Historically, leading employers in the UK and elsewhere have provided pension arrangements for the following reasons:
1. There 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. A good pension scheme demonstrates that the employer has the long-term interest of employees at heart.
3. A good scheme may help to retain and attract high-quality staff.
4. Pensions 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.
However, in recent years many employers have questioned the level and volatility of pensions cost and this has caused them to review scheme designs.
The 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.
§ Defined 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.
§ Defined 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.
In 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.
Pension 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.
Because 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.
Because 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:
§ salaries grow faster than expected;
§ longevity increases;
§ the fund investments perform less well than expected.
Under 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:
§ the fund investments perform poorly, either in the long term or in the period immediately preceding retirement;
§ the annuity rate (ie the conversion rate from lump sum to regular pension) is unfavourable - for example, because interest rates are low.
From 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).
The 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.
The 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:
§ Typical private sector final salary scheme:
o a pension of 1/60th of final-year basic salary per year of service;
o payable from age 60 or 65;
o pension in payment guaranteed to increase in line with inflation (up to 5 per cent per annum);
o part of pension may be exchanged for a tax-free lump sum;
o fixed employee contribution of 0 to 5 per cent of salary.
§ Typical public sector final salary scheme:
o pension 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 pension in payment guaranteed to increase in line with inflation;
o fixed employee contribution of 1.5 per cent to 6 per cent of salary.
The protection benefits payable on death or in the case of serious ill health are considered below.
Because 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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