Company Pension Schemes - Part I

Picture the scene. Forty years on the shop floor at Harding & Sedgewick ends with a handshake, a carriage clock and a generous pension to reflect the hard work and faithful service of a lifetime. Your final grovelling words to the boss are along the lines of: "It has been such an honour to work my fingers to the bone fourteen hours a day for a pittance of a weekly wage and a five shilling bonus every other Christmas. The outstanding growth in your personal wealth over that time and the way in which I was allowed to shine your shoes on my birthday have been a source of great pride to me. Truly a privilege, sir. Thank 'ee."

Yes, those were the days, the days of Mrs Miniver and Morris Eights, of the Movietone News and good old British honesty and pluck and people jolly well knowing their place. Those days, though, are largely gone. While occupational, aka company, pensions can provide a sound retirement income and should generally be opted for rather than against, the picture is not quite so clear as it was back then, when the sun always shone in June and we knew with such certainty who the baddies were.

The best occupational pensions are generally to be found in the public sector. If you are in the police force, for example, your pension will be generous indeed and will be paid for out of the organization's budget, not a separate investment fund. Elsewhere, though, and especially in the private sector, pensions are paid out of an investment fund into which both employee and employer contribute. This fund will be invested in a variety of things, predominantly shares.

There are two basic types of occupational pension scheme: defined benefit (sometimes known as final salary) and defined contribution (sometimes known as money purchase).

Defined Benefit

Defined benefit company pensions pay you benefits based on your final salary (or an average of your salary for the last few years of your employment). Typically, the benefits will involve a lump sum and an income for life. There may well be a number of useful frills, such as life insurance and a pension for your spouse if they live longer than you.

The lump sum and income are generally expressed as a fraction of your final salary per year of service. This can seem a little complicated at first but if you take it step by step, it's not too bad. Imagine that your pension says you'll get a retirement income of 1/60 of your final salary per year of service. Alternatively, you get the option to take a tax-free lump sum of 3/80 of your final salary per year of service and a reduced annual income of 1/80 of your final salary per year of service.

Let's also assume you have 20 years of service and you earn £30,000 in the year you retire.

If you go for the first option, you stand to receive £10,000 per year (20/60 of your final salary). By law, the maximum income you can receive is 2/3 of your salary.

If you opt for the lump sum, you will receive a one-off amount of £22,500 (60/80 of your final salary) and a reduced income of £7,500 per year (20/80 of your final salary). In this example, it would make little sense to take the cash however. A lump sum of £22,500 would only provide an annual inflation-linked income of around £900, much less than the £2,500 in pension income you are giving up.

Of course, very few of us with the same employer for 40 years these days, and so few people will get up to the maximum limit of 2/3 of their final salary as an annual pension. We look at what happens to your pension when you change jobs in a later article.

Defined benefit schemes are generally pretty attractive because employers take the risk of the investments in the fund not growing as much as expected. They have to decide on how much to invest and where to put it. They also have to monitor the progress of the investments. If it looks like there isn't enough in the pot to fund all the future pension commitments then the rate that you and your employer contribute each month can be raised well in advance. There will be a set rate for what you have to contribute out of your salary each month (which is normally expressed as a percentage of your monthly pay before tax). The more your employer puts in, the less you will have to.

Unfortunately, because the risk with these schemes lies mostly with the employer they are becoming less and less common. Indeed, the closure of defined benefit schemes to new members has garnered many headlines in recent years. In addition, in a few cases when companies have gone bust, prospective pensioners have found that their retirement income will be significantly less than they expected. This has led the government to set up the Pension Protection Fund.

Defined Contribution

The effect of a defined contribution occupational scheme is similar to having a personal pension (more on these in a later article) into which your employer makes contributions. Your benefits depend on what is put into the pension fund and how the investments perform. At retirement you can get part of the fund as a tax-free lump sum while the remainder must be used to purchase something called an annuity (these will be described in more detail in a later article as well). Basically this involves you swapping the capital you have built up for a guaranteed rate of income for the rest of your life.

Your employer may offer to match the amount you put into the pension or they might say they'll put in 1% of your salary for every 1% that you put in up to a certain limit. Your employer will work out how much to pay everyone as a salary, taking into account the average amount that it has to contribute to everyone's pension. The effect of this is that if you are putting in less than average, then you are missing out on an employment benefit.

However, just because your employer offers to put money into your pension scheme if you do, it doesn't necessarily mean that you should. It really depends on the relative level of the contributions. If your employer offers to match your contributions (or better), then it would almost certainly make sense to take it. However, if your employer only puts in, say, £1 for every £5 that you put in, then the decision is more difficult: other factors about whether or not to opt for the pension will probably be more relevant.

Unlike defined benefit schemes you have much more responsibility for your pension. You have to:

• Decide how much to put in;
• Decide which fund(s) to invest in;
• Monitor their progress and considering increasing your investment.

Our compound interest calculators can help you with the first and third points. Choosing a fund can be bewildering. We believe it's best to keep it simple and go for a low-cost option like an index tracker.