Employer Pension Schemes FAQs Flashcards
- What is cash commutation in a defined benefit (DB) pension scheme?
Cash commutation allows a member of a DB pension scheme to exchange a portion of their future
annual pension income for a lump sum payment. The exchange rate is determined by a commutation
factor set by the scheme. For instance, a factor of 12 means that for every £1 of annual pension
given up, the member receives £12 as a lump sum.
The commutation factor varies by scheme and can be influenced by the member’s age, gender, and
life expectancy. Higher life expectancy generally results in a higher commutation factor, while a
higher discount rate (interest rate) leads to a lower factor
- How do changing employee needs influence the design of pension schemes?
Changing employee needs have led to a demand for greater flexibility and choice in pension
schemes. Employees today desire more control over their retirement savings and the ability to tailor
their benefits to their individual circumstances. This has driven the development of schemes with
features like flexible retirement ages, options to take cash lump sums, and the ability to transfer
pension funds between different schemes
- Why are defined benefit (DB) schemes often popular with employees?
DB schemes offer employees a predictable and guaranteed income in retirement, calculated as a
percentage of their salary and length of service. This predictability enables employees to plan for
their future with greater confidence. Additionally, DB schemes tend to be particularly beneficial for
employees nearing retirement, as the cost of accruing benefits increases with age. This makes them
a valuable perk for older workers
- What are the key advantages of defined contribution (DC) schemes for employers?
DC schemes provide employers with better cost control compared to DB schemes. Contributions are
typically fixed, minimizing financial uncertainties for the employer. Additionally, DC schemes
generally have less stringent regulatory requirements, further reducing administrative burdens.
The flexibility offered by DC schemes can also make them attractive to employees, potentially
enhancing recruitment and retention efforts. Furthermore, the portability of DC schemes makes
them suitable for workforces with higher employee turnover.
- What are the main risks for employees in a defined contribution (DC) scheme?
The primary risk for employees in a DC scheme is the uncertainty surrounding their final retirement
income. The eventual benefit depends entirely on the accumulated value of contributions, which is
subject to investment performance, annuity rates at retirement, and the overall market conditions.
This uncertainty makes it difficult for employees to plan their retirement effectively.
Additionally, employees in DC schemes bear the full burden of investment risk. Poor investment
returns can significantly diminish their retirement savings.
- What risks do sponsors face with defined benefit (DB) schemes?
Sponsors of DB schemes face the risk of unanticipated funding requirements and the possibility of
costs exceeding initial projections. This can arise if the actuarial assumptions used to calculate
contributions prove to be too optimistic. For instance, factors like lower-than-expected investment
returns, higher employee longevity, or unexpected salary increases can all lead to higher funding
demands.
- How does a final salary DB scheme differ from an average earnings DB scheme?
Final salary schemes base pension benefits on an employee’s final salary at retirement, multiplied by
their years of service and an accrual rate.
Average earnings schemes calculate benefits based on the average earnings throughout the
employee’s career, potentially adjusted for inflation.
In certain situations, both schemes might offer similar benefits at retirement. This occurs if:
* Accrual rates are identical
* Earnings revaluation in the average earnings scheme aligns with the individual’s salary
growth
* Final Pensionable Earnings in the final salary scheme only consider the last year’s earnings
* Both schemes exclude bonuses and overtime from pensionable earnings, particularly
beneficial for employees with stable income patterns.
- What are the key differences between defined benefit (DB) and defined contribution (DC)
schemes from an employee’s perspective?
From an employee’s perspective, the key differences between Defined Benefit (DB) and Defined
Contribution (DC) pension schemes are primarily centered around risk, predictability, and
control. Here’s a breakdown of these key differences:
1. Benefit Structure
- Defined Benefit (DB) Scheme:
- The pension benefit is guaranteed and is typically based on factors such as your salary at
retirement (or an average over your career) and your years of service.
- Employees know in advance what their pension will be, often expressed as a percentage of final
salary or career average salary.
