Chapter 1 – A Background To-Pension Planning (5 marks)

Question 1

What is a pension?

Answer 1

It is a way of saving for retirement. Pension plans are now called ‘Registered Pension Schemes’ (RPS).

The government needs to encourage us all to save towards our old age, to avoid reliance on the state for income and support in retirement. They do this by giving pensions generous tax advantage

Question 2

In March 2011, the European Court of Justice made a ruling that ‘to use gender as a factor in calculating annuity rates’ was discrimination.

Answer 2

This has not been allowed since 21st December 2012.

Now all annuity contracts must be set up on a unisex basis.

Question 3

The state pension is funded on a ‘pay-as-you-go basis’

What does this mean?

Answer 3

It means that working individuals pay, through their National Insurance Contributions, for the state pensions of individuals that have reached state pension age and are claiming their state pensions.

Because there are no invested funds built up; it is termed ‘pay-as-you-go’.

NOTE: If people live longer this is doubly bad as there is more demand for state pension yet there is less people working to pay for it

Question 4

What introduced the pension freedoms.

Answer 4

The Taxation of Pensions Act (TOPA) 2014 introduced the pension freedoms.

It also introduced additional pension beneficiary options: a ‘nominee’ and a ‘successor’ who could benefit, on death, from an individual’s pension.

Question 5

What are Employer-sponsored pension schemes also known as?

Answer 5

These are also known as company or occupational schemes.

Can be divided into two types, Defined Benefit (final salary) and Defined Contribution (money purchase).

Question 6

Part of a DB schemes calculation of the amount of benefits is using the employees final salary.

What is this made up of? For example, does this include taxable P11D benefits?

Answer 6

It is only basic salary

taxable benefits, bonuses, overtime are not taken into account

Question 7

PCLS is available from DB schemes, commonly on a 3/80th accrual basis. Within most schemes, taking a PCLS will reduce the pension income through the application of a commutation factor. Most private-sector schemes cannot afford to provide PCLS without a commensurate reduction in pension income.

Cash commutation factors are chosen by the scheme and often range from 10:1 through to 15:1. If a scheme has a commutation factor of 10:1 this simply means that for each £10 of PCLS taken, annual pension income will reduce by £1. Let’s go back to Maria and consider this in more detail.

When it comes to cash commutation factors, it is ‘the higher - the better’. With a factor of 12:1 Maria will lose £1 worth of income for each £12 of PCLS she takes. If the scheme factor was 10:1 she would lose £1 worth of income for each £10 of PCLS she takes.

Answer 7

LOOK AT 1.2 and read examples 1.3

Question 8

How to calculate a DB schemes accrual rate:

Answer 8

Step 1: Scheme pension (the benefits)/ years of service = annual accrual amount

Then

Step 2: Final salary / Annual accrual amount = accrual rate

Question 9

For understanding. The reason for the names of DC & DB schemes

Answer 9

DB scheme = Where the benefits an individual receives are guaranteed/defined

DC scheme = Where contributions, rather than benefits, are defined.

Question 10

Main high level differences between
DB & DC schemes

Answer 10

DB schemes =
Benefits are based on 3 factors which are years of service, final salary & accrual rate

DC schemes =
Benefits are based on amount contributed by employer/employee and investment performance (no scheme guarantees)

Question 11

How can employer DC schemes be set up?

Answer 11

Schemes can be set up as an occupational schemes or a collection of individual schemes, selected and contributed to by the employer.

An occupational defined contribution scheme is usually established under a trust (trust-based) with trustees safeguarding employee member rights.

Individual schemes are established under contract with a pension provider (contract-based).

The member usually has their own pension pot. So, these pension funds are known as ‘earmarked’ funds.

Question 12

Why are DC schemes known as ‘earmarked’ funds and DB schemes known as un-earmarked’ funds.

Answer 12

Because with DB schemes the employee does not have their own pension pot. The benefits she is building up based on the 3 factors, will be paid out from the scheme’s assets

With DC schemes, the member usually has their own pension pot that they have made contributions into.

Question 13

There are many different types of DC schemes. What are the main ones?

Answer 13

Retirement Annuity Contract (RAC)
Personal Pension Plan (PPP)
Stakeholder Pension (SHD)
Self-invested Personal Pension (SIPP)

Question 14

If someone takes the PCLS option of their DB scheme, their pension benefits will reduce

How is this calculated?

Answer 14

In these question you will have a commutation rate/factor. e.g 15:1 or 12:1. The higher the better.

