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Pension  Scheme Types


A Defined Benefit Pension Scheme

(or final salary pension scheme) provides benefits that are guaranteed to be a proportion of final salary at retirement. The major advantage of this type of scheme for the employee is the guaranteed nature of the benefits.


The scheme sets a normal retirement age at which members will usually retire. The benefits that a defined benefit scheme will provide will primarily be based on the following three factors:


the accrual rate:

the rules of the scheme will determine the rate at which benefits accrue, e.g. 1/60th of pensionable salary for each year and complete month of pensionable service.


pensionable service:

this is usually the employee’s period of membership in the scheme;


final pensionable salary:

this is the definition of salary that is used to calculate the member’s benefits at date of leaving or retirement.


As well as a pension, a defined benefit scheme will also provide a tax-free cash lump sum, known as the pension commencement lump sum (PCLS) at retirement. The rules of the scheme will dictate how much tax-free cash can be accrued for each year of service.



Money Purchase (or Defined Contribution) Pension Schemes

The contributions paid to a money purchase pension (or defined contribution) scheme are used to establish a pension fund. The eventual size of the fund is determined by the amount of contributions paid, the charges deducted by the pension provider and the investment returns achieved over the term to retirement (or death).


The benefits provided will depend on the size of the fund at retirement or death. The member may have the option of purchasing a scheme pension or of flexibly accessing their pension savings, either via a drawdown pension option or by taking some, or all, of the fund as an uncrystallised funds pension lump sum (UFPLS). The rules of the scheme will determine which options are offered.


A scheme does not have to offer all (or even any) of the flexible access options and some schemes may only offer the option of a lifetime annuity.


A money purchase scheme may be an occupational scheme provided by an employer for the benefit of the employees, or it may be an individual arrangement funded by the member (and sometimes by the employer as well).


The main types of pension are:

Personal Pension Plans (PPPs)

are individual money purchase arrangements, whereby the contributions paid build up in a fund, which is usually either with-profits or unit-linked. The fund can be accessed by the member from the normal minimum pension age of 55 (or earlier if the member is in ill-health or has a protected pension age).



A Stakeholder Pension (SHP)

is, in effect, a low cost personal pension. The only difference is that a stakeholder pension scheme is subject to certain minimum standards, concerning, e.g. charges, investment choice, minimum contributions etc.



Group Personal and Stakeholder Pensions

An employer may wish to set up a group stakeholder or personal pension plan, rather than an

occupational arrangement. Although a group stakeholder or group personal pension plan may look similar to an occupational pension scheme, it is actually a series of individual money purchase arrangements. Within the group plan each employee has their own arrangement, which belongs to them.



Self-Invested Personal Pensions (SIPPs)

A SIPP, which is an individual money purchase arrangement, is simply a personal pension scheme that has a much wider investment choice than a traditional one offered by a life office. For example, a SIPP can invest directly in company shares or can be used to purchase a commercial property. It can also borrow funds from a third party, such as a Bank.



Retirement Annuity Contracts (RACs)

It has not been possible to take out a new retirement annuity contract since 1 July 1988, although an individual with an existing RAC can continue to contribute to it. Because RACs were previously approved under s.226 of the Income and Corporation Taxes Act 1970, they are sometimes known as section 226s.



Occupational Money Purchase Schemes

An occupational money purchase scheme works on the same principle as a personal or stakeholder pension, with the difference that an employer sets it up on behalf of its employees.


The employer sets the scheme’s eligibility requirements and the rules of the scheme specify the level of contributions to be paid and other factors, such as the age to which the company will pay contributions, the options available when benefits are taken etc.


As well as large occupational money purchase schemes, there are a few variations designed for senior employers and directors and for transfer purposes.



Executive Pension Plans (EPPs)

were generally set up as ‘one-man’ schemes aimed at directors and senior employees, usually so that higher benefits could be provided for such employees separate from the main occupational scheme. EPP’s were set up prior to April 2006.



