Defaqto

Defined benefit (DB) schemes

Defined benefit (DB) schemes are the traditional type of company scheme. DB schemes are now increasingly expensive and many have been closed to new employees. This is because these schemes, which are mainly paid for by the employer, have seen their costs rise rapidly over the last 10 to 15 years.

Final salary schemes are the most common type of DB pension in the UK, although career average pensions are also found and are becoming more common. Three factors decide the size of the eventual pension paid under a DB pension, such as a final salary scheme:

• length of scheme membership;
• pensionable pay at, or near retirement; and
• the accrual rate used.

There may be a short period before a new employee becomes eligible for DB scheme membership, as some employers do not want to go to the trouble of enrolling a new employee in the pension scheme if they leave within the first six months. A DB pension is based on pensionable pay. This may, or may not, include overtime and bonuses and the accrual rate determines how generous the scheme is. The better the accrual rate, the faster benefits build up.

How final salary schemes work

Final salary schemes were designed in the days when many people spent most, if not all, of their working life with a single employer. As a result, they reward long service at one employer, something that many think is at odds with today's more mobile working patterns.

They were also designed to fit in with the tax rules on the maximum pension that could be paid and these rules changed in 2006, when a simple overall annual limit on pension contributions was introduced (£235,000 for tax year 2007-08).

DB investment risk

A key point to note about DB pensions is that the pension paid is not directly related to how much an employee pays in, but is governed by the scheme's rules. So for an employee, a final salary scheme is good news because they do not bear the investment risk of the pension scheme. This is the risk that investments do badly and additional contributions have to be made to produce the required pension at retirement.

An employee might be asked to pay in 5 per cent of their pay as their pension contribution, with the employer adding what it believes is needed to pay the eventual pension. This could be equal to 20 per cent or more of their pay.

DB schemes worked well for many years, partly because employees leaving early either received a refund of their contributions, or had their pensions frozen when they left, with no further benefits being accrued. This meant that employees who left early ended up subsidising the pensions of those with a long career at one employer.

But pension regulations have changed the nature of the game, making it harder for employers to benefit from staff who leave early. Another factor affecting DB schemes is the rapid rise in longevity in the last 20 years, particularly among white collar workers. This has meant that pensions are being paid out for longer. Lower interest rates in recent years have also made the annuities that back DB pensions more expensive too.

DB scheme woes

For DB scheme members, the solvency, or financial strength, of both their employer and the pension scheme is an important issue. If there is not enough money in the scheme to pay the promised DB pensions and the employer is financially weak, this spells danger for the employees. DB pension schemes have faced a difficult period recently.

The end of the 90s bull market in equities, new pension regulations and accounting standards, along with improving longevity and lower interest rates, have combined to hit DB schemes very hard indeed. As a result of these factors, many DB schemes are now in deficit and have been for some years.

A scheme deficit means that the liabilities, or present and future pension obligations exceed the scheme assets. In the worst case scenario, this means that if the employer supporting the scheme goes under, there is not enough money in the scheme to pay out pensions to all members.

It is estimated that up to 125,000 DB scheme members found themselves in this invidious position in recent years, due to the collapse of companies with inadequately funded schemes.

To prevent future problems at DB schemes and to assist schemes with reducing their deficits a Pensions Regulator and a Pension Protection Fund (PPF) were set up in April 2006. This will pay individuals an income if their employer is unable to honour the DB scheme promise.

Other types of defined benefit pension schemes

Career average

In order to reduce the burden on employers of offering fully-fledged final salary schemes, some have adopted hybrid schemes which offer an element of defined benefit, but with a reduced "pensions promise."

Career average plans are also called career average revalued (CARE) schemes and have been proposed at several large employers, such as the BBC, the National Health Service and the Civil Service as a way of controlling the costs of a final salary DB plan. CARE schemes have already been adopted by Co-operative Insurance and the Nationwide building society.

Whereas a final salary pension is based on pensionable pay in the years just before retirement (usually an average of the last three years), a CARE plan uses average earnings over an employee's entire career to calculate the pension benefit.

It is argued that this approach gives more stability over pension costs to the employer, while still preserving some of the advantages of a DB plan for employees. In addition,

CARE plans are better for staff who leave early or who have fluctuating pay over their career. In calculating the CARE accrual for each year, the earnings for that year are revalued in line with an index, usually the retail price index, or the national average earnings index. This is to give greater consistency and reduce the effects of price and wage inflation.

