mind that these figures represent averages across all modes of exit, ages at retirement and assumed life expectancies at retirement. The theoretically neutral for each member will vary considerably, and will depend on many factors including the individual s state of health and life expectancy at retirement. Furthermore, the theoretically neutral s take no account of the differential tax treatment between pension and lump sum, nor the general predilection for cash. From the scheme perspective, the theoretically neutral is truly neutral only if the underlying actuarial assumptions are borne out in practice no explicit value is placed on the risks that the scheme bears that the assumptions will in practice prove to be over-optimistic, nor that members will use the option to select financially against the scheme (if, for example, the less healthy opt for maximum cash whilst those with longer life-expectancies opt for more pension). It might seem natural that schemes should offer a approaching the cost/value neutral level (suitably adjusted for selection etc). However, the more generous the cash, the greater the cost to the scheme irrespective of the value of the neutral. Thus a scheme offering a neutral will need to be less generous in other respects than a similar-cost scheme with a lower. In other words, whilst the choice of can be informed by the current theoretically neutral, the latter is a function of the set of actuarial assumptions adopted from time to time, so that the choice of is better viewed as a straightforward benefit design issue. 1. ii) Final salary scheme with 1/80ths accrual for pension plus extra lump sum option The TAG has also requested that a costing should be provided for a scheme in which the existing sepa 1/80ths pension and 3/80ths lump sum provision is maintained, but into which an option is introduced to permit members to commute some of the pension in exchange for additional lump sum at a of 12 for 1 (a structure often described as consistent with a 1/64ths accrual with option). On the low assumption, this would be identical to the current structure, but if sufficient pension was commuted to produce (after also allowing for inverse s of lump sum into pension) a total lump sum equal to that on the central assumption, there would be savings (relative to the baseline) of 0.35% of pay in a NPA60 scheme, or of 0.25% of pay in a NPA65 scheme. 4

5 2. As 1)i), but with spouses pensions accruing at the 1/120ths (irrespective of the amount of member s pension commuted) Under this alternative option, the accrual for spouses pensions would be increased proportionately with that for members pensions (before ), so retaining for members not taking advantage of the option - the relationship under which a spouse s pension represents 50% of the member s pension. The accrual for spouses pensions would thus be increased to 1/120 th, irrespective of the amount of member s pension commuted for lump sum. The resulting costs are set out in Table 2, based on the central take-up assumption adopted for costing change 1) described above. Table 2: 1/60ths scheme for members pensions and 1/120ths for spouses pensions Cost in an NPA 60 Cost in an NPA 65 scheme* scheme* 2) a) 9 for 1pa -0.40% -0.25% 2) b) 12 for 1 pa 1.10% 1.10% 2) c) 15 for 1 pa 2.10% 2.05% * changes from the baseline cost, expressed as a percentage of payroll Put another way, the building-block cost of increasing the spouse s accrual from 1/160ths to 1/120ths is around 0.3% of pay for an NPA 60 scheme and 0.35% of pay for an NPA 65 scheme (ie about one third of the spouses benefits costs shown in the attached baseline costings). For the avoidance of doubt, no allowance has been made in this section for any possibility of of surviving spouses pensions. Government Actuary s Department 26 August