Occupational pensions have a long history in the UK. In medieval times we find pensions awarded for service to the king; pensions for members of the clergy; and a pension scheme for maimed soldiers and mariners was established by Act of Parliament in 1601. In 1684 the very first civil service pension was paid.
The nineteenth century saw a small number of pension schemes being established in certain professions and companies. The provision of pension benefits by employers expanded significantly over the course of the twentieth century. In the main the bigger the company the more likely it was to provide a pension for its employees.
By 2018, all UK employers (with the exception of newly formed companies) had to automatically enrol their eligible workers into a workplace pension scheme.
Defined Benefit (‘final salary’) Schemes
Traditionally employers provided pensions for employees that have a known amount of pension and other benefits. These are ‘defined benefit’ schemes and are more popularly known as ‘final salary’ schemes. That is, what you can expect to receive is defined as a percentage of your ‘final salary’ for each year of membership in the scheme.
The amount of pension you will receive from such a scheme is dependent upon:
- the length of time you served in the scheme (known as ‘pensionable service’). This may not be the same as your service with that employer;
- your earnings prior to retirement (known as ‘final pensionable salary’). This will be based on a formula such as your actual earnings in the final year of service but more usually will be something like the average of your last three years’ earnings or the average of your best three years’ consecutive earnings ending in the last ten years. In this case ‘earnings’ may simply be defined as your basic salary without any overtime, bonuses or commission or may include some part of these; and
- the proportion of your final pensionable salary that is earned for each year of pensionable service (known as the scheme’s ‘accrual rate’). The accrual rate is typically expressed as 80ths, 60ths, 50ths or 45ths. So, if the scheme has an accrual rate of 60ths, you will receive 1/60th of your final pensionable salary for each year of pensionable service completed.
Example (1) – A member of a 60ths scheme will complete 23 years’ service just before reaching his normal retirement age and his final pensionable salary is £70,000. He will receive a pension of 23 x 70,000 / 60 = £26,833 pa
Example (2) – If a member’s scheme provides one 60th of final pensionable salary for each year of scheme membership, this would result in a pension of half of her final pensionable salary after 30 years’ of pensionable service (ie 30/60ths).
Example (3) – If a member’s scheme provides one 50th of final pensionable salary for each year of scheme membership, this would result in a pension of half of his final pensionable salary after 25 years’ of pensionable service (ie 25/50ths).
A defined benefit pension scheme may provide an element of cash lump sum as an additional benefit or it may provide the option for you to surrender some of your pension in exchange for a cash lump sum. Other benefits, such as pensions to your spouse or dependent children on your death, are also defined.
Example (4) – Mr Smith is a member of a 80ths scheme which provides him with an additional cash sum using the formula 3n/80ths of his final pensionable salary (where ‘n’ is the number of years of pensionable service). Mr Jones is a member of a 60ths scheme which allows him to exchange £1 pa of his pension benefit for each £9 of cash sum he requires. Both Mr Smith and Mr Jones have £50,000 final pensionable salary and 25 years of pensionable service. Who has the better pension benefits?
Mr Smith will receive a pension of 25 x 50,000 / 80 = £15,625 pa. In addition, he will receive a cash sum of 3 x 25 x 50,000 / 80 = £46,875. Mr Jones could receive a pension of 25 x 50,000 / 60 = £20,833 pa. However, if he wishes to receive a cash sum of £46,875 he will have to exchange 46,875 / 9 = £5,208 of annual pension. His pension would then be reduced to 20,833 – 5,208 = £15,625 pa.
The popularity of defined benefit schemes among employers has declined dramatically in recent years as employers become increasingly reluctant to bear the steeply rising costs and have to deal with complicated and onerous rules and regulations. Most defined benefit schemes still in force are provided by the Civil Service, local authorities and similar Government backed organisations. There is no doubt that employees generally are losing out as a result of this change to occupational pension schemes.
Defined Benefit (‘career average’) Schemes
Pension Schemes provided by the NHS, Education Authorities, the Police, Firefighters and Railways still provide defined benefit pension schemes but over the last few years have been moving away from ‘final salary’ to a ‘career average’ basis.
Under a final salary scheme the pension can be based on the earnings of someone at the peak of their career. For example, someone who has been a teacher for most of their career could end up being a head teacher on a very much higher salary for the last few years. This is likely to provide them with a very much higher pension for the rest of their life than would have been the case had they remained as member of the teaching staff.
Under a career average scheme an annual pension is earned as a percentage of your actual salary in each year. Whilst the pension earned in each year is increased by a measure of inflation the resultant pension could be a lot less for someone who has progressed well in their career.
Whilst we can feel some sympathy for those affected by this change the end result is still far superior to relying on the build up of a pot of money with all the uncertainty of investment returns, inflation, charges and annuity rates to contend with.
