Last month we looked at the various types of pension scheme (Defined Benefit and Defined Contribution). This month we will look at how pension schemes are funded.
Pension schemes receive contributions from both the employer and from the employees. However, the way those contributions provide benefits under a scheme depends on whether the scheme is a Defined Benefit Scheme or a Defined Contribution scheme.
Defined Benefit Scheme
The benefits under this type of scheme are defined, for example, 1/60th x Pensionable Service x Final Salary (known as a final salary scheme) or based on average earnings over the working life (known as a Career Average Revalued Earnings scheme. So, what is known are the benefits that would be paid at retirement or death but not the contributions or fund value necessary to provide those benefits.
The employees’ contributions are fixed as a percentage of Pensionable Salary, whilst the employer pays the balance of cost necessary to provide the promised level of benefit. Therefore, the employer takes on the full investment and mortality risk.
By law a Defined Benefit scheme must carry out an actuarial valuation every three years. An independent actuary values the schemes assets (value of the assets plus present value of future investment income) and liabilities (present value of future pension payments) to determine whether the scheme is in surplus or deficit, and to fix the employer’s contribute rate for the next three years.
The scheme normally has a wide range of investments, including shares, gilts, bonds and property etc. To diversify even further, funds are often invested in different industries and countries. As an example, the BBC Pension Scheme, as at 31 March 2019, invested in the following asset classes:
Defined Benefit schemes are proving more expensive to run than when they were originally set up due to low interest rates and improving mortality. As a consequence, there has been a trend over the last few years to close Defined Benefit schemes to new members and to future accrual of benefit.
The BBC Pension Scheme is a Defined Benefit scheme. It is closed to new members but is still open to future accrual of benefit for active members of the scheme.
Defined Contribution Schemes
The contributions under this type of scheme are defined. Both employer and employee contribution rates are fixed as a percentage of salary, but the benefits that can be provided by the accumulated fund are not known until retirement. Contributions are invested to create a fund. The employee usually has flexibility to choose from a wide range of funds into which contributions can be invested in. As a consequence, the employee takes on the full investment risk.
The BBC LifePlan is a Defined Contribution scheme.
Individuals who are not members of a workplace pension scheme are able to contribute to a Defined Contribution Personal Pension Plan in their own name.
Under both Defined Benefit and Defined Contribution schemes individuals can take up to 25% of the value of their retirement savings as a tax-free cash sum.
This article is for information only and is not intended to provide any form of financial advice.