Forces' new scheme expected to contain future cost increases

A new pension scheme for members of the regular armed forces started to admit new members from April 2005. It offers better survivors' benefits, but reduced options for early retirement. Members of the existing scheme will be given the option to transfer to the new arrangement from next year.

Key points A new pension scheme for members of the regular armed forces has been open to new recruits since 6 April 2005.     Members of the existing scheme will be given the option to transfer to the Armed Forces Pension Scheme 2005 on 6 April 2006.     There is a common accrual rate of 1/70th for officers and other ranks, plus a tax-free lump sum equal to three times the initial annual pension.     The new scheme offers higher levels of benefits on death or severe disablement that are no longer restricted to a legal spouse, but those who leave the service on ill-health grounds will receive only lump-sum compensation and no pension if their employment prospects are not significantly impaired.     Although normal pension age remains at 55, those leaving before that age cannot draw their preserved pension until age 65.     The MoD maintains that cost savings in one area have been used to enhance benefits elsewhere, but acknowledges that costs will not now increase in the future as they would otherwise have done due to increasing longevity.

Recruits to the regular armed forces have been able to join a new pension scheme since 6 April 2005, and current serving officers and ranks have been given the option to transfer to the Armed Forces Pension Scheme 2005 (AFPS 2005) with effect from 6 April 2006.

The new arrangements, including a separate compensation scheme for those injured due to service, "are designed to be fairer, to reflect modern practice and to meet the needs of the armed forces in the 21st century, and offer a high level of assurance for service personnel," according to the then Parliamentary Under Secretary of State for Defence speaking in autumn 2003. The AFPS 2005 has a different balance of benefits to the previous scheme, which began in 1973, and is designed to better recognise the "special status of military service" by focusing resources on dependants. The compensation scheme targets the more severely disabled.

Scheme design

The new scheme retains a defined-benefit design, but with major changes to early retirement and dependants' benefits. Attention has also been paid to equalising accrual rates for officers and other ranks. Headline improvements include an increase in death-in-service benefit to four times the member's salary, a rise in the value of spouses' pensions and an extension of dependants' benefits to unmarried couples, including same-sex partners. The design of the AFPS 2005 reflects key concerns raised during consultations and addresses "the need to make proper provision for those who are left behind when personnel are killed in service", according to the Ministry of Defence (MoD).

The launch of the AFPS 2005 is the culmination of an exercise that began in the late 1990s, and follows extensive public consultation and an influential, and at times critical, House of Commons Defence Committee report (New Armed Forces Pension Scheme outlined and Defence Committee slams proposals for Armed Forces pensions). The birth of the scheme has been tortuous - the second reading debate on the Bill providing authority for establishing the scheme was described as "interminable" by some of those present.

A scheme profile of the new arrangement appears in box 1.

Equal treatment

Officers and other ranks will earn a pension on the basis of an accrual rate of 1/70th of pay per year of service. Officers in the old scheme benefited from accelerated accrual for the first 16 years of service, so it took them only 34 years to earn a pension of 48.5% of pay, compared with the 37 years it took other ranks to accrue the same benefits. Also, pension starts to accrue from the first day of paid service for all ranks, rather than age 21 for officers and 18 for other ranks under the 1973 scheme.

Both groups now stand to benefit from a pension worth 50% of pay after 35 years' service, with the scope to accrue five more years' pension if they continue in service for 40 years - an option that was not available under the old scheme. The MoD accepts that this option "may not benefit many at the moment, but may be very valuable in the future". Members of the armed forces also receive a lump sum at retirement worth three times the initial annual pension in the new scheme.

Pensionable pay and death benefits

Pensionable pay in the new scheme is defined as the best year's pay in any of the final three years of service leading up to retirement, and includes the "X factor" (an allowance for the risks associated with active service) but excludes allowances and any specialist pay. In the old scheme, pensions were based on "representative" pay, which meant that all those of the same rank with the same length of service retiring in the same year received the same pension, regardless of actual earnings.

Widows' and widowers' benefits are better in the AFPS 2005 - spouse's pensions worth up to 62.5% of the member's entitlement are awarded for life, whereas in the old scheme the widow's pension was worth a maximum of 50% of the member's pension and ceased on remarriage or cohabitation. However, if the spouse is more than 12 years younger than the deceased member, the pension in the new scheme is reduced. Children's pensions will be paid to children born after the member leaves service, unlike in the old scheme.

