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.

Download this video clip.Video player: ou_futurelearn_mmi_vid_1189.mp4

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MARTIN UPTON

This animation illustrates how a C-A-R-E pension scheme works. C-A-R-E, or simply Care, stands for career average revalued earnings.

With a CARE scheme you earn a proportion of your pensionable pay as pension each year you work. In this case it is 1/54th of pensionable pay per year. For example if Jane earns £18,000 a year her pension pot in year 1 is worked out as one-fifty fourth of £18,000, or £333. This pot is then 'revalued' each year, using an agreed formula, to take account of price inflation. For this example let's say the pot is increased by 3.5% per year. So at the beginning of year 2 the £333 that Jane earned in year 1 is revalued by 3.5%. This means that this part of Jane's pension is increased by £12 (or £333 x 3.5%), and this gives a revalued total of £345 (or £333 + £12). The pot continues to be revalued each year until Jane retires after 20 years of service. After 20 years of being revalued by 3.5% each year Jane's year 1 retirement pot is worth £640. Jane receives a new pension pot for each year she is a member of the CARE pension scheme. So after 20 years she will have 20 separate pension pots. If Jane's pensionable pay rises by 4% then in year 2 she will be earning £18,720 and her year 2 pension pot for that year will be worth £347. Every year's pot then gets revalued in the same way that the year 1 pot is revalued. On retirement Jane adds up the pension pots earned from each year of service after each year's pot has been revalued. The total is her pension on retirement. So if Jane's pensionable pay rises by 4% every year, after 20 years' service, she can expect a pension of £13,422 per annum.

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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.