Profiting from your pension
What does your employer offer you?

Continuous talk in the media about pensions and in particular over the past few years about the demise of the final salary scheme has been a regular occurrence. But what are the schemes typically offered by employers? There are two main types of pension scheme: defined benefit (such as final salary schemes) and defined contribution, also known as money purchase schemes.

The defined benefit scheme has been the vanguard of pensions throughout the past number of decades. They promise the member a set annual income in retirement, based on the number of years’ service and the salary when the employee left the company. This amount will typically also rise in line with inflation.

The employer bears the risk of long life expectancy and investment performance. As a result, many employers have closed defined benefit schemes to new members (and in some cases to existing members too), and replaced them with defined contribution schemes which transfer all these risks to the employee. This is only an issue for employees of companies and charities. Public sector workers are still entitled to final salary pensions.

A defined contribution scheme takes contributions from the employer and employee and invests them over the long term to build up a sum of money to fund the employee’s retirement.

The employer’s contribution is normally higher than the employee’s, and both are calculated as a percentage of salary. Schemes which replaced defined benefit pensions tend to be more generous. A fairly generous scheme may offer a 10 per cent employer contribution with a 5 per cent employee contribution. Some employers also offer higher contributions for older employees, but new rules against age discrimination could put a stop to this.

Scheme members can sometimes choose from a menu of funds. These are typically actively and passively managed equity funds, commercial property funds and bond funds. As you near retirement, it is standard practice to reduce your exposure to riskier investments such as equities and shift into safer assets such as bonds or cash. Some defined contribution schemes may only have one investment choice, a “balanced managed” fund which spreads investments across a range of asset classes.

Alternatively some schemes also offer a default asset allocation, which usually starts with most or all of the money invested in equities, and transfers money into bonds as the member gets older.

Extra contributions can also usually be made through additional voluntary contributions (AVCs) that allow the member to invest in the same way as their main contributions or the choice to select from other funds available.

The government grants tax relief on the member’s contributions at their highest rate of income tax. So if they are subject to the top rate of income tax of 40 per cent, they will only sacrifice £60 of their take-home pay for every £100 put into their pension fund. The fund will have to pay some tax on dividends from equity investments, but will not be subject to capital gains tax. Once the member starts receiving their pension it will be subject to income tax. In addition a tax-free lump sum of 25 per cent can also be taken.

If the member has more than one pension scheme it is possible to keep them separately if they wish. But if appropriate, it may be more beneficial to consolidate all of their defined contribution pension savings into the scheme with the lowest charges.

Alternatively there is the option, also if appropriate, to arrange a self-invested personal pension (SIPP), enabling them to invest in a much wider range of assets than those on offer through most defined contribution schemes.

However, not many employers will allow members to invest their pension contribution outside the official company scheme. But, following the changes to the rules in April 2006, there is nothing to stop a member putting any money accrued in AVCs into a SIPP once they have received professional advice to determine if is the appropriate course of action.

Need more information? Please email or contact us with your enquiry.

Levels and bases of, and reliefs from, taxation are subject to change.