In a move that must still be considered radical for this traditional part of the public sector, partners, including same-sex ones, are entitled to benefits in the new scheme. In future, civil partners (ie unmarried opposite-sex partners) will also be covered under the old scheme. Death-in-service benefit of four times pensionable pay compares well with the three times multiplier in the previous scheme (which only recently increased to this level, from up to 1.5 times pay, as the result of intense lobbying).

Cost-neutral

The above improvements to the scheme were always intended to be cost-neutral, and are funded by changes in other areas of benefit provision. The normal pension age in the AFPS 2005 remains 55, so that those who serve to this age will receive a pension at this point. But the vast majority of personnel, who leave service before this age, will not be eligible to draw their preserved pension and lump sum until 65, up from 60 in the old scheme. Those members who choose to remain in the old scheme will receive a preserved pension at 60 for all service up to 5 April 2006, with pension accrued on service after this date paid from age 65. The MoD emphasises: "Benefits earned up to the time of change will be fully protected and available from age 60."

Big changes are made to provisions under which armed forces personnel could previously take an immediate pension on leaving the services before normal retirement age. In the old scheme, an immediate pension (IP) was available at age 37 after 16 years' service in the case of officers, and age 40 after 22 years' service for other ranks. IPs are replaced by a non-pension arrangement called early departure payments (EDPs) in the new scheme, which will deliver a lump sum and income from age 40 to 65 for those with a minimum of 18 years' service.

EDPs consist of a tax-free lump sum worth three times the annual pension (the same as for IPs), plus an income payment of at least 50% of the preserved pension (smaller than in the old scheme). Those who leave before the age of 40, other than on ill-health grounds, will not receive any payment from the new scheme until they are eligible for a preserved pension at the new, higher age of 65.

The MoD defends this arrangement, stating that the changes have been made to ensure compliance with revisions to Inland Revenue policy on the earliest date at which normal pension benefits can be taken, and to fund improvements to dependants' benefits and the cost of increases in longevity - "we know of no other employer that offers this level of benefit", the ministry stated in its response to criticisms in the House of Commons Defence Committee report.

Focus on disability

A three-tiered arrangement for ill-health retirement is introduced as part of the new scheme. Actual pensions paid will be based on the degree of incapacity, so that those severely disabled are entitled to a pension based on actual service, plus 50% of prospective service to age 55, plus the lump sum of three times the value of this initial annual pension. Those whose employment prospects are significantly impaired are eligible for a one-third enhancement to their pension, while those whose employment prospects are not significantly impaired, but who are unable to perform a job in the forces, receive a lump sum equal to 1/8th of pensionable pay per year of service (with a minimum of six months' pay and a maximum of two years' pay), with a pension preserved until age 65.

A separate compensation scheme was also introduced from April 2005 to replace the war pensions scheme and benefits paid under the old (1973) pension scheme for service-related deaths and injuries. This no-fault scheme focuses on the severely disabled and for the first time provides a tax-free lump-sum payment for pain and suffering. A tax-free guaranteed income payment will be paid for life after service, alongside the higher-level awards paid to those suffering significant loss of earnings capacity. A lump-sum award for pain and suffering will also be paid for those continuing in service but who have suffered injuries resulting from service. In addition, spouses, partners and children will receive guaranteed income payments where death is caused by service.

Moving the goalposts?

During the second reading debate on what was to become the Armed Forces (Pensions and Compensation) Act 2004, some politicians accused the MoD of moving the goalposts by changing actuarial assumptions to inflate the cost of the existing scheme, so as to make the case for a new one stronger. The government was also accused of reneging on its promise to use savings in one area of provision to enhance benefits in another. It responded that the new scheme will cost 22% of the service paybill, the same as the old one, but that the cost of the 1973 scheme was expected to rise due to "increasing costs associated with people living longer".

The government argued that "other schemes" would expect members to share this cost in the form of increased contributions or reduced benefits: "it is considered reasonable that for service personnel, those joining the new scheme should bear the cost of these longevity costs as, being on average younger, it is they who can be expected to derive the most benefit from longer retirement." The MoD considers it has achieved a "reasonable balancing of benefits that will support better retention".

