Is your work pension any good?
Work pensions are an increasingly endangered species. We show you how to size up your pension scheme.
Since the late Nineties, occupational (workplace-based) pension schemes have been under attack as employers cut their costs. This has led to many organisations curbing or even closing altogether their pension schemes.
However, this 'withering' of pension schemes has taken place almost exclusively in the private sector.
Two decades ago, most large private sector employers offered final salary pensions to new joiners. Today, the vast majority of these schemes have been shut down to new joiners. Now only one in nine (11%) of the UK's 23 million private sector workers belong to schemes paying final salary pensions.
On the other hand, more than nine in ten public sector employees get gold-plated pensions.
How good is your scheme?
When moving job or changing employer, it's important to check your future pension entitlements. In fact, after your basic salary (and bonus, if you get one), the most important factor to consider when weighing up a job offer is the pension you'll get.
This is because pensions are simply future pay, so not joining a good pension plan is like turning down a pay rise -- every year, for life. Here's what to look for in a pension scheme...
Final salary (defined benefit) schemes
Final salary plans are the 'gold standard' of pension schemes.
The joy of a final salary scheme is that the employer takes all of the investment risk and longevity risk (how long you'll live), while promising you a pension based on your years of service and salary on retirement.
Alas, thanks to their sky-high running costs, these have all but died out in the private sector. Even so, some generous employers still offer final salary pensions to new joiners, including Tesco and the John Lewis Partnership (owner of John Lewis and Waitrose).
Career average schemes
In order to reduce the ongoing cost of running guaranteed pension schemes, many employers have switched from final salary to career average payouts. In other words, your pension isn't linked to the peak salary you earned in your final year, but is based on the average wage throughout your service.
Obviously, this leads to lower payouts, but hardest hit are higher-paid employees and those who received strong salary increases during their careers. Nevertheless, better an open career average scheme than a closed final salary plan.
A typical final-salary scheme offers an 'accrual rate' of 1/60th. In other words, for each complete year of membership, you earn another 1/60th of your wage as a pension. So a career lasting 40 years would get you 40/60ths (two-thirds) of your final salary as your starting pension.
In some cases, accrual rates are 1/80th, so working four decades would earn you a pension worth half of your salary. However, the most generous schemes -- usually open only to directors, top executives and senior managers -- can offer accrual rates as high as 1/30th. In these schemes, just 20 years of service would earn you a guaranteed pension worth two-thirds of your final salary.
As well as a pension based on your income and years of membership, some final salary pension schemes -- notably in the public sector -- provide lump sums linked to your length of service.
For example, your scheme may have a pension accrual rate of 1/80th, plus 3/80ths towards a lump sum. So after 40 years, you'd get half your wage as a pension, plus 120/80ths as a lump sum, worth 1½ times your yearly salary.
These lump sums are a very valuable benefit and should never be overlooked when comparing schemes.
If you're lucky, your scheme will have a lower-than-average retirement age. Most private sector pensions have a normal retirement age of 65 for men and women. However, more generous schemes do allow retirement at 60 (or earlier, if due to ill health or redundancy).
A few lucky individuals -- including members of the Armed Forces -- are members of non-contributory pension schemes. What this means is that they don't pay a penny into their pensions, as their benefits are provided solely by contributions from their employer (usually the taxpayer).
Non-contributory, final salary pension schemes are as rare as hen's teeth these days, so if you ever get the opportunity to join one, then do so without delay.
'Death in service' cover
Another valuable benefit provided by many corporate pension plans is life insurance, known as 'death in service' cover. Typically, this will give you, say, three to four times your salary if you die in service.
In most cases, your employer pays the premiums for this insurance, so it's free to you. What's more, as these policies are written 'in trust,' they are paid to a deceased employee's beneficiaries free of all taxes. So if you have this cover, then make sure your 'expression of wishes' form is up to date. Otherwise, your lump sum from life insurance could be paid to an ex-spouse, for example!
Defined benefit schemes lift your pension payments each year, usually in line with inflation. While most still link to the RPI (Retail Prices Index) measure of inflation, many schemes are switching to the lower CPI (Consumer Prices Index). This means that, all else being equal, RPI-linked pensions are more valuable than CPI-linked pensions, as the RPI rises faster than the CPI.
Defined contribution schemes
Having reviewed defined benefit schemes, now let's look at their inferior alternative: defined contribution or money purchase schemes. How big these pensions get depends on four things:
- How much your employer pays in (the higher its yearly contributions, the better);
- How much you pay in (your yearly contributions);
- Your investment returns over time (the higher, the better); and
- The fund's charges (the lower, the better).
Let's briefly look at the first two factors:
Your employer's contributions
Ideally, you want your employer to be as big-hearted as possible by footing most of the bill for providing you with a retirement income.
Some generous employers pay a flat percentage of your pay into your pension, even if you don't contribute a penny. In some cases, this no-strings payment could be 10% or even 15% of your before-tax salary.
However, many employers prefer to match your contributions £1 for £1, known as 100% matching. For example, you pay in 5% of your salary and your employer pays in another 5%.
As well as contributing according to a "You pay X%, we pay Y%" formula, you can also make additional contributions to your workplace pension. The advantage of doing this is you get tax relief at your highest tax rate.
For a basic rate taxpayer, a £100 pension contribution costs £80, thanks to 20% tax relief. For a higher rate (40%) taxpayer, a £100 contribution costs £60. For those earning over £150,000 and thus paying 50% tax, a £100 contribution costs a mere £50.
Therefore, paying an extra, say, 5% of your wage into a pension could cost you just 4%, 3% or even 2.5% of your pay, thanks to tax relief. This explains why many people pay additional voluntary contributions (AVCs) into their occupational pensions
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