Occupational salary-related schemes
Some employers offer these schemes. They are sometimes called final salary or defined benefit. This is because they usually provide a pension based on:-
- the number of years you have been a member of the scheme (known as pensionable service);
- your pensionable earnings (often averaged over the last three years before retirement); and
- the proportion of those earnings you receive as a pension for each year of membership (called the accrual rate). The most common accrual rates are 1/60th or 1/80th of your pensionable earnings for each year of pensionable service.
The scheme is run by trustees who look after scheme members’ interests and your employer contributes to the scheme.
Your employer is responsible for ensuring there is enough money at the time you retire to pay you the pension.
Occupational defined contribution schemes (money Purchase)
Some employers offer these schemes. They build up a personal fund for each employee which is converted into an income at retirement. They are a type of money purchase pension. The scheme is run by trustees who look after scheme members’ interests and the employer usually contributes to the scheme. The employer deducts your contributions from your salary before it is taxed.
How does it work?
Money purchase pensions build up a pension fund using your contributions and your employer’s contributions (if they make any) plus investment returns (if any) and tax relief. It helps to think of money purchase pensions as having two stages:
Stage 1
The fund is usually invested in stocks and shares, along with other investments, with the aim of growing the fund over the years before you retire. Remember though that the value of investments may go up or down.
Stage 2
When you retire you can take a tax-free lump sum from your fund and use the rest to secure an income – usually in the form of a lifetime annuity.
The amount of pension income you’ll get will depend on:
- how much you pay into the fund;
- how much, if anything, your employer pays in;
- how well your investments have performed;
- what charges have been taken out of your fund by your pension provider;
- how much you take as a tax-free lump sum;
- annuity rates at the time you retire; and
- the type of annuity you choose.
What you need to think about
Think carefully if you are planning not to join your employer's pension scheme. It is not usually a good idea to turn down a pension scheme to which your employer will contribute on your behalf.
The benefits of these schemes are that:
- your pension benefits are linked to your salary while you are working, so they automatically increase as your pay rises;
- your pension entitlement is not dependent on the performance of the stockmarket or other investments;
The pension scheme will normally increase your pension income each year in line with the Retail Prices Index (RPI) or a set percentage, whichever is the lower.
Risks in these schemes
Some salary-related occupational schemes have been in the news because the employer has become insolvent and there wasn't enough money in the employer's pension scheme to pay the pensions it had promised to its current and former employees.
The government set up a Pension Protection Fund in April 2005 to protect members of salary-related schemes. The fund pays some compensation to scheme members whose employers become insolvent and where the scheme does not have enough funds to pay members' benefits. The level of compensation may not be the full amount.