Defined Contribution (‘money purchase’) Schemes
Most small and medium sized employers, and an increasing number of large employers, are looking to a different type of occupational pension scheme to provide income in retirement to their employees. These do not have a table of defined benefits upon which you can rely. Instead, what is known for certainty is the contribution that you, and more particularly your employer, is to make to the scheme. These are ‘defined contribution’ schemes and are more popularly known as ‘money purchase’ schemes.
Under a money purchase scheme there is no definite pension amount to which you can look forward. Instead, your pension is dependent on the amount that you and your employer contribute; the investment fund(s) that you choose to use (or the default fund) and the returns achieved in the future on that fund(s); the charges on the fund(s); and the level of annuity rates available at the time you need to purchase your pension. As annuity rates are at historic lows most retirees are choosing to use a form of pension drawdown instead of purchasing an annuity and that in itself adds more risk and more charges.
This move to money purchase occupational pension schemes is having a significant effect on the prospective benefits of the employees involved. The problem is not just that employees no longer know what to expect at retirement but both employers and employees are contributing far too little to these schemes. The average total contributions to money purchase schemes are estimated to be around half as much as those previously made to defined benefit schemes.
Tax reliefs and exemptions for registered pension schemes
Registered pension schemes benefit from the following:
- tax relief on member contributions
- tax relief on employer’s contributions
- employer contributions are not taxable on the member
- certain lump sum benefit payments and lump sum death benefits are exempt from tax
- income and gains are generally exempt from tax
- contributions into and payments from a registered pension scheme are generally exempt from inheritance tax
Early leaver options
The Department for Work & Pensions (DWP) legislation provides a level of benefit protection to a member of an occupational pension scheme who leaves that scheme before their ‘normal pension age’ under that scheme. This is referred to as ‘preservation’.
The principal requirement of preservation is that where you leaves pensionable service under an occupational pension scheme with at least 2 years ‘qualifying service’ you will be entitled to a minimum level of preserved benefit from the scheme. This preserved benefit is referred to more specifically as a ’short service benefit’.
However, a scheme doesn’t have to wait the full 2 years to give you such short service benefit rights. Schemes are free to give you these rights much sooner.
Where you leave pensionable service after a minimum of 30 days but before acquiring rights to short service benefit DWP legislation still requires that you be given a transfer of your accrued rights, which will include the elements provided by your employer as well as your own contributions.
Employers have to automatically enrol all staff between age 22 and State Pension Age (SPA) who earn at least £10,000 (2022/23) a year into a qualifying workplace pension scheme (QWPP).
The minimum contribution level for defined contribution arrangements is 8% of qualifying earnings, where at least 3% is being paid by your employer. If your employer contributes the minimum amount, you must contribute at least 4% of qualifying earnings, with a further 1% coming from tax relief.
You must normally be enrolled as soon as you start work if you are over the age and earnings thresholds. However, employers can delay the automatic enrolment date by three months subject to informing you in advance and giving you the choice of opting in during the waiting period.
Employers have six weeks from the automatic enrolment date to enrol you into the scheme (backdated to day one) and provide you with required information. You then have up to a month to opt out. If you opt out you will be automatically re-enrolled every three years.
Pension Protection Fund
The Financial Assistance Scheme (FAS) was the forerunner to the Pension Protection Fund (PPF) for companies which went into liquidation between 1 January 1997 and 5 April 2005. The FAS is now administered by the PPF.
The PPF protects members of certain occupational pension schemes providing defined benefits where the scheme is under-funded and the employer has become insolvent. In such circumstances the PPF may take over the funds and assets of the pension scheme and then pay compensation in lieu of the benefits due from the scheme.
All schemes go through an assessment period before entering the PPF. The level of benefit which members of schemes administered by the PPF receive depends on whether they were already in receipt of pension benefits before their employer became insolvent.
If the pension scheme qualifies, the PPF can pay 90% of expected benefits to members below retirement age. Those over retirement age, those receiving ill-health early pensions and those receiving survivors’ pensions normally qualify for 100% compensation.
However, there is a cap on how much can be paid out. From 1 April 2021, the cap at age 67 has been set at £44,810. As the cap is applied before your compensation is reduced to 90%, the actual amount you would receive as a capped member retiring at 67 is £40,329. The cap varies by age. For example, at age 60 it is £34,749. The later you retire, the higher the annual cap is set, as you will be receiving payments for a shorter period of time.
Pension Tracing Service
It is possible for former scheme members to lose track of their pension benefits from previous employers.
If this applies to you then you should go to https://www.gov.uk/find-lost-pension. This is a service provided by the Department for Work & Pensions and their website also provides details of how to request contact details from the Pension Tracing Service by phone or by post.
Links to more information about pensions
- Pension planning
- Death benefits from pension schemes
- How do ISAs and pensions compare?
- Older pension contracts
- Pensions for women
- Personal pensions
- State pensions
- Uncertain about how to take your pension?
- Starting a pension if you are self employed
- Money Advice Service Workplace Pensions
- If you need personal financial advice on Occupational Pensions then I am happy to introduce you to Flying Colours Life who have access to independent financial advisers throughout the UK
This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.
Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.
If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.