Pensions are not an easy subject to grasp. We give a basic overview of all the different options available to organisations in plain English; looking at final salary schemes, money purchase schemes, stakeholder pensions and group personal pension schemes.
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Pensions can be a minefield for the most experienced HR professional; for the unseasoned, the task of taking on responsibility for the company pension scheme is likely to result in panic. Advice is widely available from pension consultants, pensions regulatory bodies and training organisations, but the best place to start is with a grasp of the basics.
The problem for most HR staff is understanding the various types of pension schemes that are available. These include final salary, money purchase, group personal pension and stakeholder. All have their advantages and drawbacks as a staff benefit.
1 Final salary schemes
• Pros: Attractive to employees, therefore very effective as a recruitment and retention tool.
• Cons: The employer takes the financial risk, and may need to provide additional funding if a deficit occurs.
• Who uses them? Historically, large manufacturing companies were expected to provide them, encouraged by the trades unions.
Today, few new schemes are being established, unless there is a contractual obligation on the part of the employer to do so.
Final salary pension schemes have long been seen as the best pension an employee can get. This is because they promise to pay you an income in retirement that is based on a percentage of your final salary every year for the rest of your life. How this percentage is calculated can get complicated, but put as simply as possible: it will depend on how long you have worked for your employer and will be based on a fraction of your pensionable earnings (this is usually your basic salary, excluding bonuses, commissions or benefits). So you land up with a calculation that refers to length of service; typically one-sixtieth or one-eightieth for each year of service. For example, someone in a final salary pension scheme based on sixtieths who worked for their employer between the ages of 25 and 65 (40 years of service) would be entitled to a pension of forty sixtieths or two-thirds of their final salary, the maximum allowed. Fewer years of service will mean a smaller pension.
However, final salary pension schemes have become less popular with employers mainly because they have to foot the bill if there is a shortfall between how much pensioners have to be paid and how much is available in the pension fund. Because shares have not performed well in recent years, many organisations have decided that the burden of guaranteeing the pensions of their employees is too great a risk. Ian Luck, associate director with financial services company Smith & Williamson says: “It can cause a conflict in companies. The HR director would love to be able to offer a final salary scheme, but because of the risks the finance director wouldn’t.”
2 Money purchase schemes
• Pros: Employer contributions are fixed (hence it is called defined contribution). Like final salary schemes, it has a board of trustees using advice from fund managers to decide where to invest.
• Cons: Members take the financial risk if stock markets and other investments do not perform.
• Who uses them? Companies that may have come from a background of final salary schemes and want to maintain control of their employees’ pension scheme.
In recent years, some of the country’s biggest employers have abandoned final salary schemes in favour of money purchase plans (which are a type of defined contribution scheme), which operate in a very different way. Money is paid into a fund which is invested on the employees’ behalf, and when the employee retires whatever is in their fund is used to buy an annuity which provides a regular income for life. Part of the fund may also be used to provide a tax-free lump sum.
A group money purchase pension scheme is set up to run under trust rules and is administered by trustees, who are obliged to operate the scheme within strict guidelines to provide security and protection for the scheme members. Employees who join the scheme become members and may have to make additional contributions into the fund themselves.
Roger Mattingly, director of HSBC Actuaries and Consultants and head of public relations at the Society of Pensions Consultants, says: “The downside to money purchase schemes is the uncertainty about how much retirement income will be received. This depends entirely on stock market investment performance, and is fine if retirement coincides with a buoyant market. Employees retiring at a time when the market has been falling will be worse off on retirement.”
3 Stakeholder pensions
• Pros: Employers are not legally required to make contributions into the fund, although employees may ask them to.
• Cons: Members take the financial risk if stock markets and other investments do not perform. Whether or not the company promotes this as a good plan, staff will expect the employer to have done sufficient research to find the best one.
• Who uses them? Firms that have occupational schemes that are not inviting new members, or those with only a few staff.
A stakeholder pension is a type of low-charge defined contribution pension scheme. All employers which employ five or more people and don’t provide an occupational pension (or a group personal pension with at least 3% employer contribution, without a requirement for the member to pay any more than 3%), must provide access to a stakeholder scheme. Although employers can set a stakeholder up under a board of trustees almost all choose to provide access to a scheme that is run by an approved pensions provider. A list of approved stakeholder providers can be found on the Occupational Pensions Regulatory Authority’s website at www.opra.gov.uk. Stakeholder pensions can be purchased from these commercial financial providers (which include banks, building societies and insurance companies). Employees who join the scheme must be offered a payroll deduction facility to enable them to make contributions, which should be passed to the stakeholder pension provider within nineteen days of the end of the month in which they are deducted.
4 Group personal pension scheme
• Pros: The level of employer contributions can be stable, and there is less administration. Also there is said to be a wider choice of funds available than with stakeholder schemes (although some providers dispute this)
• Cons: Members take the risk if stock markets and other investments do not perform. Employers which want to promote these schemes as an attractive benefit, may have to increase their contribution.
• Who uses them? Newer companies with no previous scheme history establishing a pension plan from scratch.
A group personal pension scheme (GPP) is considered to be more sophisticated than a stakeholder pension (however, the two are very similar). A GPP is essentially a cluster of individual personal pensions, rather than a single common fund. Each member builds up their own personal pension fund, while the employer collects their contribution through the payroll system and passes them on to the pension provider. Although employers are required to make contributions to the scheme of at least 3% of salary on behalf of their employees (to avoid the requirement to provide a stakeholder) the contract is between the individual employee and the provider of the personal pension, often a life insurer. The employer simply acts as a facilitator to establish the contracts and administer contribution payments.
Smith & Williamson’s Luck adds: “Like any pension scheme, the success of a GPP will depend on how well it is structured and communicated. And also how committed the company is to ensuring that the administrative system is up to scratch.”
To further your knowledge of pensions turn to organisations such as the Pensions Management Institute. It sets out to maintain and improve professional standards within the pensions industry, recently has introduced a Retirement Provision Certificate to help human resource professionals understand the basics of the various pension schemes. Sue Howlet, secretary-general, says: “Pensions are an incredibly complex subject, so if you are considering a pension scheme, it is vital that you are aware and have a basic understanding of all the available options. You need to be familiar with the language and terminology of the pensions market and also to take some expert advice before making any decision.”
What is the difference between a defined benefit pension scheme and a defined contribution scheme?
• Defined benefit (DB) schemes provide a pension based on an employee’s final pensionable salary calculated against the number of years of employment or years of membership within the pension scheme. An employer with a DB scheme makes an ‘open-ended’ financial commitment to guarantee employees with pension benefits. Types of defined benefit schemes include final salary pensions, added years, additional voluntary contribution schemes, and some hybrid pension schemes. The defining quality of a DB scheme is that what gets promised is the level of pension rather than the level of the contributions, hence the name. DB schemes are trust-based.
• Defined contribution (DC) schemes involve the employer and/or employee paying a specified level of contributions into the pension fund. Growth on the fund results from investment of the contributions up to the point of retirement when the fund is converted into a pension. The key quality of a DC scheme is that while the amount being paid into the fund is known, or the contributions are defined, the eventual amount of pension received can’t be guaranteed. All DC schemes work on the same principle, however, they can differ in terms of how much the employer pays into the fund on the employee’s behalf, how the funds are invested, and what the options are at retirement. Money purchase, group personal pension (GPPs) and stakeholder schemes are all DC schemes. A GPP is a contract-based schemes (the contract is with a pensions provider), as are most stakeholder schemes. In theory stakeholder schemes can also be run by a board of trustees, while a money purchase scheme always are.