Wrong decision could cost £100,000

The decision whether to transfer in to the AFPS 2005 is a "difficult" one for the 200,000 people recently offered the option, according to Commodore Martin MacPherson, assistant general secretary of the Forces Pension Society (FPS), a campaigning body with a membership of 46,000. The FPS suggests: "making the wrong decision now could cost you and your partner more than £100,000 in lost pension benefits over the course of your retirement". The decision depends on individual factors including the age at which an individual joined the old scheme, rank and salary, marital status, length of service, and career and retirement aspirations.

The FPS is "delighted" that a number of anomalies surrounding widows' pensions in the old scheme are resolved in the new one. It is also pleased that the new scheme will avoid the situation arising of personnel being deprived of pension, through no fault of their own, because they were forced to leave the service at a particular point due to staffing issues. The new definition of pensionable pay, based on the best year's pay out of the last three years, also means that people should no longer suffer from the pension "troughs" that used to arise, for example, during periods of public sector wage restraint.

However, the FPS is less impressed with the decision to end the system of immediate pensions, which will affect the income of a large number of non-officers discharged at age 40. The society has calculated that the value of the new EDP over its lifetime, that is, until a preserved pension is paid at 65, for someone who leaves at 40 is around 20% less than the old IP, although the gap between the two payments falls with age. The FPS also points out that those who leave service before the age of 40 used to be eligible for a preserved pension at age 60, but will now have to wait until 65 to collect this benefit.

Commodore MacPherson suggests that factors likely to influence individuals' decisions to transfer into the new scheme include the better spouse's, dependants' and death-in-service benefits, and the eligibility of common law and same-sex partners. Also, he believes that highly skilled personnel, whose earnings and pensions expectations outside the armed forces are high, will not feel the penalty of the lower EDP as sharply as those who have relied on the IP under the 1973 scheme.

Impartial oversight

The FPS is gratified that, as a result of its lobbying, the Armed Forces Pay Review Body has been given a remit to conduct independent oversight of the new AFPS, and will benchmark the scheme's benefits against other public sector arrangements every five years and flag up any deterioration to the government. One of the FPS's complaints has been that "uniquely, in the public sector", the old scheme has no trustees, no independent oversight and no statutory protection for the scheme member. This has meant that men and women in the armed forces have depended entirely on the employer to discharge the duty of care fairly: "sadly, this has not always occurred," the FPS maintains.

The MoD states on its website that, although the government is currently consulting on whether to offer a career average earnings arrangement rather than a final-salary scheme for both civil servants and NHS staff, AFPS 2005 "takes full account of the government agenda for pensions … and was approved by the Treasury before its introduction". So the implication is that no such change will be considered for armed forces personnel.

