Your IndustryDec 4 2014

Different types of workplace pensions

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The key difference between defined benefit, defined contribution and, in future, defined ambition pensions are the levels of risk and benefit each type of pension will offer.

Defined benefit/final salary

Defined benefit schemes are ones where there is a promise of a benefit based on three main factors: length of service, salary and an accrual rate. Essentially, an employee has a contract which guarantees they will receive a set amount in annual income for each year they are employed.

The risk on the provision of the pension rests primarily with the sponsoring employer who must ensure the funds are in place to meet the promises made.

David Brooks, technical consultant at Broadstone, says defined benefit is basically a blank cheque and subject to many risks - inflation, interest rate and longevity - that can have a massive impact on the size of the benefit promises.

He says defined benefit schemes are a highly regulated area, which can be expensive and time consuming. But he says defined benefit schemes also offer paternalistic employers a great way to demonstrate you care.

Mr Brooks says: “(Defined benefit) is fantastic for members, who have a clear and stable view of what their retirement income will look like.”

Defined contribution/money purchase

Defined contribution is where a pot of money accumulates based on contributions into it from the employer and often the member, which will (hopefully) grow with investment returns but will also be subject to tax charges.

The resulting pension/income the member receives is based on the size of the fund in which they they have bought units, and the at-retirement solution they subsequently use to access their fund.

With defined contribution pensions, Jamie Jenkins, head of workplace policy at Standard Life, says the benefits the employee receives in retirement are dependent on several factors including how much is contributed into the plan, how long the money is invested for and how the investments perform.

From next April and from age 55, Mr Jenkins says the money can be accessed via drawdown, or taken out to purchase an annuity, to provide an income. New style lump sums are also an option from next year to provide ad hoc access when needed by the employee.

With the Budget 2014 flexibilities, Broadstone’s Mr Brooks says these schemes do look very attractive at the moment for savers, and they are generally cheap for employers to offer. But Mr Brooks says defined contribution still represents a massive risk on the individual and huge unknowns in regards to what the end retirement income figure will be.

Standard Life’s Mr Jenkins says getting employees engaged with their pension in a defined contribution arrangement is perhaps the biggest challenge of these schemes, which wasn’t as important in a defined benefit plan.

Mr Jenkins says auto-enrolment has been designed to overcome this by opting people into a pension, but he adds engagement is still key as auto-enrolment minimum contributions will typically not be sufficient to provide the desired standard of living in retirement.

He says: “It is also important for the employer that members are engaged for the scheme to provide a good return on their investment - otherwise it is just a cost without being valued by employees.”

Defined ambition

The government is also proposing a new type of pension, known as defined ambition, which would act as a halfway house between a defined benefit and defined contribution with the aim of reinvigorating workplace pensions.

The main way of achieving this, according to Standard Life’s Mr Jenkins, is by sharing the investment risk between the employer and employee.

There are several ways of doing this, including:

1. Implementing a minimum pot size at the employee’s chosen retirement date. The amount of income this would give the employee would still be an unknown, but a minimum pot size is “guaranteed” to remove some of the investment risk.

2. The employer pays a guaranteed pension income to the employee, but has the flexibility to change the date at which the income would start to allow for factors such as changes to life expectancy. This could mean employees need to continue working for longer than they had planned for.

3. The employer sets employee expectations on a broad estimate of what the likely pension benefits would be at retirement. As the employee approaches retirement, these estimate ranges narrow to give more certainty on what the employee can expect to receive.

The government is also exploring the opportunities offered by Dutch-style collective defined contribution schemes, which use member income to buy deferred annuities from a set age and then pooling remaining monies into risk assets.

Standard Life’s Mr Jenkins says DA pensions give employees more incentive to save by offering more certainty about what they will receive in retirement, without putting the same burden on the employer as a defined benefit scheme.

However, Mr Jenkins warns defined ambition is more opaque and complex than a defined contribution plan and the success of such a scheme relies heavily on employees’ trust in those making the decisions.

In today’s world, Mr Jenkins says consumers want transparency – a major reason why with-profits is no longer popular, he adds.

While members of defined ambition schemes will have more certainty, John Reeve, senior consultant at Premier Pensions Management, says it should not be forgotten that they still have the possibility of a shortfall in their income.

Mr Reeve says these arrangements will also suffer from being very new to the market and so are untested and largely unknown to employers and individuals.

He says: “In a market which is complex enough already, further confusion in this regard can lead to a lack of trust and uncertainty.”