How Does Your Company Pension Work?

Types of company pension

There are two types of company pension. The first is the defined contribution, or money purchase scheme, and the second is a defined benefit, or final salary scheme.  (You can read more about the traditional state pension here).

A defined contribution scheme works on the principle of what you put in is what you get out. In reality the contributions made into the scheme (by you and your employer) will pay out an amount that depends upon investment performance within the fund. This is the most common form of company pension scheme now.

A defined benefit scheme pays out a certain sum each year after retirement. This sum is usually based upon the number of years of service accumulated and the salary at retirement, or an average salary over the last few years of service.

Calculating the pension paid by a defined benefit scheme

Such a scheme is usually calculated on an accrual rate and the number of years of service accumulated. Common accrual rates are 1/60^th, 1/80^th, and 1/40^th. This means that your salary would be multiplied by the accrual rate, and then by the years of service, to calculate the annual amount paid under the pension scheme. For example, if your final pensionable salary (which may be your salary in your final year or an average as explained above) is £50,000, the scheme is a 1/40^th, and you have 20 years’ service, then your annual pension would be £25,000 ((50,000 x 1/40^th) x 20).

Calculating the pension paid by a defined contribution plan

The amount you receive in retirement from a defined contribution plan will depend upon two things. First is the performance of investments held within the scheme through to your retirement, and the second is the annuity rates achievable at the time you retire. This means that your retirement income is not known, nor guaranteed, until the time you retire and take your benefits.

Investment choice

Employees in a defined contribution plan can choose how their money is invested. Each group plan will have a default fund, and many employees invest within this fund. However, it is recognised that some will want to take either a lesser risk for security (particularly those nearing retirement) or a greater risk for potential growth (particularly new, younger members). Group personal pension schemes allow this flexibility.

How much can you contribute?

Your contributions will depend upon your salary, but are subject to several sets of rules. The first is the maximum annual allowance rule, which stipulates you cannot put more than 100% of your salary into pension schemes in any single year, with a maximum of £50,000 in 2012/ 13, before tax relief is withdrawn.

The second is a statutory minimum that must be invested in pensions from your employer and your salary, over a minimum annual wage amount. This amount is set at 2% from 2012 to September 2017, but then rises to 8% by October 2018. The employer must contribute a minimum of 1% in 2012, and a minimum of 3% in 2018, with the employee minimums set at 0.8% plus tax relief and 4% plus tax relief respectively.

Do I have to join a company scheme?

From October 2012, automatic enrolment in company schemes is being phased in. All employees in large firms will be automatically enrolled first, and then eventually the rules will apply to all companies operating in the UK.

However, there are other requirements needed to be met to be enrolled.

• The first is that you are not already in a suitable workplace scheme;
• Second, that you are at least 22 years old, and under the state pension age;
• Third, that your salary is at greater than a defined minimum (in 2012, this is £8105);
• Finally, that you work in the UK.

You will be able to opt out of the company scheme if you want, but you will lose out on your employer contribution and the tax relief paid by the government. You also won’t be eligible for other benefits.

Other Benefits available under company pension schemes

Most company pension schemes offer their members additional benefits such as:

Death in Service payment

Essentially a life insurance benefit, which pays out accumulated pension contributions from a defined contribution scheme, or a set amount (usually based on a multiple of salary) if in a defined benefit scheme.

Partner’s Pension

A partner’s pension may be paid to the surviving partner of an employee enrolled into a defined benefit scheme upon death after retirement, though within a defined contribution plan this will depend upon the type of annuity bought.

Early Retirement

Members of defined benefits plans may also be able to retire early (usually from age 55) and take a reduced pension accordingly.

Taking your pension benefits

Under each type of scheme, a tax free lump sum of up to 25% of the accumulated fund can be taken. Under defined benefit plans, the cash sum available at retirement is calculated by multiplying 25% of annual pension by 20 (years). So, for example, if you are entitled to £25,000 as a pension, then the maximum lump sum available would be £125,000.

Under all pension schemes, company or private, taking a lump sum reduces the income potential of your pension plan in retirement, because you have taken money from the ‘pot’ available.

Under a defined contributions scheme, the amount of annual pension you receive will depend upon the investment returns achieved throughout the life of your pension, and the type of annuity you buy with those funds.

Indexation

Both defined benefit and defined contribution schemes may pay out benefits that are linked to the rate of inflation. In other words, your retirement income will increase by the inflation rate each year, in an attempt to keep parity of spending power.

In conclusion

Defined benefits schemes are less common now because of the expense in running them. Part of this expense is because of the way in which they pay benefits and the level of benefits paid. There is no investment risk with a defined benefit scheme, and benefits are guaranteed. If you are enrolled into one of these schemes, conventional advice is to remain enrolled and not to transfer to a different policy. Most commonly these schemes are now only run within government bodies, such as the armed forces or police, and even then the benefits available are being reduced.

Unlike personal pension plans, a company scheme means that your employer will contribute towards your retirement, and there may also be other valuable benefits available to employees within a scheme, such as life insurance.

The changing company pension scheme laws are clearly an attempt by the government to encourage people to make their own pension and retirement arrangements rather than relying on diminishing state benefits in old age.