Box 1: Scheme profile - Armed Forces Pension Scheme The 2005 scheme started to admit new recruits to the army, navy and air force into membership from 6 April 2005. Around 200,000 current members of the previous scheme have been given the option to transfer into the scheme from April 2006. Full scheme name: The Armed Forces Pension Scheme 2005 (AFPS 2005). Type of scheme: Statutory, unfunded, contracted-out, final-salary scheme. Pensionable earnings: Basic salary including the X factor (an allowance for the risks associated with active service) but excluding allowances and specialist pay. Final pensionable earnings: The highest amount of pensionable earnings received for any period of 365 consecutive days during the last three years of service. Members' contributions: None. Accrual rate: 1/70th of final pensionable earnings per year of service for officers and other ranks. A pension of half final pensionable earnings is therefore available after 35 years' service, but there is an option for those remaining in service to earn a further five years' pension on service up to 40 years. Retirement lump sum: All members automatically receive a tax-free pension lump sum of 3/70ths of final pensionable earnings per year of service. Members can exchange all or part of their lump-sum payment for an increase to their pension on terms calculated by the actuary. Eligibility: All ranks from first day of service. Re-entry arrangements: Armed forces personnel can join belatedly or rejoin the scheme once prior to age 55, provided they are medically fit. Re-employment: Those who have left the services in the past with an old-style immediate pension may have this reduced if they are re-employed in future to ensure that the new salary plus pension do not together exceed the salary at departure (adjusted for inflation). The new early departure payments (see below) will stop for the duration of any re-engagement, and restart when a member leaves the service before age 55. Normal pension age: 55 for personnel still in the services at that age, but preserved benefits for early leavers are not paid until age 65. Pension increases: Once in payment the total pension is increased annually in line with the retail prices index. This includes ill-health pensions but not early departure payments (see below) prior to age 55. AVC options: Members can buy added years but there are no other additional voluntary contribution (AVC) options. However, the Ministry of Defence has negotiated special low charges with Scottish Widows for those members wishing to make freestanding AVCs. Death-in-service lump sum: Four times pensionable pay at death. Death-in-service pensions: Payable to a spouse or partner, including a same-sex partner and based on an accrual rate of 1/112ths (and therefore worth up to 62.5% of the member's pension entitlement) and on actual service plus half prospective service to age 55, subject to a maximum of 37.33 years' service. They are payable only if the member has at least two years' service. Such pensions are awarded for life, regardless of whether the deceased's partner remarries or cohabits. The pension is reduced if the survivor is more than 12 years younger than the member. Existing relationships of members who transfer to the new scheme are not affected by this rule, provided they do not get divorced or dissolve the civil partnership. Children's pensions are based on the balance of the member's pension after payment of the partner's pension, though no child can receive more than 25% of the member's pension. Where no partner's pension is payable the full pension is split between the children, subject to no child receiving more than 33%. Death-in-retirement pensions: As for death in service, but with no enhancement. If death occurs in the five years following retirement a tax-free lump sum of the balance of the first five years' pension is payable. Early retirement pensions: A system of early departure payments (EDPs) operates to compensate those who leave the services after a minimum of 18 years' service and who are at least 40 years of age. Payments under the EDP scheme consist of a tax-free lump sum of three times the value of the annual pension, plus an income payment equal to at least 50% of the value of the preserved pension. The EDP is payable until a pension and lump sum are awarded at age 65. The EDP income increases by 1.6667% of the preserved pension for each complete year of service past the 18 years' service/age 40 "early departure point". Medical and dental officers have separate arrangements. Ill-health early retirement: A three-tier system operates. The most severely disabled receive an enhancement worth one-half of potential future service to age 55; those whose employment prospects are deemed to be significantly impaired receive an enhancement of one-third potential service to normal retirement age; and those whose ability to obtain gainful employment is not deemed to be significantly impaired, but who are unable to carry out service duties, receive a tax-free lump sum based on 1/8th of pensionable pay per year of service (subject to a minimum payment of six months' pensionable pay and a maximum of two years' pensionable pay). This last group will instead receive an EDP if eligible. Late retirement pensions: Accrual of pension for over 40 years is not permitted. Transfers-in: These buy added years even if money-purchase benefits. Members are only able to transfer in a maximum of 35 years' service. Pension payments: Monthly in arrears by BACS direct to account. Early leavers: Leavers with under two years' service are reinstated in the state second pension. Preserved benefits: They are revalued in line with the retail prices index but cannot be drawn prior to age 65 except in clearly defined circumstances. Service-related injury compensation: A new compensation scheme sits alongside the new AFPS 2005 to compensate those where death or injury is caused by service. The no-fault scheme provides a tax-free lump-sum payment for pain and suffering for the first time for those in service, in addition to a tax-free income after service for those who suffer significant loss of earnings capacity. Benefits are provided to dependants where death results from service and extends to partners. Compensation will be reduced by any armed forces pension that is paid. Administration: Pensions administered by the pay, pension and personnel administration department of the relevant service. Scheme's professional advisers: Actuary: Government Actuary's Department. Our research This scheme profile was produced using information on the Ministry of Defence website and with the assistance of the service personnel policy pensions team at the ministry.

Our research This feature is based on the Armed Forces (Pensions and Compensation) Act 2004, which set the framework for the new arrangements, and the Armed Forces Pension Scheme Order, which includes the scheme rules in its Schedule 1, and on information on the MoD website (at www.mod.uk/issues/pensions). We are also grateful to the service personnel policy pensions team at the Ministry of Defence for providing detailed comments on a draft of this feature.