7.1.4 Occupational pensions
Occupational pension schemes are set up by employers for their employees. They typically provide a package of benefits:
- a retirement pension for the employee payable from the scheme’s normal pension age (often 65) or later
- a tax-free lump sum for the employee at retirement
- a pension payable if the employee has to retire early due to ill health
- pensions for a widow, widower, registered civil partner and dependent children if the employee dies either before or after retirement. Most schemes also pay such a pension to an unmarried partner
- lump sum life insurance if the employee dies before retirement.
There are generally two types of occupational pension scheme: defined contribution schemes (also called money purchase schemes) and defined benefit schemes.
Defined contribution schemes invest contributions from the employer, and normally the employee as well, to build up a pension pot for the employee. Personal pensions also work on this basis (more about this later this week). The key features to note are that employees don’t know in advance how much pension they might receive, and the pension is directly affected by factors such as the value of investments rising and falling with the stock market.
By contrast, a defined benefit scheme promises to pay a specified pension at retirement (often – but not necessarily – linked to the employee’s pay while working). In a defined benefit scheme, the yearly pension is commonly worked out according to a formula, for example:
Yearly pension = accrual rate × number of years in scheme × salary
The accrual rate is a fraction, typically 1/60th or 1/80th. How ‘salary’ is defined depends on the type of scheme and its rules. For instance, the salary that counts towards the pension might be less than the total salary the employee gets. In a ‘final salary scheme’, salary would mean pay just before retirement (or pay at the time of leaving if the person leaves before reaching retirement).
Increasingly, defined benefit schemes are shifting to a ‘career average revalued earnings’ (CARE) basis. This means the pension is based on average pay over all the years in the scheme, after adjusting each year’s pay for inflation between the time it was earned and the person retiring or leaving the scheme.
Whatever the definition of salary, this type of formula works in basically the same way. For example, a person earning £36,000 a year and retiring after thirty years in a 1/60th scheme would receive a pension of 1/60th × 30 × £36,000 = £18,000 a year.
The pension from a defined benefit scheme is usually increased each year in line with price inflation. Historically this was measured by the RPI but in 2010 the government announced that pensions for retired public sector workers would rise in line with the (typically lower) CPI. The pension from an occupational defined contribution scheme was covered by similar rules but, since April 2005, the retiring employee can usually choose whether or not the pension will be increased each year.
The key point is that the level of pension promised does not directly depend on factors such as stock market performance. For example, while a slump in stock markets is likely to push up the cost to the employer of funding the promised pension, the employee’s promised pension would be unchanged.
Nonetheless, indirectly, the employee could be affected if the increasing cost to employers of providing this type of pension results in the employer closing or changing the pension scheme or, worse still, going out of business, leaving the pension pot with too little in it to pay the promised pensions.
In recent years there’s been a marked decline in the number of employees who belong to defined benefit schemes. This shift has affected employees in the private sector: by 2016, there were over four times as many active members of defined contribution schemes as there were of defined benefit schemes (ONS, 2017).
Where defined benefit pensions continue for existing members, in many cases the pension formula has been changed to promise less generous pensions in future. New employees are typically offered membership of defined contribution schemes instead.
For the employer, defined contribution schemes are less risky than defined benefit schemes because the employer promises only to pay specified contributions– a predictable, stable cost to the employer’s business.
Defined contribution schemes are also less costly because most employers pay far less into this type of scheme than they would into a defined benefit scheme. In 2016, the average employer contribution to private defined benefit schemes was 16.9% of an employee’s pay, compared with just 3.2% for a defined contribution scheme (ONS, 2017). What this means, of course, is a reduction in the money going into an individual’s pension pot, which will tend to reduce the resulting pension.