Issued: 10 November 2004
Once an organisation employs five or more staff, the minimum requirement (with limited exclusions) is to offer the staff access to a stakeholder scheme. Should staff decide to join the stakeholder scheme the employer is obliged to pay across the members' contributions to the chosen provider. The employer is under no obligation to make a contribution to the stakeholder scheme itself.
What other types of pension scheme are there?
Final Salary Schemes
A final salary scheme is recognised as the gold standard of pension schemes, certainly from a member's point of view. This is because there is a known expectation of what the member will receive at retirement. Typically, pensions received from final salary schemes are based on a formula using the amount of:
- 'pensionable' service built up,
- an accrual rate and
- reference to the final salary (be that actual final salary in the year before retirement, average of the last three years' salary or some other permutation.)
A common accrual rate is 1/60th. Under this formula the member would receive 1/60th of their final pensionable salary for each year accrued. For example, a member building up 30 years of pensionable service would receive 30/60ths or half of their final pensionable salary as a pension.
Frequently, these schemes also provide valuable additional benefits such as life assurance, ill-health early retirement benefits and dependants' and children's pensions as part of the package.
Career Average Schemes
A career average scheme tends to be slightly less generous than a final salary scheme, though this can depend on the member's working pattern and salary variations. The career average scheme differs from the final salary scheme in that the member earns a defined amount of pension each year. This is based on the scheme’s accrual rate and the member's salary for that particular year. Typically, the pension bought will be 1/80th of the member’s salary each year.
For example, a member earning £10,000 would have built up a pension of £125 at the end of that year (1/80th of £10,000). If in the following year, their salary increased to £11,000, they would then earn a pension of £137.50 (1/80th of £11,000) at the end of that year. At retirement all of these year-on-year amounts are added up, usually with some form of cost of living increase, to provide the member’s annual pension.
As with final salary schemes, there are often life assurance and dependants' benefits built in.
From an employer's perspective, this type of scheme may be more attractive than a final salary scheme as the cost is more manageable. Additionally, a change in pensionable salary only affects future pension accrual, unlike in a final salary scheme where this would increase the whole of the member's pension.
Money Purchase Schemes
In simple terms, a money purchase scheme is a tax-efficient savings plan which is invested and converted into pension at retirement. This type of scheme is perceived as the least popular scheme among staff as, like a stakeholder scheme or private pension plan, it has an unknown outcome and all the risk falls on the member. However, these schemes do offer more flexibility of benefits than other types .
The employer and the employee usually both contribute and the outcome depends on three factors:
- the amount paid into the member's fund;
- how the fund grows; this is dependent on how the assets it is invested in perform, and the value of the fund may rise and fall over time; and
- the conversion factor or annuity rate at retirement.
There may be the option to add life assurance and dependants’ benefits at an additional cost.
How much do these schemes cost?
This is obviously an important question when choosing a pension strategy. The most expensive schemes tend to be final salary. The main drawback of a final salary scheme, as far as employers are concerned, is that it is an unknown cost. There is a known benefit at retirement and this level of benefit must be funded for and can change. In recent times poor investment returns and more significantly increased longevity have led to an increase in costs. Employers joining a final salary scheme need to be aware of this volatility.
Career average schemes tend to be 'mid-range' in terms of cost. They offer defined benefits based on average earnings as opposed to final salary, therefore costs are generally lower. The contribution rate should remain fairly stable in the long term and certainly will not have the volatility associated with a final salary scheme. This allows employers to budget for pension costs more easily.
Finally, money purchase schemes are becoming more popular because although they do not have a known outcome, they do have a known cost. Basically the employer can set the contribution level at whatever rate they wish, except that the Inland Revenue currently requires that an employer provide at least one tenth of the overall funding. It is common for an employer to match, or sometimes double, the contribution rate paid by the member. The amount need never change, even if the investment returns are poor, as a defined level of benefit is not being funded for. This type of scheme tends to be popular with finance directors!
For all of the above, there may also be set up costs, depending on which route is chosen. If you can find entry to a centralised scheme, where costs are shared by a number of employers, the costs will certainly be greatly reduced and perhaps there may not be any set up costs at all. Setting up your own pension scheme for your staff only will usually attract set up costs along with ongoing administration and investment costs. This may involve an annual charge or be on a fee-based arrangement whereby the provider charges in line with the level of work actually carried out.
What other factors do I need to take into consideration?
Although cost has a major impact on the pension strategy, there are other considerations to take into account. The first may be staff retention. Does your organisation have a high staff turnover and would having a good pension scheme in place improve this? Individuals are becoming increasingly aware of the advantages of being in a good occupational pension scheme, and this may prove a critical factor when considering a job offer.
What are your competitors doing? This could be closely linked to the point above in that the companies you are competing with for staff may have a superior pension scheme. For instance, local government staff can join a generous final salary scheme.
Workforce profile may also dictate what would work best for your staff. Staff on variable hours, whose salaries fluctuate from year to year may be better suited by a career average scheme than a final salary arrangement. However it can be difficult, if not impossible, to find arrangements which will suit everyone.
Finally there is the employer’s outlook on staff welfare and benefits. In the social, voluntary and charitable sectors staff are typically paid a lower salary than they could command in the private sector. To balance this many employers like to provide decent side benefits, such as a good pension scheme, where they can afford to do so. Though again, some employers are restricted by budgets and funding.
Doesn't the government provide a pension?
All individuals who pay National Insurance contributions are entitled to a State pension. State pension benefits are paid directly from incoming National Insurance contributions. When the State Pension was first introduced in the early part of the 20th century, a very small percentage of the population actually survived to receive their benefits.
However, with improved diets, better living conditions and medical advances this percentage has gradually increased. At the same time the birth rates have been falling. This is naturally leading to an ageing population and, as the ratio of those paying National Insurance to those receiving State Pension decreases, so the government is having to find more money to fund the benefit.
A recent report produced for the government by the Pensions Commission, chaired by Adair Turner, highlighted this. Although no recommendations have been made as yet, the report concluded that there were four choices available in the longer term. Namely:
- pensioners will become poorer relative to the rest of society; or
- taxes/National Insurance contributions devoted to pensions must rise; or
- savings must rise; or
- average retirement ages must rise.
As the first option is extremely unattractive, the report concluded that a combination of the other three choices would be the most likely solution.
Where can I get more information on pension schemes?
Most financial advisers, banks, insurance companies and financial consultancies will provide information on pension products. You can find general information about pensions on The Pensions Service website at http://www.thepensionservice.gov.uk/
Alternatively, charitable, social, educational, voluntary and not-for-profit organisations may wish to contact The Pensions Trust direct for further information on 0845 123 6660 or email contact@thepensionstrust.org.uk
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