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Career Average Revalued Earnings Scheme
Pensions Beginners Page
Welcome to the first in a series of articles designed to introduce readers to some pensions' related topics.
Career Average Revalued Earnings Scheme
This article looks at Career Average Revalued Earnings ("CARE") schemes. These are defined benefit schemes where benefits are based on earnings throughout an employee's career rather than the more common approach of basing benefits on earnings near retirement.
Defined benefit schemes are typically thought of as 'final salary' schemes which use a formula such as:-
Pension = (pensionable service/accrual rate) x final pensionable earnings
Final pensionable earnings are often an average of earnings in the few years before retirement. Whatever the definition of final pensionable earnings it will relate to earnings over the last years of a member's pensionable service.
So for each year of pensionable service the pension accrued in that year is based on earnings close to retirement age. For a member aged 20 this could be in 40 or more years' time. Earnings are of course subject to promotions, bonuses, salary increases and so on, and could be subject to greater increase close to retirement to help boost the pension further.
A CARE scheme by contrast calculates the accrued pension each year and revalues this from the year of accrual to retirement age using an appropriate index. Putting this into a formula, the pension at retirement is:
(1/accrual rate) x (year 1 pensionable earnings) x (year 1 index revalued to retirement)
plus
(1/accrual rate) x (year 2 pensionable earnings) x (year 2 index revalued to retirement)
plus
...
plus
(1/accrual rate) x (year n pensionable earnings) x (year n index revalued to retirement)
Perhaps this is better illustrated using an example. Say a scheme provides 1/60th of Career Average Revalued Earnings for each year of Pensionable Service and a member joins 5 years before retirement. The total pension is calculated as shown in the table below.
| Year |
Pensionable Earnings (PE) |
Accrued Pension (PE/60) |
Index at start of year |
Index at Retirement Age |
Revalued Pension |
| 1 |
£12,000 |
£200 |
100 |
122 |
£244 |
| 2 |
£14,000 |
£233 |
105 |
122 |
£271 |
| 3 |
£8,000 |
£133 |
110 |
122 |
£148 |
| 4 |
£10,000 |
£167 |
115 |
122 |
£177 |
| 5 |
£16,000 |
£267 |
120 |
122 |
£271 |
|
|
|
|
Total Pension: |
£1,111 |
Why use this method?
The method is seen as a way of providing employers with greater stability of costs whilst still maintaining a valuable defined benefit arrangement; the unknown final salary factor being replaced with a revaluation mechanism. CARE schemes allow individuals with fluctuating career earnings to benefit from those earnings in their pension calculation and they are more compatible with the increasing flexible working patterns of today.
We are often asked whether the benefits will be higher or lower than a final salary benefit. This depends on how an individuals earnings increase during their career; the benefit will be very similar where earnings increase roughly in line with the index used for the CARE scheme.
What index should be used?
The two most commonly used indices are national average earnings (NAE) and the Retail Prices Index (RPI). These may be used alone, may be capped, or applied in addition to a fixed percentage.
As you might expect, both indices are commonly used. Of course it would be useful if there was a precedent to follow but use of both of these indices is prevalent elsewhere in benefit calculations. Currently the basic state pension is subject to RPI increases, and deferred pensions are also subject to an RPI based increase between leaving and retirement age (known as "section 52a orders"). However, in the calculation of Guaranteed Minimum Pensions, contracted-out earnings are subject to NAE increases.
Administration and consultancy issues?
Though at first glance CARE schemes appear to add a further layer of complexity to the administration of a scheme, with today's technology this is easy to overcome.
However, employees need to really understand their scheme basis and so clear communications are vital. The design of annual benefit statements will play a major part in this.
Paul Latimer, June 2005.