- Defined Contribution (DC) Scheme:
- The pension you receive depends on the contributions made (both by you and your
employer) and how well those contributions have performed in the investment markets.
- There’s no guaranteed amount at retirement—your pension is based on the total value of
the pension pot you’ve accumulated.
2. Risk
- DB Scheme:
- The employer (or the pension scheme) bears the investment risk and longevity risk (i.e., the risk
of the pension fund running out if you live a long time).
- From an employee’s perspective, this scheme is relatively low-risk, since the pension is
predetermined.
- DC Scheme:
- The employee bears all the investment risk and longevity risk.
- Your pension depends on how the underlying investments perform, meaning it could fluctuate
with market conditions. This makes it a higher risk option for employees.
3. Predictability and Security
- DB Scheme:
- Offers high predictability because you know how much income you will receive in retirement.
This can make financial planning easier.
- The scheme often provides inflation protection through index-linking, meaning pension
payments rise over time to keep pace with inflation.
- DC Scheme:
- Retirement income is uncertain because it depends on the fund’s performance and the decisions
made on how to draw down the pension pot (e.g., annuity, drawdown, lump sums).
- There may be no automatic inflation protection, although employees can buy inflation-protected
annuities at retirement (which can reduce the initial pension value).
4. Control and Flexibility
- DB Scheme:
- Limited flexibility for employees during the accumulation phase, as the employer determines
how the scheme is managed.
- Once you retire, your pension is generally fixed, and options for how you receive it (such as lump
sums or regular payments) are often predetermined.
- DC Scheme:
- Employees typically have more control over their investment choices during their working years
(depending on the scheme’s options), and they have more flexibility in how they access their pension
pot in retirement (e.g., through drawdown or buying an annuity).
- Post-retirement, DC schemes allow for flexible withdrawals or a full lump sum, but this requires
careful planning to ensure the pension pot lasts through retirement.
5. Contributions
- DB Scheme:
- Contributions from employees are typically fixed, and the employer is responsible for ensuring
that there is enough money in the scheme to pay future pensions.
- Employees have less involvement in managing the scheme’s funding or performance.
- DC Scheme:
- Contributions from both the employee and employer are usually set as a percentage of salary.
The total accumulated is invested, and the performance of those investments determines the size of
the pension pot.
- Employees may be able to adjust their contribution rates and select how their pension pot is
invested.
6. Portability
- DB Scheme:
- These schemes are less portable. If an employee leaves the company, they may receive a
deferred pension, but the benefits are often locked in and can only be accessed at the scheme’s
retirement age.
- DC Scheme:
- DC pensions are typically more portable. Employees can transfer their pension pot to another
provider or scheme if they change jobs, offering more flexibility for those who move employers
frequently.
7. Longevity and Market Impact
- DB Scheme:
- The income is guaranteed for life, regardless of market conditions or how long you live, making it
more secure in this respect.
- DC Scheme:
- The size of the pension pot can be significantly affected by market downturns, and if an
employee lives longer than expected, they might risk running out of money unless they manage
withdrawals carefully or buy a lifetime annuity.
8. Employer Commitment
- DB Scheme:
- Employees rely on the employer’s financial health to some extent. If the employer (or scheme)
struggles to meet pension promises, there can be concerns about funding shortfalls (though there
may be protections like pension insurance or government backstops).
- DC Scheme:
- Once contributions are made, there is no further financial commitment from the employer. The
pension pot is fully owned by the employee, making the employer’s future financial health less of a
concern.
Summary
- DB schemes offer security, predictability, and employer responsibility but are rigid and less common
due to their cost to employers.
- DC schemes offer flexibility, more control, and portability, but they carry higher risks and
uncertainty for the employee regarding the final pension amount.
From an employee’s perspective, a DB scheme provides more certainty but less flexibility, whereas a
DC scheme offers more control but greater risk and responsibility in managing one’s retirement
income
