A Pensions Overview – by Dean Rogers

9 Dean NNWhat is a pension? A pension is deferred pay. Part of what you’d otherwise earn is put aside and usually invested for you to access when you retire. The government offer tax incentives to the employee and the employer to encourage this saving, as it will reduce the long term costs of looking after older people who’ve retired. The monies that are deferred, or put aside, are known as pension contributions.

Is it a good deal?
All pensions are usually a good form of savings. This is because of the tax breaks offered by government and because the employer also contributes. Not many forms of saving include a top-up from someone else. Although private sector schemes can go up and down in value depending upon markets this also applies to all savings plans and pensions also benefit from additional legal protections. There are also legal limits on how much firms can charge to run these investments.

Most pensions also offer some form of life insurance and salary protection for dependents which can be very useful (e.g. banks can expect this to support mortgage applications).

How do pensions work?
Most private pensions have a fixed amount that is paid in, known as a defined contribution. This will be made up of the employees contribution (how much you pay in) and the employers contribution (how much they pay in). This pot of money is then invested. The investments are meant to grow and increase the value of the pot, like most savings.

You should get regular (usually annual) statements about how much your pension is worth and different schemes offer different levels of input and control over how and what your money is invested in.

When you reach retirement age (usually sometime between 60 and 67) you can choose to access your pension pot. Until recently this nearly always meant converting the value of the pot at that point in time into something called an annuity – meaning that you used it to buy an annual income. Since the Coalition government loosened regulation around accessing pensions a far wider range of options are now available. Independent financial advice is strongly recommended for anyone approaching retirement, but particularly with a private sector pension.

What a “Defined Benefit”?
The main difference between a private sector pension and a public sector pension is that public sector schemes (lie the Civil Service Pension Scheme or the Local Government Pension Scheme) is that the public sector scheme give a guaranteed income in retirement – removing the need to buy a annuity and setting strict rules and limitations around flexibility when accessing the pension. The guaranteed income is known as a defined benefit.

Providing a defined benefit is expensive. The amount of deferred pay from employees to meet this guaranteed income tended to be relatively high, which contributed to the impression of public sector staff traditionally earning less than their private sector counterparts. However, it is even higher for employers and has generally become progressively more expensive as working patterns have become more flexible, women have remained in schemes and gained greater equality, and people have begun to survive longer past retirement.

Traditional pension schemes offered 1/80th of salary for each year of service up to a maximum of 40 years so employees would have a pension worth half their final salary. In local government this became 1/60th with higher contributions to recognise that people were more likely to work 30 years than 40. However, this kind of formula has looked increasingly inflexible and has been stretched at both ends by atypical final salaries – some having huge pay hikes near retirement and others looking to work less in the run-up to retirement. Therefore, new pensions schemes have been developed that still offer a guaranteed income but based on average earnings over your career not a final salary. These are even more expensive (especially for the employer of a stable workforce) with the local government scheme offering 1/49th for each year of earnings.

What are the key pension questions?
Union Representatives and employers considering choosing a pension scheme need to consider the key questions that potential members are likely to want to ask and assess the pensions being offered by balancing the key answers.

The key questions are likely to include: How much will it cost and can I afford to pay in? Can I pay in more if I want? This will apply for employees and employers. Too much pay being deferred may not make the work attractive or sustainable but too little being saved may make the scheme seem worthless. Increasingly, people are looking to get around this by offering flexible contributions that can go up and down depending upon personal circumstances – eg. Paying back bank loans after college or saving to buy a house then you may pay less into the pension; earning more as you get towards retirement and can afford to save a bit more then you pay in more.

How transferable is the pension?
This is a big question if people are expecting to move between employers and/or change jobs at different stages. A big disadvantage of the public sector scheme is that they are increasingly non-transferable – i.e. change jobs and you have to start building your pot again. You can end up with lots of small pots none of which are worth very much and miss out on accumulative interest from a bigger pooled investment.

The stakeholder model promoted by the last labour Government which introduced compulsory opting-in to pensions for all employees was designed around people being able to take their pension with them. This isn’t straight forward and employers will seek to entice some employees to stay by varying their contributions but generally transferability is something to find out about.

How do variations in pension impact on pay now?
If pensions are deferred pay then if some people have more expensive pensions will they earn less now? The answer is quite probably, although not necessarily. Private contractors will seek to save money (and make profits) from reducing their employer contributions. It does not automatically follow that they will look to vary employee contributions.

If employee contributions vary significantly then this can lead to problems between staff groups and perceived unfairness, especially as people’s understanding of pensions is limited. Unions (and sensible good employers) would want to minimise the risk of employees opting out of a good pension scheme because it looks like they’d be better off in the short term choosing a cheaper pension scheme, or opting out at all. This is acutely important in low paid roles where any deferred pay is difficult in austere times.

Non- contributory schemes (where employees are offered a pension without deferring any pay) are particularly dangerous in this regard. They can look like a great deal but could encourage staff to opt-out of an old-style public sector scheme with guaranteed benefits – costing the employees thousands in the long run whilst saving the employer many more thousands in the medium to longer term. Non-contributory schemes are also less likely to be easily transferable.

Dean Rogers

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