From: "Tim"
Newsgroups: uk.finance
Subject: Re: how much reduction is typical for early retireees pension?
Date: Fri, 22 Jun 2007 12:30:07 +0100
Bytes: 8525
>> "RobertL" wrote
>>> My employer's scheme reduces my pension by 1/3% for each
>>> month I retire earlier than my 60th birthday. So that's 4% per
>>> year, which seems OK. but this is provided I am still emppoyed
>>> by the company at the time I retire. But if I am not employed with
>>> the company they reduce it by 1/2% per month. (6% per year).
>>>
>>> I cannot see how the actuaries would justify that. ...
>>
> "Tim" wrote:
>> It's actually perfectly justifiable, and in fact to be expected...
>>
>> It's all because of the increases that would be granted between
>> the proposed early retirement and normal retirement. The 4%pa
>> reductions for "active" members allow for the fact that the current
>> pension is effectively increased upto normal retirement by salary
>> increases (as the pension is based on final salary at normal
>> retirement date). Salary increases are generally accepted to
>> have been around 2%pa more than inflation over the longer term.
>>
>> However, for "deferred" members, their current pension would
>> only generally be increased at (around) inflation between now
>> and normal retirement. In other words, the pension that they
>> are giving up (from normal retirement), to get the reduced
>> early pension now instead, is 2%pa less than the "4%pa
>> reduction factors" allow for. So it would need to be reduced
>> by another 2%pa if the 4%pa factors were to be used;
>> it's easier just to use the 6%pa factors in the first place!
>
"Ronald Raygun" wrote
> Could you run that by me again, slowly? ...
OK, let's try this - with some numbers(!) :-
To make things simple, let's use:
Inflation : 2%pa
Salary increases : 4.5%pa
Investment Return / discount rate : 7%pa
Value ("cost") of a pension payable immediately...
... to a 60-year-old : £1,800 per £100pa pension
... to a 55-year-old : £2,000 per £100pa pension
Let's consider a member currently aged 55,
with a "current pension" of £1000pa.
First look at an "active member" (still employed) ...
The pension is expected to rise at 4.5%pa to about:
(£1,000pa x 1.045^5) = £1,246pa in the next 5 years,
so its value then is:
(£1,246pa /£100pa x£1,800) = £22,431.
That value now is: (£22,431 / 1.07^5) = £15,993.
To give an equivalent value now, the reduced
early retirement pension would have to be:
(£15,993 /£2,000 x£100pa) = £800pa.
That's a reduction from the "current pension"
of £1000pa, of 20.0% (4.0% for each year early).
Now look at a "deferred member" (no longer employed)...
The pension is expected to rise at 2%pa to about:
(£1,000pa x 1.02^5) = £1,104pa in the next 5 years,
so its value then is:
(£1,104pa /£100pa x£1,800) = £19,873.
That value now is: (£19,873 / 1.07^5) = £14,169.
To give an equivalent value now, the reduced
early retirement pension would have to be:
(£14,169 /£2,000 x£100pa) = £708pa.
That's a reduction from the "current pension"
of £1000pa, of 29.2% (5.83% for each year early).
So, using the above figures, the early retirement
reduction required (to give a pension payable
immediately of equivalent value to the alternative
payable from normal retirment age), is only 4.0%pa
for an active member but 5.83%pa for a deferred member.
"Ronald Raygun" wrote
> ... It seems to me you've added 2% which
> you ought to have subtracted instead.
>
> Please consider the following illustration:
... OK ...
"Ronald Raygun" wrote
> Members A and B, who are contemporaries, would both
> normally retire at 65 with 40 years' service under their belts.
>
> Member A decides instead to retire at 64 with 39 years
> service. Compared to staying on until 65, he suffers a 2%
> reduction due to missing out on a final salary increase, ...
Yep - that's why his reduction factor (being applied to the
"current pension", which doesn't have that 2% final salary increase),
is only 4% and not 6% (which it might be, if the factor were instead
to be applied to the (notional) pension at normal retirement date).
"Ronald Raygun" wrote
> ... a further reduction of 2.5% due to
> losing one year's pensionable service, ...
That's a bit of a red herring - the actuarial reduction factors
only apply to pension accrued to date, so we can ignore any
missed future service when considering the reduction factors.
"Ronald Raygun" wrote
> ... and a 4% actuarial reduction on top.
>
> Member B ceases employment at 63 with 38 years service and
> becomes a deferred member, initially planning to draw his pension
> at 65. This costs him a drop of 4% in pensionable salary and 5%
> due to losing 2 years' pensionable service. Fair enough so far.
>
> Later he decides to draw his pension one year early,
> from 64, because his pal (member A) has persuaded him
> to join him for some gentle hillwalking in the Himalayas.
>
> What justifies him losing an additional 6% instead of 4%?
Because that is what makes his reduced early
retirement pension equal in value to the pension he
would otherwise get from normal retirement age!
"Ronald Raygun" wrote
> If the reduction is purely actuarial, then the only
> consideration is that the pension -at whatever level-
> will be payable for one year longer than otherwise.
That is allowed for with the difference between the
costs of £2,000 and £1,800 in my example above.
But - the pension fund will also "lose out" on a year's
investment return, altho' it will not increase the initial pension
for that year. The difference between these two effects is
roughly 7%pa - 4.5%pa = 2.5%pa in my example above
for the active member, or 7%pa - 2%pa = 5%pa
in my example above for the deferred member.
"Ronald Raygun" wrote
> But there is another consideration, and that is that the pot fed by
> pension contributions will be smaller for B than for A. Their
> contribution records for the first 38 years of their service are the
> same, but A has paid an additional year's worth. If the average
> pension fund growth per annum is more than 2% above inflation (and
> it usually is, isn't it?), then A's fund will be roughly (but slightly
> less
> than) 39/38 as big as B's and this would therefore justify A's pension
> being 2.6% more than B's, when all is said and done, given that
> they are being brought into payment at the same time as each other.
As already noted, the extra year's service is a red herring.
"Ronald Raygun" wrote
> Yet A's is 8.5% less than if he'd stayed on to 65, and B's is 15%
> less. That doesn't seem right to me. Does it to you? If so, how?
If we write salary at age 64 as 'S64', and assuming 80ths accrual, then:
A : (39 / 80 x 'S64') x 0.96 instead of (40 / 80 x ('S64' x 1.045)) is
10.4% less.
B : ([38 / 80 x 'S63') x 1.02] x 0.94 instead of
(40 / 80 x ('S63' x 1.045^2)) is 16.6% less.
But around 5% of B's loss comes from becoming deferred...
At age 62.99999 his anticipated pension,
just from past service, from age 65 is:
38 / 80 x ('S63' x 1.045^2) = 0.519 x 'S63'
but on becoming deferred at age 63.00001 it is only:
38 / 80 x ('S63' x 1.02^2) = 0.494 x 'S63'
0.494 is only 95% of 0.519...
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