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 firm often looks after the investments, and the pensions are typically paid by taking money out of the fund to buy annuities. The changes to pension rules we look at in the next two sections are, however, providing alternatives to buying annuities for those approaching retirement.
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, 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.
With defined benefit schemes, the entitlement to a pension is contractually set out and is typically a proportion of the final year’s salary or of the average salary earned when a member of the scheme. The proportion is usually based on the number of years in the scheme.
With defined contribution schemes the annual pension (or ‘annuity’) is linked to the value of the pension pot built up ahead of retirement. The determination of the annuity takes into account prevailing investment returns – particularly long-term interest rates – and estimates of longevity (since this provides a forecast of the length of time the annuity will be paid). Consequently the annual pension you will get cannot be forecast in the same way that it can with defined benefit schemes. Pension reforms enacted in the UK in 2015 do, though, now give those with defined contribution schemes more options for using their pension pots than just drawing an annuity. We look at these reforms in the next two sections.
The year 2012 saw the start of a new government-led pensions initiative with auto-enrolment workplace pension schemes. Larger firms were required to offer a workplace pension scheme to their employees and contribute to the scheme as well. Employees aged 22 or over and earning more than £10,000 a year are automatically enrolled onto schemes unless they are already in a scheme or they make the decision to opt out. This move was designed to increase the numbers of people in pension schemes. Evidence to date shows only 8 per cent of employees electing to opt out of their workplace scheme – far less than had been forecast when auto-enrolment started (The Times, 2015). By 2018 all firms in the UK will have to offer auto-enrolment schemes to their staff and be making contributions into their scheme.
In the UK and elsewhere contributions to schemes attract income tax relief as governments are keen to encourage people to save for their retirement. In 2016/17 the annual limit on contributions that attract such tax relief is £40,000.
The government also applies a lifetime tax allowance on an individual’s pension fund. From April 2016, this lifetime allowance fell from £1.25 million to £1 million. Holdings beyond this limit will be taxed at 55 per cent when drawn down on retirement. This is the third cut in the lifetime allowance since 2011/12 when the allowance stood at £1.8 million and the move is aimed at curtailing the growth of tax relief on pension contributions.