Cash balance plans

Cash balance plans are another form of DB pension. They have been widely used in the US as a means of moving away from final salary schemes, but have not caught on in the UK in large numbers. A cash balance plan could be described as a DB plan that resembles a defined contribution pension, or a halfway house between DB and DC pensions.

Under a cash balance plan, an employee receives a credit to a hypothetical cash balance account for each year of service. This could be a fixed amount, such as 5 per cent of their salary. On retirement, the employee receives the total amount in the cash balance account and it is used to purchase an annuity, as in a DC pension.

This means that the employee is subject to the movement of annuity rates, which is not the case in a final salary scheme. On the other hand, individuals receive a fixed amount each year and can see the value of their pension fund growing steadily.

Cash balance plans have been criticised in the US as being less generous than final salary schemes, especially for older employees who lose the link with their final salary.

Defined contribution (DC) schemes

As already stated, DB schemes might not suit employees with relatively short service at an employer, they can be expensive to operate and employees are dependent on the financial strength of their employer and the adequacy of the DB scheme funding.

Defined contribution (DC), or money purchase, schemes avoid these problems, although they bring issues of their own. With a DC pension, the benefit an employee receives is directly related to contributions being paid into the scheme by the employer and the employee and the investment performance of the pension fund assets.

For example, an employee could have 5 per cent of his pay going into a scheme, while the employer adds 5 per cent of the employee's pay. The combined contribution of 10 per cent of pay is then invested on the employee's behalf.

On retirement, the member purchases an annuity with their pension fund which pays them an income in retirement. So compared to a DB scheme, the employee bears the investment risk in a DC scheme. If contributions are reasonably high and the DC fund does well, an employee could get a generous pension.

DC investment

For employees in DC schemes, investment is a major issue. DC schemes usually give their employees a range of investment options and ask them to make a decision over where they want to invest.

If they cannot decide where to invest, their contributions are placed in what is called a "default" fund. In looking at investment, it should be remembered that higher returns almost invariably mean that more risk has to be taken.

This is known as the risk v reward trade-off. Equities, or company shares, are one asset that can produce high returns, but equally, they can also fall in value. Bonds, which pay a fixed income, are a lower risk investment, but carry less potential for high returns.

Investment choice

The employees' investment choice can be framed in a variety of ways. There may be a range of investment funds to choose from, such as UK and overseas equities, fixed income or bond funds and perhaps deposit or cash funds.

However, this choice can be confusing to non-investment experts, so employers may offer funds graded according to the risk associated with them. For instance, younger and more risk receptive members could pick an "adventurous investor" fund. This might invest more heavily in riskier assets with prospect of higher returns.

At the same time, a cautious fund could be offered which aimed to give more stable returns and less chance of an upset, or period of negative returns. This could be more suitable to older members, whose funds have less time to recover if investment markets perform badly.

Lifestyle and absolute return funds

Another DC investment option is a "lifestyle" fund. This aims to help members by gradually switching its investment policy from riskier assets, to less risky assets, as they approach their planned retirement date.

Lifestyle funds are often used as a default fund in DC schemes. A newer alternative is to offer members an absolute return approach. This is a strategy of giving a fund manager the freedom to invest in a wide range of assets in order to generate a positive return. In this way, an absolute return fund aims to produce a return of 5-7 per cent a year, year in and year out, which can help DC members plan for their retirement.

Different types of DC scheme

There are now a range of DC pension arrangements open to employers and employees. One distinction is whether a DC scheme is trust-based or contract-based.

Trust-based schemes are set up under a legal trust, with trustees appointed to oversee the way the scheme is run. The trust is often set up by an employer, with senior personnel and employee representatives acting as trustees.

Employers with existing DB schemes can set up a new trust-based DC scheme, or add a DC section to an existing trust-based DB scheme. One attraction of a trust-based scheme is that it allows the pension scheme trustees to appoint whom they think are the best investment managers and the best scheme administrator.  If those appointed do not measure up, then they may be removed and new appointees sought.

The alternative to is to set up a contract-based GPP with a pensions company that provides all of the services needed. This may be cheaper and simpler, but makes it harder to change things without moving the entire scheme to a new provider.

