9 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
- 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. 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).
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 30 years in a 1/60th scheme would receive a pension of 1/60th × 30 × £36,000 = £18,000 a year.
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. Watch the animation to learn more about how CARE pension schemes work.
In recent years there’s been a marked decline in the number of employees who belong to defined benefit schemes. 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. What this means, of course, is a reduction in the money going into an individual’s pension pot, which will reduce the eventual pension income.