Small Self-Administered Schemes (SSASs)

are aimed at company directors and senior employees. A SSAS is defined as a self-administered scheme that has less than twelve members, all of whom must be trustees. They offer a separate pension option for directors and senior employees due to their special additional features and, in particular, for the investment options they provide.



Section 32 Policies

Were, designed to accept benefits transferred in from an occupational pension scheme set up prior to 6 April 2006.



Targeted Money Purchase Schemes

Targeted money purchase schemes are ‘hybrid’ schemes with features common to both defined benefit schemes and money purchase schemes. Under a targeted money purchase scheme a target level of benefit is determined, usually in line with the benefits provided by a defined benefit scheme, i.e. a pension that is a proportion of final salary at or close to retirement. An actuary calculates the contribution rate required to provide the targeted benefit.


The contribution rate for each member is regularly reviewed to keep the funding of the scheme on course to provide the intended level of benefit, often with the advice of an actuary. At retirement, the value of the member’s money purchase assets may be topped up, if necessary, to ensure that the target level of benefits is provided. This topping up may come from either an unallocated account held within the scheme for this purpose; or additional special contributions from the employer.


Hybrid Schemes

are defined benefit schemes that also has some of the characteristics of a money purchase scheme.


Defined Benefit Scheme with a Money Purchase Underpin

This provides pension benefits at retirement or earlier death that are the higher of the benefits calculated on the normal defined benefit basis and the benefits arising from a notional money purchase plan. It offers a transfer value for early leavers that will be the higher of the fund built up in a notional money purchase arrangement and the transfer value based on the defined benefits provided by the scheme.


The money purchase underpin could be beneficial for employees who leave the scheme before normal pension age because:


  • the preserved money purchase account, which should still notionally grow in line with the underlying scheme investments, may well produce a better pension at retirement than a defined benefit preserved pension;


  • if a transfer value is taken, it may well be the larger of the notional money purchase account or the cash equivalent of the deferred defined benefit.



Money Purchase Scheme with a Defined Benefit Underpin

This type of scheme offers the scheme member a money purchase benefit, with a minimum level of pension related to their final salary and so is in many respects the mirror image of the money purchase underpin scheme. The scheme operates by having the usual money purchase account for each member plus a separate unallocated account to meet the cost of the guarantee where there is insufficient in the member’s account.


The most common type is a Contracted-Out Money Purchase Scheme with a GMP underpin.



Career Average Pension Schemes

Career average schemes are those where the formula used to determine benefits is based on the average earnings over a member’s career and not on their earnings at or near a set age. This tends to reduce the benefits provided to the member and thus the cost to the employer of operating such a scheme.


Anyone whose pay significantly increases as retirement approaches is better off in a traditional defined benefit scheme, rather than a career average scheme. However, it may work out better for a member whose salary reduces as retirement approaches (perhaps because of a move to a less senior position in later years).


The earnings may be revalued in line with price inflation or, more generously, some assessment of earnings inflation. However, an individual’s actual career progression, which may lead to significantly higher earnings in the later years of their working life, is effectively ignored. This is because each year is considered in isolation, rather than the total pension accrual being based on the salary at or close to retirement.


Some employers replace their defined benefit schemes with career average arrangements as a halfway house between defined benefit and money purchase. They sometimes accompany the change with a small increase in accrual rate, e.g. 1/60th to 1/56th.


It is important to remember that such a change is only in respect of future accrual.


Benefits in a career average scheme are calculated based on pension accrual on a year by year basis as follows:


each member accrues a proportion of their pensionable salary for each year of pensionable service, e.g. 1/56th per year; for active members of the scheme the amount accrued in each year will be based on the member’s salary for the year in question; and each year’s accrual will then be revalued to retirement in line with the scheme rules; this could be in line with inflation (e.g. with increases in the CPI) or by a fixed amount each year.