LGPS 2014 is a career average scheme. You may also hear the terms ‘CARE’ or, to give its full title, ‘Career Average Revalued Earnings’. When used in relation to the LGPS 2014, all these terms refer to the same method of calculating your pension as described below.
A defined Benefit
The LGPS 2014 is a defined benefit scheme. Defined benefit pension schemes - including career average pensions – calculate pensions using a set formula. In the case of LGPS 2014 that formula is as follows:
Pension = Membership x Accrual Rate x Pensionable Pay
In a career average scheme, the pensionable pay for each year is used to calculate a pension for that year. Each year’s pension is then revalued (i.e. increased) by inflation. Each year’s revalued pension is then added together to arrive at the total pension. So the total pension builds up as follows: Pension for year 1 x revaluation plus Pension for year 2 x revaluation plus Pension for year 3 x revaluation plus And so on….until plus Pension for final year
So let’s look at each element in the above formula…
Membership
This is normally the amount of time you are contributing to the pension scheme and is also known as pensionable service. It is measured in days, although for the sake of simplicity the examples below assume whole years.
Accrual rate
The accrual rate is the proportion of pensionable pay that each year of membership adds to your pension. The rate is normally expressed as a fraction (although some schemes show it as a percentage). For the LGPS 2014 the accrual rate is 1/49th (or 2.04% if expressed as a percentage). This means that for each year of membership you will build up a pension of 1/49th of your pensionable pay for that year. You may see the terms ‘accrue’ or ‘accrual’ used. These just mean the amount of pension that has been built up for the year or in total. If you opt for the 50/50 option, you will get half the benefits, meaning an accrual rate of 1/98th.
Pensionable pay
Pensionable pay is the amount you earn for hours worked including non contractual overtime and, for part-timers, ‘additional hours’. This is the amount you pay contributions on and the amount your benefits are based on.
The basic calculation
To explain how your pension builds up and is revalued let’s take one step at a time. We have already said that each year’s pension is a fraction of that year’s pensionable pay. The example below shows how that builds up over time to create the total pension.
Example 1
Neil has a pensionable pay of £10,000 this year so will ‘accrue’ 1/49th of that pay towards his pension i.e. £10,000 x 1/49 = £204.08. If Neil was in membership for 5 years and there were no pay rises or inflation to take into account, his pension would build up as follows:
Year 1: £10,000 x 1/49 = £204.08
Year 2: £10,000 x 1/49 = £204.08
Year 3: £10,000 x 1/49 = £204.08
Year 4: £10,000 x 1/49 = £204.08
Year 5: £10,000 x 1/49 = £204.08
Total: £1,020.40 per year
However, pay does normally rise over time and there is inflation to consider, so we will see how revaluation is needed to ensure the pension does not lose its value.
Revaluation
One of the most important features of LGPS 2014 is the way that your pension is revalued as it builds up. This is significant as there could be a period of 40 years or more between your first year’s pension saving and your retirement date. Over this period of time the real value of the early years’ pension will have been reduced by effects of inflation.
To stop this, the LGPS 2014 will revalue each year’s pension build up in line with inflation (CPI).
Example 2
If Neil receives no pay rises but inflation is 3% each year, then his pension would be revalued as follows. The further in the past the pension is earned, the more multiples of 3% it is increased by. This results in an increased total pension when compared with Example 1:
Year 1: £10,000 x 1/49 = £204.08 Revalued = £229.70
Year 2: £10,000 x 1/49 = £204.08 Revalued = £223.01
Year 3: £10,000 x 1/49 = £204.08 Revalued = £216.51
Year 4: £10,000 x 1/49 = £204.08 Revalued = £210.20
Year 5: £10,000 x 1/49 = £204.08 Revalued = £204.08
Total: £1,083.50 per year
You can see that compared with the Example 1, the first 4 years of pension built up have been increased to take account of inflation. Year 1 has been increased by the most as it is furthest in the past and so its needs a greater increase to retain its value against inflation.
Example 3
Finally, let us assume that Neil did receive pay rises in which case the pensionable pay for each year would increase before revaluation is applied. With inflation at 3% each year and a consistent pay increase of £500 per year, the calculation of his total pension would be as follows:
Year 1: £10,000 x 1/49 = £204.08 Revalued = £229.70
Year 2: £10,500 x 1/49 = £214.29 Revalued = £234.16
Year 3: £11,000 x 1/49 = £224.49 Revalued = £238.16
Year 4: £11,500 x 1/49 = £234.69 Revalued = £241.73
Year 5: £12,000 x 1/49 = £244.90 Revalued = £244.90
Total: £1,188.65 per year
So in this example both increases in pensionable pay and inflation have been built into the calculation of Neil's pension.
Tax Free Cash Lump Sum
You can trade some of your annual pension for a cash lump sum on retirement. For every £1 of annual pension given up you will get £12 of cash. Up to 25% of your LGPS benefits (including any Additional Voluntary Contributions but subject to some HMRC limits) can be traded in this way.
Example 4
Neil's total pension after 5 years is £1,188.65. Presuming this is his only pension saving (other than state pension) he could take a maximum of £5,094.21 as a lump sum leaving him with an annual pension of £764.13.