If it says 15:1 this just means, for every £15 of PCLS u take, your pension benefit will reduce by £1

For example,

£120,000 taken. DB scheme has a commutation factor of 15:1.

£120,000/15 = £8000
Pension benefits therefore reduce by £8000 from whatever it is.

Question 15

What are annuity rates based on?

Answer 15

Long dated GILTs.

Question 16

State pensions were introduced in 1908 via the Old Age Pensions Act. The modern system came via the National Insurance Act 1946*, and introduced contributory state pensions for UK individuals, paid at 65 for men / 60 for women.

A variety of statutes then introduced ‘earnings-related’ state pensions which include:

Graduated Pension Scheme (GPS):

State Earnings-Related Pension Scheme (SERPS)

State Second Pension (S2P)

Question 17

HISTORICALLY, DB schemes and some DC schemes could ‘contract out’ (so ‘opt-out’) of part of the state pension. It was never possible to contract out of the basic state pension, only the earnings-related elements.Graduated Pension Scheme (GPS) AND State Earnings-Related Pension Scheme (SERPS) AND State Second Pension (S2P)

Question 18

What is the Employer Arranged Advice Allowance?

What is the Pensions Advice Allowance?

Answer 18

These are 2 aims introduced by the government so make consumers better informed in relation to pension choices. It allows them to pay for financial advice in two main ways

Employer Arranged Advice Allowance =

Allows employers to pay for their employees to receive financial information and advice without this being classed and taxable as a benefit in kind (BIK), if the annual cost is not greater than £500. (If the payment exceeds £500 per employee, any excess will be an employee BIK)

Pensions Advice Allowance =

Allows members of a defined contribution (DC) scheme to take up to £500 tax-free from DC pension plans. This allowance will be available to redeem against advice costs, to try and ensure individuals are not priced out of accessing suitable retirement financial advice. This allowance is useable up to 3 times, allowing tax-free funds of up to £1,500 to be used towards the cost of financial advice. These funds are available at any age and must be paid direct to the financial adviser

Question 19

True or false. You can no longer contract out of the earnings related state pension?

Answer 19

True, contracting out has been abolished

Question 20

Auto-enrolment rules mean that all employers must enrol eligible employees or ‘eligible jobholders’ into a qualifying pension scheme.

Question 21

Peter and Paul are twins and have just reached state pension age (SPA). Peter’s first weekly pension payment is £203 whereas Paul’s is only £140. What explanation could there be, for this difference in State Pension payments?

Peter was a member of contracted out scheme for part of his working life.

Paul was a member of contracted out scheme for part of his working life.

Paul is married whereas Peter is single.

Peter is married whereas Paul is single.

Answer 21

Paul was a member of contracted out scheme for part of his working life.

If Paul contracted out for part of his working life, his State Pension payments will be reduced.

NOTE: People contracted out as it meant they could divert the contributions of the Earnings Related pensions to their own private schemes or employer pensions. They may have done this because they felt they could get better returns than a higher state pension, ib their own schemes perhaps because of better investment performance

Question 22

Changes in life expectancy have meant that the Debt Management Office (DMO) have recently…

issued more index-linked gilts.

issued more long-dated gilts.

bought back more index-linked gilts.

bought back more long-dated gilts.

Answer 22

issued more long-dated gilts.

Longer life expectance leads to greater state pension funding, which increases the PSNCR. The government funds this by raising monies through gilt issues, and long term NS&I products.

Question 23

Bob has been a member of his employer pension scheme for the last 16 years. He has an annual salary of £15,000. What is his scheme accrual rate if he is entitled to an annual DB scheme pension of £5,333?

1/45th

1/60th

1/80th

1/100th

Answer 23

£5,333 ÷ 16 years = £333.31.

£15,000 ÷ £333.31 = 45. Bob has a 1/45th DB scheme accrual rate.

You can check this by doing:
16/45 x 15000 = 5333

Question 24

Which of the following types of Registered Pension Scheme result in the employer bearing the bulk of the risk in terms of pension guarantees and investment growth?

Defined benefit.

Defined contribution.

Money purchase.

Added years.

Answer 24

Defined benefit.

With a DB scheme, the employer bears the most risk, as they guarantee benefits to the individual.

Question 25

John has an employer-sponsored scheme that he is auto-enrolled into. John is most likely to be a…

non-eligible jobholder.

entitled worker.

eligible jobholder.

eligible worker.

Answer 25

eligible jobholder.

Auto-enrolment is associated with an eligible jobholder therefore John must fall into this category.