MSE’s Academy of Money
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3 Occupational pension schemes

As the term suggests, occupational pension schemes are offered by employers to their staff.

There are two types of occupational schemes:

  1. Defined contribution schemes (also called money purchase schemes). These schemes are the most common type these days. Here, what you get from your pension scheme will depend on the size of the pension fund (or ‘pot’) you accumulate.
  2. Defined benefit schemes. Few of these are now open to new joiners as they are expensive for firms to run. With defined benefit schemes the size of your annual pension is usually linked to your salary – for example, the salary in your last year prior to retiring, or your average salary during your time as a member of the scheme. Those lucky enough to already have one should recognise that these are the gold-plated pensions as they tend to pay out the most.

If you are starting a pension now it is highly likely that defined contribution scheme will be the one you’ll have to go for. In fact, membership of such schemes has increased significantly in recent years, as a result of the closure to new membership of many defined benefit schemes and the policy of ‘automatic enrolment’ onto pension schemes (you will look at automatic enrolment later in this session). In 2018 there were nine times as many employees who were active members of private sector defined contribution schemes as there were in defined benefit schemes (ONS, 2019b).

Watch Video 2 and learn about the differences between the two schemes, then try the activity below.

Download this video clip.Video player: Video 2 Understanding pension schemes
Skip transcript: Video 2 Understanding pension schemes

Transcript: Video 2 Understanding pension schemes

NARRATOR
Saving for retirement is important to ensure you have enough to live on in your later years, and a private pension is a tax efficient way to do so. That’s because when you put money in, you automatically get tax relief, so your pension pot is effectively topped up by the government.
[COINS CLINKING]
If you take your employer’s pension, they also have to contribute to your pot, so you effectively get a pay rise. Though, as you’ll almost certainly be paying into a pension yourself, it means you’ll have less in your pay packet when you start to save this way.
The most common type of pension, these days, is a money purchase pension. It’s simply a pot of cash you and your employer can pay into which you get tax relief on over many years. There’s no way to know how much your pot will be when you come to draw on it. The size of your fund will depend on what you contribute and how investments in the fund perform over the years.
When you draw money from a defined contribution scheme, which you can do from age 55, you have a number of choices. You can take 25% of it as a tax-free lump sum, you can use the fund to buy an annuity where you give your pot to an insurance company in return for an annual income, or you can withdraw cash from your fund and spend or invest it as you wish. This has become an option since 2015. It’s best to get financial advice before choosing as it’s a crucial, but also complex, decision.
The other type of pension is a defined benefit or final salary pension, only available via an employer. These days, most people who start a new pension will have a money purchase pension, as defined benefit schemes are expensive for employers to run because people are living longer and investment returns have fallen.
What you get in a defined benefit scheme is clearer. It is based on a formula of your salary and a number of years that you and your employer have paid into the scheme. An example is, if someone is in a scheme for 20 years that pays 1/60 of their final salary with that firm, then they get a third of that final salary a year when drawing from their pension. On a 30,000 pound year final salary, their pension will be 10,000 pounds a year.
Some defined benefit schemes use the salary in the final year before retirement. But, in recent years, it’s become increasingly common to use the average annual salary during the membership of the scheme. This normally reduces the pension, as the salary in the last year of employment is usually higher than the average.
So if you’re in a defined benefit scheme, you have some certainty about your future pension income. If you’re in a defined contribution scheme, you do not have certainty about the final size of your pension fund.
End transcript: Video 2 Understanding pension schemes
Video 2 Understanding pension schemes
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Activity 3 Who bears the pension risk?

Timing: Allow approximately 5 minutes

Having watched Video 2, who do you think bears the risk when it comes to the pension provided under:

  • a defined benefit scheme?
  • a defined contribution scheme?
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Discussion

With a defined benefit scheme the employer is making a promise about the amount of the pension an employee will receive. This is set out through an equation linked to the employee’s earnings and the number of years of membership of the scheme. So, the employer bears the risk.

With defined contribution schemes the risk is shifted to the employee. The employer makes no defined pension promise. The pension obtainable will be linked to the size of the employee’s pension fund on retirement – something that cannot be forecast with certainty.

Defined contribution schemes are also less costly for employers as most pay far less into this type of scheme than they would into a defined benefit scheme. This means a reduction in the money going into an individual’s pension pot, which reduces the eventual pension.

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