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Managing my investments
Managing my investments

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5.3.2 Funded and pay-as-you-go pensions

Figure 7 Pensions in a nutshell
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 provision
State scheme: additional pension State Defined benefit Pay as you go State provision
Occupational scheme: final salary

Some pubic sector employers

Private sector and some public sector schemes

Defined benefit

Defined benefit

Pay as you go

Funded scheme

State provision, usually employee too Footnotes   1

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   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 income is taxable.


Footnotes   2National Employment Savings Trust.


Footnotes   3Employees must contribute to NEST. Back to main text

In the previous sections 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 out. So, in the example of teachers, a person who reached the position of head teacher would lose out in relative terms from this change.

Pensions in a nutshell

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 taxpayers 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, 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.