Group money purchase schemes

Group money purchase schemes are basically company schemes with a DC, or money purchase, structure. They can be set up by employers, but it is more common for an insurance company to set up a group money purchase scheme for an employer.

Scheme administration, investment and some member communications are generally included in the package of services from the scheme provider. With DC schemes such as this, a range of funds are offered and the charges on those funds will affect scheme members. A poor fund choice and expensive funds will not be beneficial to members, so they must hope that their employer picks a good provider.

Service is another variable - poor administration can mean that members receive a poor service, with delays or mistakes in applying contributions and providing information. These schemes can also contract in, or out, of the state pension system.

If they contract out, the employer and employees pay a lower rate of national insurance, but give up part of the state pension benefit which would otherwise be received on retirement. Instead, a rebate is invested in what is known as a ‘protected rights’ fund on the member's behalf.

There is currently much debate over the merits of contracting out, with many experts saying that the rebate offered by the government is not sufficient to make it worthwhile. COMPS and CIMPs are two acronyms for contracted-in and contracted-out money purchase schemes.

Group personal pensions

Generally speaking, GPP schemes are a collection of individual personal pension policies set up by an employer and are seen as one of the simplest options for an employer looking to set up a group pension.

Personal pensions were introduced in 1988 in a bid to stimulate greater pension saving by individuals not eligible to join a company sponsored scheme. They are set up on an individual basis and can be a relatively expensive type of pension.

GPPs are usually provided by large insurance companies that are active in the pensions market. These companies frequently distribute products through financial advisers who are remunerated on a commission basis.

This means that the advisers can earn a large sum of money for recommending a particular product, which has led to accusations of bias over product selection.

The alternative to paying an adviser a commission from the provider is for an employer to pay an adviser a fixed fee for their work, but this incurs a cost on the employer. Personal pensions have improved over the years, from the inflexible and expensive plans first offered in the late 80s and 1990s.

Now, members can expect to pay around 1-2 per cent in annual management charges and should have access to a wide choice of investment funds. An employer setting up a GPP scheme for its employees may also be able to negotiate more favourable terms, if their business is attractive to the scheme provider.

Otherwise, in all other respects, if you have a group personal pension it is really just a personal pension contract between you and the insurer, with your employer making a contribution, which  is likely to be   3-6 per cent  of your salary.

Some employers will match the contributions made by the employee up to a certain level.

Stakeholder pensions

Stakeholder pensions were launched by the government in April 2001 to give individuals and employees who are not eligible to join good company pension scheme, a low-cost pension option.

Stakeholder pension charges are capped at 1.5 per cent for the first 10 years and 1 per cent thereafter and members are not penalised for transferring between providers, for changing contribution levels or for stopping or suspending contributions.

Stakeholder pensions are usually sold by insurance companies and other pension providers and can be set up on an individual or group basis, with the latter being more common, as it is more cost effective.

Under regulations introduced with stakeholder pensions, employers with more than five relevant staff are required to offer access to a stakeholder pension, unless they have an existing scheme that meets certain standards.

But employers are under no obligation to make contributions on behalf of their employees. Hence,  the relative failure of stakeholder pensions and plans for a new National Pension Savings Scheme (NPSS) as proposed by Lord Turner's Pensions Commission, to encourage mass participation in pension savings.

The NPSS is planned to start in 2012 with a system of personal accounts for employees.

The details of this scheme are still being decided but the aim is for personal accounts to have a limited choice of funds and low annual charges of around 0.3-0.5 per cent a year.

Additional voluntary contributions

Since April 2006, it has been possible to contribute up to 100 per cent of earnings in total into any pension/s, up to a maximum of £235,000 for the tax year 2008-09.

Prior to April 2006, there were strict limits on how much could be saved into a pension and these rules varied according to the type of pension.

In order to permit employees to make up the difference between their normal pension contributions under scheme rules and their permitted maximum, additional voluntary contribution (AVC) plans were used and are still in existence.

SSASs and Group Sipps

Two other types of company pension are available in certain circumstances. Small self-administered schemes (SSASs) are set up as very small occupational pension schemes, typically for small owner/managed businesses, or family businesses.

They can be useful as the pension fund can be used to purchase commercial property which is used by the business. This is tax-efficient and SSASs can also make loans to companies.

Group self-invested personal pensions (Sipps) are a new development in the self-invested personal pension market.