Understanding workplace pensions
Workplace pensions are an important part of your pay package as they are deferred pay. However they are also the part that is often the least understood by members.
Studies have shown that a lack of understanding contributes to poor decision-making when it comes to pensions, so here are some pension basics.
There are two main types of workplace pensions:
- Defined benefit (DB) – where the amount you’re paid is based on how many years you’ve worked for your employer, the salary you’ve earned and a pre-agreed accrual rate (this is a fraction of your salary, historically a 1/60 or 1/80, that is multiplied by the number of years you worked to determine your pension). This type of pension pays out a secure income for life, which increases annually in line with inflation.
- Defined contribution (DC) – where your monthly pension contributions buy units in a fund, which fluctuates daily, so the final amount is not guaranteed. The accumulation of these units is commonly referred to as your 'pension pot'. At retirement age, members traditionally exchange this for an income for life by buying an annuity. These are also known as Money Purchase Pensions.
There are two common types of defined benefit pensions:
- Final salary which uses the accrual rate and your final salary to determine your retirement pension income.
- Career Average Revaluated Earnings (CARE) which uses the accrual rate against your salary in each tax year you work to determine the amount you will be paid in retirement. The pension accrued in each tax year is revaluated annually in line with inflation.
For more detailed explanations of pension types, visit the Pensions Advisory Service website.
The UK pensions landscape has changed significantly over the last two decades, with declining numbers of defined benefit pensions open to future accrual and increasing provision of defined contribution pensions.
In 2016-17, there were 28,000 open defined contribution schemes in the private sector against only 820 defined benefit schemes.
Defined benefit schemes are commonly referred to as ‘Gold Plated’ pensions. This is because they provide a guaranteed, index linked income in retirement.
That guarantee means that the risk with this type of pensions lies with the sponsoring employer. Should the employer and employee contributions invested not meet the expected returns, the employer has to make up the shortfall.
Not only that, if the benefits paid out by this type of pension are higher than expected (due to increasing life expectancy for example), the extra funding also has to come from the employer.
As a result, many defined benefit schemes are in deficit and have recovery plans in place for sponsoring employers to make up the shortfall in the scheme.
If an employer becomes insolvent and has a shortfall in the funding of the pension scheme, the Pension Protection Fund provides a safety net.
While the risk of investment performance and life expectancy falls on employers in defined benefit schemes, it falls on individuals in defined contribution schemes. The level of the employer and employee contributions to this type of pension is extremely important.
Contributions – how much?
The only guaranteed income most young people in the private sector will have in retirement is the State Pension. The full weekly rate for the New State Pension is £164.35 (2018) and is only designed to keep pensioners above the poverty line.
Pensions professionals advise members of defined contribution schemes to save between 15% and 20% of their salaries into pensions to achieve a comfortable income in retirement.
The Money Advice Service’s pensions calculator is a good resource to estimate an appropriate amount you should save. (Please note there are other calculators that are available).
This sounds like a large amount, but pension tax relief and contributions from your employer mean it can be achieved.
Standard rate taxpayers will receive 20p of pensions tax relief paid into their pension for every 80p they contribute. Employers will also make contributions to your pension if you are enrolled in a workplace pension scheme.
Typically employers’ contributions increase the more you pay, up to a maximum limit. We recommend that members review the structure of employee and employer contributions to see if increasing their contribution could increase the amount their employer pays.
Prospect negotiators work hard to ensure that members enjoy an above average employer contribution.