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Tuesday, 19 February, 2002, 14:17 GMT
Company pensions: A basic guide
What most of us with company schemes are less clear on is how they are actually working for us. What risk is there and who bears it, for example. BBC News Online has this basic guide.
What is a company pension?
A company pension is a pension scheme set up and administered by a company for its employees. It may be contributory - with employees making pre-tax payments direct from their salaries - or non-contributory, in which case the company makes the payments on its employees' behalf.
In contributory schemes, companies will commonly match employee contributions. This is why financial advisers usually recommend workers join company schemes as soon as they can.
Pension holders will also be able to make pre-tax additional voluntary contributions (AVCs) if they wish. This involves paying into a separate fund that will provide additional income for retirement.
Companies commonly offer a choice of several investment products, usually varying in the amount of risk involved.
Are all company pension schemes similar?
Far from it. Pensions have been back in the headlines recently because several large companies have been ditching one type of scheme - known as final salary - in favour of another, known as money purchase.
These moves have been widely interpreted as being against the interest of most employees concerned.
In some cases, the old schemes are merely being closed to new employees. In others, the schemes are being closed for existing members, with their contributions being either frozen or transferred into another type of scheme.
What's the difference between final salary and money purchase pensions?
Final salary - or defined benefit - schemes offer pensioners a proportion of their salary at retirement. The amount is commonly calculated as one sixtieth of salary multiplied by years of service.
In other words, someone who has stayed with the same employer for 40 years can expect a pension worth two-thirds of their final salary.
Any risk involved lies with the employer because it is promising to pay out a proportion of your salary irrespective of the investment returns your pension fund achieved.
With money purchase - or defined contribution - schemes, the eventual pension is determined by how much money is paid in, how well the investments perform and what rate is obtained for the annuity, an investment product providing an annual income that the pension holder is legally obliged to buy.
The risk of poor investment performance - or untimely decline in annuity rate - lies with the individual pension holder.
This means that if stock or bond markets fall into a prolonged downturn as your retirement approaches, you risk being left with a much smaller pension pot than might otherwise have been the case.
Why are companies ditching final salary schemes?
There are a number of reasons. The main one seems to be that it's good for companies to transfer the risk of poor investment performance to the individual pension holders.
Many companies took advantage of strong stock market performance in the 1990s to take contribution "holidays" from their final salary schemes.
This saved them money but, with stock market returns now looking much less rosy, some companies are now left with what look like hefty obligations to pension holders.
Instead of using the good times to pay for the inevitable bad times, some companies appear to have banked a quick cash benefit and then decided to bail out when returns fell.
Other factors cited include: more red tape, stemming from a new accounting rule: increased life expectancy, resulting in bigger payout obligations and a government decision to tax dividends on pension funds.
Some companies are also using the opportunity of a switch to money purchase schemes to reduce the amount of money they contribute into employees' pensions.
So final salary schemes are much the best option?
Not necessarily. Assuming you stay with the same employer for a long time (and the employer stands by the scheme), they certainly should be.
However, money purchase schemes can be more flexible and might be more appropriate for workers who regularly move employers.
As long as your pension fund manager switches most of your funds out of riskier products as you approach retirement, you should be reasonably protected against a sudden drop in the stock market.
Many financial advisers also recommend building up a portfolio of savings for retirement as a way of reducing risk.
This might include ISAs, buy-to-let property or free-standing AVCs, which are not linked to a company pension plan.
Advisers also say it is best to avoid buying all your products from the same supplier.
Despite some beefing up of regulation recently, scandals have not been unknown in the pensions and investments industry, so it is best not to put all your eggs in one basket.
The best advice is to check with an independent financial adviser.
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