2 : 2 Types of Pension Schemes

Question 1

What’re the 3 main types of pension scheme?

Answer 1

• State
• Occupational
• Retirement annuity

Question 2

What’re examples of the legislative and tax changes which blurred the distinctiveness of the three types of pension?

(2)

Answer 2

• Additional voluntary contributions (AVCs)
• ‘Contracting out’ of the State Earnings Related Pension Scheme (SERPS)
• From 1988, employers could also contribute to an individual’s personal pension.

Question 3

What is automatic enrolment (auto-enrolment) and when was it introduced?

Answer 3

Where it became mandatory for employers to auto-enrol their eligible workers into a pension scheme.

2012.

Question 4

What is the default retirement age?

Answer 4

There no longer is one.

While many schemes still have age 65 as the age of retirement, no one can be forced to take the pension at that age.

Question 5

What is the limit to how much a person can put into a pension scheme?

Answer 5

There is no limit.

However, there are tax limits which result in a tax charge.

Question 6

What is ‘aaccumulation’?

Answer 6

The process of building up a pension pot

Question 7

What is ‘decumulation’?

Answer 7

The process of taking the pension benefits on retirement

Question 8

How does the Old Basic State Pension (BSP) (Pre 6 April 2016) work?

Answer 8

Old SP applies to a man born before 6 April 1951 and a woman born before 6 April 1953. This pension can be deferred and the rules will apply to a person born before those dates even if they take the SP after 6 April 2016.

To get the full BSP, the individual requires a total of 30 qualifying years of NICs or credits. For 2018, the full pension is £125.95 per week. On top of this an individual may be eligible for the Additional State Pension (ASP). If an individual reached SPA before 6 April 2016 and started claiming BSP, they will automatically receive any ASP that they are eligible for; there is no need for any additional application. There is no fixed amount of ASP

Question 9

How does the New State Pension (SP) (Post 5 April 2016) work?

Answer 9

It is a single tier (ie, just the one element) and applies to a man born on or after the 6 April 1951 and a woman born on or after the 6 April 1953. In 2018, the pension is £164.35 per week. Individuals will need ten qualifying years to get any SP and 35 qualifying years to get the full pension.

There are transitional provisions for those who have built up qualifying years or credits prior to 6 April 2016, to ensure that they will not receive a lower pension amount than they would have received under the previous system rules, so long as they meet the new ten-year minimum qualifying period.

Question 10

Why are DB pensions falling out of favour with employers?

Answer 10

They’re seen by many employers as too expensive and is less flexible to a more mobile workforce.

Question 11

What are the accounting treatments for pensions under Financial Reporting Standard 17 (FRS17)

(4)

Answer 11

• pension scheme assets are measured using market values
• pension scheme liabilities are measured using a projected unit method and discounted at a corporate bond rate (based on a bond with a credit rating of AA)
• the pension scheme surplus (to the extent it can be recovered) or deficit is recognised in full on the balance sheet
• the movement in the scheme surplus/deficit is analysed into: the current service cost and any past service costs;

Question 12

What’re the 2 key structures of Work Place Schemes (WPSs)?

Answer 12

1. defined benefit (also referred to occasionally as ‘final salary’)
2. defined contribution (also referred to occasionally as ‘money purchase’).

Question 13

How are WPSs mostly constituted?

Answer 13

As trusts

Question 14

The benefits from DB schemes are a promise to pay a pension based on:

(3)

Answer 14

• the member’s years of service in the pension scheme
• the member’s final pensionable salary (or some derivation of this)
• the scheme’s accrual rate.

Question 15

EG:

Gareth joined XYZ ltd when he was 44 and, having served a one-year probationary period, was allowed to join the company’s WPS. He is soon to retire at age 65, and has a salary of £33,000 pa plus £7,000 bonuses for sales.

The Occupational Pension Scheme is a ‘60th’ scheme that bases pensions on basic salary only.

Answer 15

His estimated pension benefit is therefore:

(£33,000 x 20) / 60 = £11,000 pa

Question 16

What do some schemes, generally in the public sector such as the National Health Service (NHS) scheme lso provide?

Answer 16

A tax-free cash payment in addition to the pension entitlement

Question 17

What is commutation?

Answer 17

When schemes allow tax-free cash to be taken, but only via commutation, ie, forsaking some annual pension for a lump sum amount.

Question 18

Why is the funding of DB schemes is risky for employees?

Answer 18

Because the scheme promises the member a level of benefits that has to be met in the future. This can be a difficult objective to achieve, as the vagaries of long-term investments play a big role in the success or failure of the scheme funding, but the promise remains.

