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Last Updated: Wednesday, 16 July 2003, 07:38 GMT 08:38 UK
How do hybrid pensions work?
By Richard Shackleton
European Partner at Mercer Human Resource Consulting

Richard Shackleton
Richard Shackleton of Mercer

Some of the UK's biggest companies have begun introducing "hybrid" pension schemes. The plans are a halfway house between final salary schemes, and money purchase plans. A pensions consultant explains how they work.

Over the past year, there have been many stories of companies closing their final salary schemes in favour of money purchase arrangements.

Final salary schemes offer the promise of a pension based on length of service and final pay.

Money purchase plans, on the other hand, provide an individual retirement fund into which you and your employer contribute.

The ultimate pension under a money purchase scheme depends on the level of investment returns earned on your fund and the cost of buying a pension at your retirement.

Why are companies doing this? Mainly because it transfers the risks from them to you and your fellow employees.

This does not necessarily mean money purchase schemes are worse - much depends on how much you and your employer contribute.

Sharing risks

More recently, there are signs that companies are seeking to share these risks more evenly with their employees by providing alternative final salary schemes with lower guarantees.

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The schemes might promise pensions based on average career earnings rather than final pay, or change the amount of pension you can expect for each year of service you complete.

Alternatives that are now gaining attention are hybrid schemes.

Such schemes can take various forms, but all have one thing in common - they combine money purchase and final salary schemes in some way.

The advantages of hybrid schemes can best be illustrated by looking at two designs.

Perhaps the most common hybrid is the "nursery scheme". Here, you are provided with money purchase benefits until you reach a given age, say age 40, at which point you become eligible to earn final salary benefits.

If you are young and stay with the company for only a short period, you benefit from the full value of both your own and your employer's contributions.

This may compare favourably to a traditional final salary scheme as the value of benefits for young mobile workers can often be low.

At the same time, older members who retire directly from service with the company will be able to predict their pension with some degree of certainty, and therefore plan for their retirement.

Halfway house

For the company, the age at which members are entitled to switch to final salary benefits is crucial - the lower the age the higher the degree of risk the organisation is willing to take.

The company is able to continue to provide some protection of your pension whilst reducing its overall risks
An alternative arrangement would cap the salary used for calculating your final salary pension (at say 25,000), with additional money purchase benefits being provided if you are earning a higher amount.

Lower paid employees are therefore protected and continue to receive final salary benefits in full.

Meanwhile, higher earners will receive a fixed amount of "protected" pension for each year of service, topped up by the proceeds from their money purchase account.

The risk retained by the employer depends on the level of the cap - and the extent to which it is increased each year - relative to average salary levels in the scheme.

The higher the cap, the higher the degree of risk the company retains. The appropriate level of cap will vary depending on the sector the organisation is operating in.

In summary, hybrid schemes have something to offer everyone.

You can be protected by receiving a core level of defined benefit and can plan your retirement with the knowledge of this safety net.

You also have the opportunity to invest your individual money purchase fund to try and maximise your top-up pension.

From the company's point of view, it is able to continue to provide some protection of your pension whilst reducing its overall risks.

The views expressed are solely those of Richard Shackleton's and not the BBC's. Any guidance is for general information only and does not constitute financial or legal advice.

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