Oct 18, 2010

Why Provide Pensions?

Historically, leading employers in the UK and elsewhere have provided pension arrangements for the following reasons:
1.  Add a note hereThere is a perceived moral obligation to provide a reasonable standard of post-retirement living for employees, especially those with long service. A similar logic extends to providing pensions for dependants on a current or retired employee's death. This obligation is less apparent in countries where state pension provision is at a higher level than in the UK.
2.  Add a note hereA good pension scheme demonstrates that the employer has the long-term interest of employees at heart.
3.  Add a note hereA good scheme may help to retain and attract high-quality staff.
4.  Add a note herePensions can be a tax-efficient form of remuneration. This was a particularly significant issue in the past when personal rates of income tax were higher than now and when other tax-efficient vehicles (eg ISAs or offsetting mortgages) were not widely available.
Add a note hereHowever, in recent years many employers have questioned the level and volatility of pensions cost and this has caused them to review scheme designs.

Add a note hereMain Scheme Types
Add a note hereThe two main approaches that have been adopted for pension provision in the UK are described below. Recently, some employers have begun to adopt other designs and these are discussed further later in this chapter.
§  Add a note hereDefined benefit (final salary) schemes. The employer's pension promise to the employee is expressed by means of a formula specified in the scheme rules. The pension is typically proportional to service and (some definition of) salary. Traditionally, the salary used has been that paid over the last year (or sometimes three years) before retirement, which is why they are often known as 'final salary' schemes. A typical design is shown in the section 'Final salary scheme design' below.
§  Add a note hereDefined contribution (money purchase) schemes. Here the employer's pension promise to the employee is expressed as a contribution formula, typically expressed as a percentage of salary. The contributions are invested and the money used at retirement to purchase a regular income, usually via an annuity contract from an insurance company. The employer's contribution as a percentage of salary may be fixed, age related or linked to what the employee pays - see below.
Add a note hereIn both types of scheme, employer and employee typically contribute to a fund. In a defined contribution scheme, members have individual shares of the fund, which represent their personal entitlements and which will directly determine the pensions they receive. In a defined benefit scheme, all employee and employer contributions are paid into a combined fund and there is no direct link between fund size and the pensions paid.

Add a note hereApportioning Risk
Add a note herePension provision is an extremely long-term and unpredictable business. Consider a female employee currently aged 25. It is not possible to predict the future trajectory of her salary, how long she will stay in employment, her age of retirement, how long she will live after retirement and whether she will have a partner or other dependant(s) when she dies.
Add a note hereBecause of these uncertainties, there are risks attaching to pensions provision for the employer and/or the employee. The apportionment of this risk varies considerably, depending on the type of pension scheme provided.

Add a note hereFinal Salary Risks
Add a note hereBecause the pension is based on a guaranteed formula, there is a risk that the cost of providing this guaranteed benefit will be higher than expected. Typically employee contributions are fixed and those of the employer vary based on specialist advice from the scheme actuary. Hence, the risk of higher-than-expected costs falls on the employer. Costs might exceed expectation if, for example:
§  Add a note heresalaries grow faster than expected;
§  Add a note herelongevity increases;
§  Add a note herethe fund investments perform less well than expected.

Add a note hereDefined Contribution Risks
Add a note hereUnder a defined contribution scheme, the cost of employer contributions is predictable but there is a risk that the resulting pension falls short of expectations. This risk normally falls on the employee. For example, the pension may not meet expectations if:
§  Add a note herethe fund investments perform poorly, either in the long term or in the period immediately preceding retirement;
§  Add a note herethe annuity rate (ie the conversion rate from lump sum to regular pension) is unfavourable - for example, because interest rates are low.
Add a note hereFrom the above discussion, it can be seen that there is a huge philosophical difference between final salary (guaranteed pension, variable cost) and defined contribution (uncertain pension, fixed cost).

Add a note hereTypical Provision in the UK
Add a note hereThe design of final salary schemes, the reasons behind the recent widespread move to defined contribution schemes, and the design of such schemes and some of the new hybrid designs emerging, are discussed below. More detailed design elements such as member contributions, contracting out, protection benefits and leaving-service benefits are then examined.

Add a note hereFinal Salary Scheme Design
Add a note hereThe final salary pension scheme has been the mainstay of occupation pensions in the UK for many years. Until around the earliest years of the 21st century, designs were relatively standardized, as in the following examples of typical private sector and public sector final salary schemes:
§  Add a note hereTypical private sector final salary scheme:
o    Add a note herea pension of 1/60th of final-year basic salary per year of service;
o    Add a note herepayable from age 60 or 65;
o    Add a note herepension in payment guaranteed to increase in line with inflation (up to 5 per cent per annum);
o    Add a note herepart of pension may be exchanged for a tax-free lump sum;
o    Add a note herefixed employee contribution of 0 to 5 per cent of salary.
§  Add a note hereTypical public sector final salary scheme:
o    Add a note herepension of 1/80th of final-year basic salary per year of service, plus lump sum of 3/80th of basic salary per year of service;
o    Add a note herepension in payment guaranteed to increase in line with inflation;
o    Add a note herefixed employee contribution of 1.5 per cent to 6 per cent of salary.
Add a note hereThe protection benefits payable on death or in the case of serious ill health are considered below.
Add a note hereBecause final salary schemes provide a high level of certainty for the participant (provided the scheme is adequately funded), they tend to be favoured by employees and unions. In addition, because of modest employer contribution rates, many defined contribution schemes are expected to produce lower pensions for most members than a typical final salary scheme, although defined contribution schemes may be better for younger, mobile employees.


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