Question 19

Who predominantly carries the risk?

Answer 19

By the employer, as they are committing themselves to a promise to pay for an unknown period of time, because they do not know how long the member will live, post retirement.

Question 20

What are the strict rules that govern the safekeeping of pension funds for?

Answer 20

So that they are not used to prop up an ailing company (Maxwell pension scandal),

and

to try to ensure, as far as possible, that the scheme funding is sufficient to meet the liabilities.

Question 21

Who does the ownership of the scheme assets lies with?

Answer 21

The trustees, who must safeguard the assets on behalf of the members.

Question 22

Why are statutory increases in pension entitlements used in workplace DB schemes?

Answer 22

To ensure they at least match inflation

Question 23

What are the advantages of a DB scheme?

4

Answer 23

• Member knows roughly what they will receive
• Member benefits from statutory revaluing to keep pace with inflation
• Helps retention of staff for an employer, particularly as such schemes are becoming rarer
• The member does not have any of the investment risk

Question 24

What are the disadvantages of a DB scheme?

4

Answer 24

• Scheme carries all the investment risk
• Scheme must appoint trustees, actuaries and auditors and formalise costing structure
• Scheme must contribute to compensation schemes, adding to costs
• If the employer goes bust, the scheme may enter the Pension Protection Fund and the promised pension might be reduced

Question 25

How have trustees of DB scheme been trying to reduce costs?

Answer 25

• closing the scheme to new members, and therefore just maintaining their liability to members who joined before a certain date
• closing the scheme to all members, which is a more drastic approach to the one above
• reducing the accrual rate, say from a 60th scheme to an 80th scheme
• increasing the normal retirement age, so the pension will be paid for a shorter period
• altering the definition of final salary – there has been a growing trend for career average schemes, which use the average of the revalued earnings for an individual over the whole of their period in the scheme, rather than just the final, probably highest, salary
• insisting on an increase in employee contributions
• reducing pension increases to the statutory minimum, if the scheme paid higher discretionary benefits in the past.

Question 26

What is the role of trustees in a DC scheme?

Answer 26

Because DC WPSs come under workplace scheme rules, trustees must still be appointed, but their role is less significant as far as the funding of the scheme goes.

Question 27

Where does the risk lie with DC schemes?

Answer 27

As long as contributions have been paid into the scheme, employers have no further liabilities to meet.

The risk associated with the ultimate scheme benefits is therefore transferred almost entirely to the member

Question 28

What are the advantages of a DC scheme?

5

Answer 28

• Employer knows exactly where their commitment ends
• Good fund performance could lead to higher benefits
• Helps retention of staff for an employer
• Lower costs for an employer to run
• Easy access to pension following pension freedoms

Question 29

What are the disadvantages of a DC scheme?

4

Answer 29

• Member carries all the risks, investment and annuity
• Poor fund performance could lead to lower benefits
• Unknown benefits – so hard to plan ahead
• Pensioner could run out of money if they access pension flexibly

Question 30

How are most DC schemes invested?

Answer 30

On a monthly basis, as a percentage of monthly salary

Question 31

Do members have to wait until annuity age?

Answer 31

No.

But can opt for income drawdown plus a 25% lump sum

Question 32

What are Hybrid Pension Schemes?

Answer 32

A hybrid pension scheme has characteristics of a defined benefit (DB) scheme and a defined contribution (DC) or money purchase scheme

Question 33

What is the major benefit of a Hybrid Pension Scheme?

Answer 33

The risk is shared between the employer and the employee.

Contrast this to a DB scheme where the risk lies with the employer and a DC scheme where the risk lies with the employee.

Question 34

What is a Combination scheme?

Answer 34

A type of hybrid pension:

Two types of benefits accumulate simultaneously – a DB portion and a DC portion controlled by the member.

Question 35

What is a Self-annuitising DC scheme?

Answer 35

A type of hybrid pension:

This begins and operates in the same manner as a DC scheme until the member retires. Upon retirement, the fund is used to purchase an income for the member, however, the annuity rates are not market rates but based on rates within the scheme’s own rules.

Question 36

What is a Cash balance scheme?

Answer 36

A type of hybrid pension:

The member receives a cash lump sum at retirement which is then converted into an annuity. While this is quite similar to a DC scheme, however, the lump sum is not based solely on the investment’s raw performance. Returns may be guaranteed or ‘smoothed’ depending on the rules of the scheme

Question 37

What is a Underpin scheme?

Answer 37

A type of hybrid pension:

Benefits at retirement are computed on a DC and DB basis and the member gets whichever is higher.