Company pensions explained Defined contribution schemes
A defined contribution (DC) or money purchase pension scheme is one that invests the money you pay into it, together with any employer’s contribution and gives you an accumulated sum on retirement - with which you can secure a pension income, either by buying an annuity or using income drawdown.
Company pension schemes are increasingly a DC, rather than defined benefit (DB), where the pension you receive is linked to salary and the number of years worked.
As an alternative to a company pension scheme, some employers offer their workforce access to a Group Personal Pension (GPP) or stakeholder pension scheme.
In either case, this is run by an external pension provider (typically an insurance firm) and joined by members on an individual basis. It's just like taking out a personal pension, although your employer may negotiate reduced management fees. They may also make a contribution on your behalf. GPPs are run on a DC basis, with each member building up an individual pension ‘pot’.
How defined contribution schemes calculate pension income
The amount you get depends on the performance of the funds in which the money has been invested and what charges have been deducted.
Although your total pension pot usually increases each year you continue to pay into the scheme, there's no way of accurately predicting what the final total will be and how much pension income this will provide.
Investment choices for DC pension scheme members
Unlike those who belong to a DB pension scheme, members of DC pension schemes have a degree of choice as to where their pension contributions are invested.
Many opt to put their money in the scheme’s ‘default fund’, but some will want to be more cautious, investing in cash funds and corporate bonds, while others may prefer a more ‘adventurous’ mix, with equity and overseas growth funds.
GPPs also offer investment choice, often between funds run by the pension provider.
Securing pension income
Defined contribution pension schemes allow you to build up a personal fund, which is then used to provide a pension income during your retirement. The usual way of doing this is to buy a lifetime annuity. The alternative is to leave your pension pot invested and draw a regular income from it each year.
Lifetime annuities are essentially a form of insurance, which removes individual risk by paying out a set amount each year for the rest of your life. How much you get depends on your age, your health and the prevailing annuity rates at the time you come to convert your fund.
A workplace fund will usually negotiate a rate on your behalf, but you're not obliged to take this and can opt instead, to shop around, comparing rates from other providers. This is called exercising the open market option (OMO).
For those with poor health, it can be particularly advantageous.
Drawdown schemes are less predictable. They continue to depend on investment performance to maintain your pension pot. If the investments do badly, or you deplete your capital too early, there's a risk of your income declining significantly before you die.
Taking a tax-free sum
Before buying an annuity, you can, on retirement, take up to 25% of your pension savings as a tax-free lump sum. This reduces the pension income you can secure by buying an annuity, but may be worthwhile if you need the money (to pay off outstanding debts, for example) or decide to invest it independently. The earliest you can draw a pension or take a lump sum is from the age of 55.
Additional company pension scheme benefits
As well as providing a pension fund, most company pension schemes offer additional benefits to their members. The most common is a ‘death in service’ payment to your spouse, civil partner or other nominated individual if you die before reaching pensionable age.
This is a form of life insurance, based on your salary at death. Your accumulated pension contributions may also be refunded. If you have ceased paying into the scheme at the time of death (because you no longer work for the firm, for example) your accumulated contributions will be returned, plus the investment growth they have achieved.
A partner’s pension may be paid if you die after buying an annuity, depending on the type you have purchased. Some have a five- or 10-year guarantee, others specify a spouse’s pension for life. But if you didn't choose these options, your partner will get nothing.
Group Personal Pensions may also include an element of life assurance, with employees having death in service cover. The sum paid may range from the premiums paid to the accumulated value of the fund.
Protected pension funds
Defined contribution schemes are protected by the Financial Services Compensation Scheme (FSCS). Most occupational and personal schemes hold funds under trust on behalf of their members.
If the provider goes into liquidation, this money is not available to its creditors. Some older personal schemes are invested in with profits funds, which may be at risk if a provider fails. Compensation from the FSCS would be limited to 100% of the first £2,000 plus 90% of the remainder of the claim in such cases.
If an employer goes out of business and the occupational pension fund (whether defined benefit or defined contribution) has lost money as a result of fraud or other dishonesty, the loss may be made good from the Fraud Compensation Fund.
This is financed by a levy on all occupational schemes covered by the fund.
Where an occupational defined contribution scheme involves any firm authorised by the Financial Conduct Authority (for example, managing investments), if that firm caused a loss through dishonesty or negligence and the firm had become insolvent, then it might be possible to claim compensation from the FSCS.
All personal pensions are protected in the same way by the FSCS.
In either case, the extent of the protection varies, depending on how the pension scheme is arranged. If the pension is run by an insurance company and invested on a with-profits basis, the limit is 90% of the claim without limit.
In other cases, compensation is capped at £50,000 if the firm running the scheme fails. However, usually, the administration of the scheme will be handled by a separate firm and the underlying investments will be held in trust for the members and so should not be at risk if the administrator failed.
If the firm looking after or managing the investments failed, compensation would usually be capped at £50,000.
Most holdings in Self-invested personal pensions (SIPPs) are similar to funds held in trust. They belong to the SIPP member rather than the provider. Cash held in a SIPP is more vulnerable, however, and will only be protected by the FSCS to a maximum of £85,000.
Annuities are protected by the FSCS on the basis of Long-term Assurance. From 1 January 2010, you are covered for 90% of the claim, with no upper limit.