Anthony Hilton: Sums for MPs' pay do not add up now they've thrown a curveball on pensions

It is unfortunate that the proposals on MPs' pay, which came out this week and which are designed to make the process open and transparent, have at their heart a very dubious pensions transaction.

Because few journalists understand how pensions work, all the comment has been on the headline pay award – the £7,600 a year needed to push the salaries of MPs up to £74,000 for the next parliament.

Yet the pensions deal – allegedly a saving – will probably cost much more than the pay rise.

Let's try to explain why. Three different elements go into making up the amount of pension a person will receive in a final salary scheme like MPs have now. One is the size of the final salary, the second is the number of years the person has been in the scheme, and the third is the accrual rate – which is the rate at which the pension entitlement grows every year expressed as a percentage.

The typical two thirds of final salary pension scheme is arrived at on the basis that someone works for 40 years, which is multiplied by an accrual rate of 1.66 per cent. This gives a figure of 66 per cent to be applied to whatever that final salary is.

It follows that if you want to inflate a pension entitlement, you can either bump up the person's salary late in their working life, give them a credit for more years than they have actually worked (a favoured ploy when trying to recruit an executive from outside) or increase the accrual rate.

Likewise, one way to reduce pension costs in a scheme such as this is to reduce the salary figure against which the percentage entitlement is applied.

The easiest way to do this is to switch from final salary to career average salary – a number which is almost always lower.

That is one element of what is proposed for MPs. Their final salary scheme will close, preserving the benefits earned so far, and a new scheme will open with the new parliament on a new career average basis.

But this brings us to the tricky bit. When the current scheme closes and the accrued entitlements are frozen, you would expect this to be on the basis of the MP's current salary of £66,000. But to the astonishment of pension experts, MPs are to be given the credit for the pay increase which they have not yet in fact received, so the locked-in salary for the basis of the pension calculation will be £74,000. This will be worth between £2,000 and £4,500 a year of additional pension, depending on how long they have served.

Now the potential cost of this is huge. With the current low rates of interest and inflation, actuaries calculate that £1 of additional inflation-proofed pension requires about £35 of additional saving. The MPs' scheme also has a higher than normal accrual rate, and this means that the feed-through impact of this extra salary credit will be well over £100,000 for each MP with 15 years' service, and proportionately more or less for the others depending on how long they have served.

It is said that the total cost of the proposals, including the pay increase, will be only £500,000 a year. I can only conclude that the sums were done by the same person who was £10bn out on the projected costs of the HS2 high-speed rail link.

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