UNDERSTANDING PENSIONS
Pensions can be quite confusing for the majority of people. This article summarises the main types of pension arrangements and looks at how they are funded.
TYPES OF PENSION SCHEMES
There are three main types of pension schemes:
- State Pension
- Defined Benefit pensions; and
- Defined Contribution pensions.
State Pension Scheme
Prior to April 2016, the State pension was made up of two parts:
- Basic pension
- Additional State Pension.
Provided sufficient contributions were paid, most people were entitled to receive the Basic State pension. The Additional State Pension was based on a member’s earnings between two salary bands and was known as State Earnings Related Pension (SERPS) but then replaced in 2002 by the State Second Pension (S2P).
Employers that provided an occupational pension scheme for their employees could contract out of the additional State earnings-related pension on condition they provided at least as good benefits through their occupational pension scheme. In return, both the employer and the employee paid reduced National Insurance contributions.
The BBC Pension Scheme was contracted out of the State Additional Pension.
From April 2016 a new flat-rate State Pension was introduced. The full new State Pension from April 2020 is £175.20 per week.
Defined Benefit (DB)
This provides a salary-related pension which pays out a secure income for life and increases each year. The employer takes on the full investment risk of the scheme.
If the pension is based on a member’s pensionable service and salary close to retirement or leaving the scheme, it is known as a Final Salary pension scheme.
Alternatively, if the pension is based on average pay whilst a member of the pension scheme, it is known as a Career Average Revalued Earnings pension scheme.
The BBC Pension Scheme is a defined benefit pension scheme. Depending on when members joined the scheme, they could be in either the Final Salary or the Career Average Revalued Earnings section of the scheme.
Defined Contribution (DC)
Under this type of scheme contributions are paid into a fund which accumulates and applied at retirement to provide retirement benefits.
The fund available on retirement depends on:
- how well the investment performed;
- how much the individual and the employer (if appropriate) paid into the scheme; and
- the charges deducted.
At retirement the accumulated fund (after taking any tax-free cash) can be applied to purchase an annuity or provide an income under drawdown.
Under this type of pension scheme the employee takes on the full investment risk.
Defined Contribution pension schemes include workplace, personal and stakeholder pension schemes.
The BBC LifePlan is a Defined Contribution Group Personal Pension Plan.
FUNDING
Defined Benefit Schemes
As the benefits under this type of scheme are defined (e.g. 1/60th x pensionable service x final salary) the employees’ contributions are fixed as a percentage of pensionable salary, with the employer paying the balance of cost necessary to provide the promised level of benefit. Therefore, the employer takes on the full investment risk.
The scheme normally has a wide spread of investments, including shares, gilts, bonds and property etc. To diversify even further, funds are often invested both in the UK and overseas markets.
These schemes are very expensive to run and as a consequence most defined benefit schemes are now closed to new members and future accrual of benefit.
The BBC Pension Scheme is a defined benefit scheme. It is closed to new members but still open to future accrual of benefit for active members of the scheme.
Defined Contribution Schemes
As the contributions under this scheme are defined, the contribution rates are fixed as a percentage of salary, but the benefits that can be provided are not known until retirement. Contributions are invested to create a fund. The employee has flexibility to invest in a wide range of shares and funds, however the employee takes on the full investment risk.
The BBC LifePlan is a defined contribution scheme.
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.
