Are career average revalued earnings (Care) pensions a better bet?

If you read nothing else, read this:

• Based on an employee’s average salary, career average revalued earnings (Care) pension schemes are generally lower cost and lower risk than defined benefit plans, but the savings can be modest.
• Switching from a final salary to a Care scheme only reduces the salary risk as the other defined benefit risks remain.
• Care plans are more complex to run than final salary plans.
• Unlike defined contribution schemes, they give employees some certainty about their pensions savings, which should make them better received by staff.

Care pension schemes seem a good alternative to final salary plans, but the savings may not be great, says Peta Hodge

A number of UK employers have moved from final salary pensions to career average revalued earnings (Care) schemes in an effort to reduce the cost and risk of their provision.

A Care scheme aims to deliver a pension based on a member’s salary in every year of employment, not just their final one. Each year’s pay is typically revalued in line with an index, such the retail price index (RPI).

As with final salary plans, the member’s contribution is usually fixed, with the balance of cost met by the employer.

One of the biggest advantages of Care over final salary schemes is the reduced cost for the employer. John Cockerton, consulting actuary at Towers Watson, says: “Traditional actuarial thinking is that pay growth exceeds inflation and Care plans typically revalue in line with inflation.”

Flexible working patterns

Care plans can also be a better fit with flexible working patterns. For example, they can be preferable for staff with variable earnings, particularly those who shed hours or responsibilities in the run-up to retirement. Because there is no link to final earnings, mobile staff are not penalised for leaving the scheme early.

Chris Sheppard, head of Mercer’s strategy and design group, says that if an employer is determined to move away from final salary, most employees would prefer a Care scheme, which still allows them to target benefits at retirement, rather than a defined contribution (DC) arrangement.

“In the current financial climate, with the majority of employees expecting little or no real salary growth, a Care design could be particularly attractive,” he adds.

More complicated to run

But Care schemes are not without their disadvantages and are more complicated to run than final salary schemes because employers have to keep lifetime salary records. They also still carry a lot of risk for employers, explains Peter Routledge, head of London retirement consulting at consultancy Towers Watson.

“Only salary risk is reduced,” he says. “The other defined benefit risks, such as inflation, investment and interest rates, remain. An extra danger is the prospect of discovering that a move to Care has not cut enough cost, necessitating additional disruptive pensions change. Employers considering Care should make sure it will achieve their goals in terms of cost and risk.”

Cockerton expresses similar concerns, saying that even the cost savings offered by a Care scheme are not guaranteed. “For example, the civil service now operates a Care plan linked to RPI. If civil servants’ pay growth is limited to below inflationary rises, then the Care plan could give a larger pension than a final salary arrangement.”

Communication problematic

Communicating the switch to Care may also be problematic, says Cockerton, because final salary is the gold standard and any alternative is likely to be seen as inferior.

But Care schemes do have strong selling points, says Fraser Smart, northern region director at Buck Consultants. For example, a Care plan can be presented as a fairer option than a final salary pension because it favours longer-serving employees who obtain pay progression through promotion. Employers may find this message difficult to get across to staff, however.

“It is a lot easier to explain X% of your final salary than to communicate the principle of earning a chunk, adding revaluation, earning a chunk, and so on,” says Smart.

Although Care schemes are not risk-free and can be complicated to run, organisations that offer them are likely to stand out from those that offer only DC plans.