Occuptional pension schemes

Generally speaking employers offer two main types of pension scheme.

1. Defined Benefit or Final Salary Pension Schemes
Defined Benefit schemes provide a pension that is a fraction of pay at or shortly before retirement. For this reason they are also referred to as Final Salary schemes. Many schemes define the benefit as 1/60th or 1/80th of final salary for each year of service, subject to HMRC limits.

Such arrangements are very attractive to employees as the eventual pension is directly related to the members’ standard of living before retirement. In addition in theory the employee does not need to worry about whether the fund will enough money to purchase the pension accrued or the possible level of annuity rates at retirement.

The employer, however, is unable to accurately forecast the cost of the scheme, as the ultimate pension is dependent on the final earnings of members. Thus a period of high wage inflation shortly before an employee’s retirement will dramatically increase the contributions required to fund that employee’s pension. Consequently, the employer has what is often described as an ‘open ended’ cost commitment to provide benefits.

2. Defined Contribution or Money Purchase Pension Schemes
Defined Contribution schemes are far simpler arrangements. Essentially contributions are invested for each individual member and the accumulated fund is used to purchase benefits upon retirement.

The employer has the advantage of always knowing how much the pension scheme will cost. However, the employee does not know how the eventual pension will relate to his standard of living at retirement as it will depend of fund performance and annuity rates at the time.

Virtually all new schemes are now being established on a Defined Contribution basis. Many major employers have in fact closed their Defined Benefit schemes to new members and some have even decided to close them to existing employees. There are a variety of reasons for the closure of Defined Benefit schemes, including tax changes, administrative expense and accountancy rules which bring the costs of such arrangements more clearly onto a company’s balance sheet.

You may also hear of Group Pension Plans in the context of occupational schemes. In order to reduce administration costs some companies may provide access to and contribute to a Group Pension Plan via an insurance company. Technically speaking, these are Personal Pension Plans albeit ‘branded’ by an employer. For more information, please refer to the Personal Pension section.

Employees can often make Additional Voluntary Contributions to a scheme and in some cases these may well be matched by the employer. In the case of Defined Benefit schemes it may be possible purchase added years to enhance benefits. Clearly, these options should be fully investigated prior to entering into any private arrangement.