Oct 27, 2010

Defined Contribution Scheme Design

Add a note hereThere is a very wide variety of defined contribution design models available, as follows:
§  Add a note hereEmployer contribution is a fixed percentage of salary. For example, the employer pays 8 per cent of salary for all members. This is easy to understand and explain.
§  Add a note hereEmployer contribution is a percentage of salary that increases with age (or service). For example, the employer pays 6 per cent of salary for all members, increasing to 9 per cent at age 40 and 12 per cent at age 50. This design partly mirrors the way final salary schemes work and may be targeted to deliver a benefit equal to a certain percentage of final or average salary.
§  Add a note hereEmployer contribution is a multiple of that paid by the employee. For example, the employer will pay double what the employee contributes up to a maximum employer contribution of 10 per cent of salary. This design ensures that employer spend is targeted on those who most value it.
Add a note hereAll three approaches are fairly common, and are often used in combination. For example, the employer may pay a fixed contribution of 3 per cent of salary and then match what the employee pays up to 5 per cent of salary. Hence, the maximum employer contribution is 8 per cent of salary.
Add a note hereThere is also considerable variation in the maximum available employer contribution rates. Typically, for staff and middle managers these range from 3 per cent to 15 per cent with a median of around 8 per cent (source: Hay Group Survey of Employee Benefits 2003).
Add a note hereIt is evident that the lower levels of contribution are highly unlikely to deliver an adequate retirement income unless the employee makes substantial contributions and/or has other forms of saving. For example, a pension contribution of 3 per cent of salary made from age 20 to age 60 might be expected, using conservative assumptions, to provide a pension of only around 10 per cent of final salary.
Add a note hereAt retirement, the employee may take up to a quarter of the fund as a tax-free lump sum. The remainder of the accumulated fund is used to purchase a regular pension ('annuity') from an insurance company. The member typically determines the form of annuity chosen, subject to some government-imposed restrictions. The decisions required include:
§  Add a note herethe rate at which the annuity should increase in payment;
§  Add a note herethe benefits payable to a surviving partner on death;
§  Add a note herewhether the annuity should be guaranteed or on an investment-linked basis (for example, a 'with profits' annuity).
Add a note hereThere is also the option not to take an annuity initially and instead 'draw down' an income from the pension account. (This approach is used mainly by more financially sophisticated members and/or those with larger individual funds.)


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