7.2.2 Funded and pay-as-you-go pensions
In the previous discussion you might have worked out that average salary pensions would be cheaper to provide than final salary schemes if, even after adjusting for inflation, a worker’s average pay over many years was lower than their pay just before retirement.
Workers whose pay tends to peak in mid-career might gain from a switch, whereas workers whose pay tends to peak towards the end of their career would lose. So, in the example of teachers, a person who reached the position of head teacher would lose out in relative terms from this change.
| Pension scheme | Organised by | Basis on which pensions are provided | How pensions are financed | Who pays? |
|---|---|---|---|---|
| State scheme: basic | State | Defined benefit | Pay as you go | |
| State scheme: additional pension | State | Defined benefit | Pay as you go | |
| Occupational scheme: final salary | Some public sector employers | Defined benefit | Pay as you go | State provision, usually employee too Footnotes 1 |
| Private sector and some public sector schemes | Defined benefit | Funded scheme | Employer, usually employee too Footnotes 1 | |
| Occupational scheme and NEST Footnotes 2: defined contribution | Private sector employers | Defined contribution | Funded scheme | Employer, usually employee too1, 3 |
| Personal pension | Individual | Defined contribution | Funded scheme | Individual (employer occasionally) Footnotes 1 |
Footnotes
Footnotes 1Tax relief on contributions and on the return from pension fund investments means the State also pays towards the cost of occupational and private pensions. However, some of this tax relief is clawed back once pensions start to be paid because pension incom is taxable. Back to main text
With most occupational schemes and all personal pensions, money is paid into the scheme to create a pension pot – a pool of investments. These are called funded schemes. Employers pay into occupational schemes and usually require employees to contribute too. With other types of scheme, individuals often fund the whole scheme.
In most large, occupational defined benefit schemes, experts are appointed to manage the investments, and pensions are paid directly from the fund as they fall due. With defined contribution arrangements, an insurance company often looks after the investments, and the pensions are typically paid by taking money out of the fund to buy annuities.
By contrast, state pensions are pay-as-you-go (PAYG) schemes. There is no pension pot. Instead, the pensions paid out today are financed from National Insurance and other tax revenues collected today. Sometimes this is referred to as a ‘contract between the generations’, with today’s tax payers paying for today’s pensions on the understanding that when they retire, their pensions will be paid for by the taxpayers of the future.
Some public sector occupational schemes (covering, for example, civil servants, teachers, National Health Service (NHS) workers and the Armed Forces) are also financed on a PAYG basis, with employees’ contributions and general tax revenues used to pay the pensions of many retired public service workers. In contrast, the schemes for local authority employees and university lecturers in some universities are funded schemes.