Tricky Pension Conundrum : AVC versus actuarial reduction?

I wouldn't have thought so. 100% of the AVC would have to be used to buy an annuity. As things stand, you can take a reduction in pension in exchange for a lump sum. Currently it's not worth it in many schemes, but it might become worthwhile in the future.

Better to save the extra in an ISA., IMO.

Thanks. How much are you assuming goes into the ISA?

The gross 2.75% of the pension contribution or the net amount left after income tax?

Let's assume a normal rate tax payer.

Cheers

The principle of the ISA is that you pay tax on the way in, but not on the way out. That suggests the net after tax amount.

"Richard Brooks" wrote

I'd say it could depend on your current age. Suppose a 2-year actuarial reduction knocked off (say) 13% from the pension (realisitic rate - some (good) factors might knock off less!). Then, if this were "worth" 2.75% contributions, then the entire pension (pre-reduction) would be "worth"

21.2% conts (employee & employer combined).

I don't know how generous the benefits are in your scheme, but to be worth

21% conts I'd expect either the benefits to be extremely generous, or you'd need to be not far off retirement age already. If you are below, say, 40 then I'd have thought that the benefit of no actuarial reduction would *not* be worth paying 2.75% conts for.

Overall I'd say paying 2.75% conts looks to be "break-even to poor value".

Employer currently paying a lot more due to deficit, intending to bring their contribution down to nearer 10% on the longer term.

Members pay 5% contributions for 1/60th accrual at NRD 62. The extra 2.75% makes a total of 7.75% to secure full 1/60th accrual at NRD 60.

So for each year that you pay an extra 2.75% contribution, you save a 2 year actuarial reduction (call it 10%) in the amount of pension payable for the rest of your life from age 60.

Trying to be as simplistic as possible:

Pension = 1/60th of salary per year Contribution = 2.75% Actuarial reduction for 2 years = 10%

So if the annuity rate is 16.5 at NRD 60 it would be cost neutral.

Of course, we can't know what the annuity rate will be at retirement in (say) 20 years time or what the actuarial reduction rate will be at that time. Salary growth would also seem to be important, because in effect contributions are paid on average salary over the period from now to retirement, but the benefits are based on final salary at retirement.

Leaving the scheme before retirement also introduces the effects of revaluation in deferment.

Hmmm....

"Richard Brooks" wrote

I think the above is only really realistic when you are close to retirement. Eg pay 2.75% of salary in the very last year before retiring - this "buys" a pension of 10% of 1/60th of salary, ie 0.1666% of salary.

However, if that 2.75% of salary had been paid 40 years before retirement, it would (hopefully!) grow from investment returns, and of course (as you said yourself) the pension would be based on *final* salary which again (hopefully) would be higher than the salary on which the contribution had been paid. Overall (especially in the longer term - 40 years should be sufficient!), you would usually expect investment returns to exceed salary increases - possibly by around 2% per annum. This means that the "cost neutral" annuity rate will be much higher than 16.5, for the 2.75% contribution made 40 years before retirement.

To put some numbers to this, suppose investment returns are 6%pa and salary increases are 4%pa. Then the 2.75% contribution will grow to 28.3% of that initial salary, by the time of retirement. Also, the final pension will be 0.1666% of *final* salary, which will be around 4.80 times *initial* salary - ie final pension of around 0.80% of initial salary.

This gives a ("cost neutral") annuity rate of 28.3 / 0.80 = 35.4. Doesn't sound so good now, does it?

"Richard Brooks" wrote

Right, so the scheme "expect" that 5% + 10% = 15% contributions overall (long-term) should provide enough to pay for a pension of 90% of 'scale' from age 60.

Well, if 90% of scale costs only 15% conts, then 10% of scale should only cost contributions of one-nineth of 15%, or 1.666%. But they are charging you 2.75% for this??

The figure of 10% may well prove optimistic for the employer. In the short term they are currently paying more like 30%.

This is why they are changing the retirement age. If their contribution rate doesn't come down, I suppose at some point they may just bite the bullet and wind up the scheme.

"Richard Brooks" wrote

The amount they are paying now can be ignored. If they expect that the long-term required contribution rate (after the changes in scheme benefits - higher ret age), is 15% overall - then any extra that they are paying now is only being made to make-up for the current deficit. The true "value" of the benefits currently being accrued has nothing to do with the shortfall from the past - it is related simply to the long-term required contribution rate.

Granted - if they were just "hoping" that the contribution rate will come down to 10%, then they may well find that they do need to wind-up if it turns out to be higher. But their actuaries should have made the calculations to decide what the long-term reduced rate of contributions is likely to be, after the changes to scheme benefits. Of course they can be wrong, but if it is their "best estimate" that 90% of 1/60ths at age 60 will cost 15%, then it follows that their "best estimate" of the cost of 10% of

1/60ths at age 60 should be 1.666% - not 2.75%.

They may well, of course, be expecting that only older members will wish to pay the extra to keep the lower retirement age. In that case, the cost *is* likely to be more than 1.666% - and if you are already fairly close to retirement yourself, then paying 2.75% may be OK for you. But if you are still young, bearing in mind that the 2.75% is really only required for older members, you may well find that it is not cost-effective. Just something to bear in mind!