FOOL SCHOOL
Company Pensions

November 26, 2004

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.

Anyway, getting back to the point, there are two basic types of occupational pension scheme: defined benefit (also known as final salary) and defined contribution (also known as money purchase).

Defined Benefit

With a defined benefit pension scheme, the final 'benefit' is what defines how much the policy is worth. In effect, the final benefit -- aka 'how much you get' -- is guaranteed. Typically, your eventual benefits from this type of scheme are defined as a proportion of your final salary and, I dare say you've already worked out that this is why they're often called final salary schemes. With this type of pension, your retirement income (and any lump sum that you stand to get) simply comes out of the total pension pot that your employer has been building up over the years for all employees. If the investments have performed badly and there isn't enough in the pot, then your employer has to stump up the difference. Of course, if the investments have performed well and there is extra in the pot, then the employer often gets to keep the extra. Fair enough.

Defined Contribution
  
In a defined contribution pension, the value of the policy is defined by what is put into it. It makes no difference what you're earning when you retire; the level of your pension income depends on how much is put into your scheme and how well the investments perform over the years. If the investments perform well, then you will be able to buy a bigger income. For this reason, they are sometimes known as 'money purchase schemes'. However, if performance is poor, then you'll end up with a lower retirement income than you were hoping for. In this case, it's you that takes the risk, not your employer.
 
In the next week's articles we'll at each of these two main types of company pension in more detail.

Find out more in our pension centre.