Defined contribution schemes

Defined benefit schemes

Funded pensions

Unfunded pensions

Pension funds

Pensions can be financed in two ways: unfunded or funded.

Unfunded pensions are, in effect, 'pay as you go' schemes. Examples are the state retirement pension, financed by the National Insurance Contributions of today's workers, and pensions for civil servants, the police service and firefighters. The latter group of pensions is financed by taxation and borrow­ing. (Because they are not true funds, contributed by the pensioners during the period when they were working, and in which are held identifiable assets, we shall not consider them further.)

Funded pensions come in three types:

- Defined benefit schemes;

- Defined contribution schemes; and

- Hybrid schemes.

All have their own funds, with identifiable assets.

Defined benefit schemes are the standard schemes of this century. Contribu­tions are made by employees and (usually) by their employees, who earn themselves a benefit (pension, of which part can be taken in a lump sum) of either ¹/₆₀ or ¹/₈₀ of their final salary (or the average of the last three years' salaries) for every year in which contributions are made. Thus, 40 years' service gives a pension of ²/₃ or ¹/₂, of final salary if the benefit is ¹/₆₀ or ¹/₈₀ respectively. The assumptions are that employees stay in their jobs for a long time and that salary changes are upwards. However, it is now a fact that job changes are more frequent, so transfers have to be made between funds. Second, the 'upward salary' assumption makes it hard for older workers to move to part-time or less remunerative work with their employers as they approach retirement age.

A severe problem can arise with these schemes if there is a period of substan­tial inflation (as there was) because the earlier contributions are unable to finance the higher final salaries caused by the inflation. As a result, [he em­ployers are required by the trustees of the schemes to make up the contributions and this can be a drain on their profits and cash flows. Moreover, if inflation then slows (as it did), the schemes may become 'over-funded' instead of 'un­derfunded', so that a 'pensions holiday' is declared. In some funds, the over-funding has allowed employees, as well as employers, to pay lower con­tribution rates. These 'defined benefit' schemes have been virtually universal in the largest companies and typically are run by trustees advised by mer­chant banks in their investment decisions. A more common term for them is 'final salary' pensions.

Defined contribution schemes are the opposite, in that the contribution per­centages rarely change. They build up a fund which is used to buy an annuity when the employee retires. Their other name is a 'money purchase' scheme and. typically, they are provided by life assurance companies for smaller firms. Personal pensions are a type of 'money purchase' pension, as are AVCs taken out after 1988. Recently, some of the retail banks have instituted defined contribution schemes for their new employees; other employers may follow. There is less chance of a money purchase scheme becoming underfunded, because contributions rise in line with inflation, and benefits are not linked to inflation or salaries.

Дата добавления: 2014-12-29