plans
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Section XVII
State and occupational
pensions
Types of pension schemes
The pension arrangements provided by employers to their employees represents and
have therefore to be intended as employee benefits and more in particular as deferred
benefits. Employers put in place these plans, which individuals can join at the beginning
of their working life, essentially in order to ensure that their employees will continue to
receive an income also after the conclusion of the employment relationship, enabling
them to hopefully maintain their standard of living after retirement.
Well-developed pension plans can potentially represent a significant component of total
reward packages helping organizations to both attract and retain quality employees. The
importance of pensions plans, however, may differently be perceived by the individuals
forming an organization workforce; this, despite the remarkable resources and costs
faced by employers to introduce and administer these schemes. Indeed, the more
various the workforce composition, the wider the difference in perception employees are
likely to express as regards this particular type of benefit.
Generation Y employees are typically likely to be remarkably less interested in pension
plans vis-à-vis Baby Boomers and Veterans. This different perception, however, is
supposedly mostly due to the age factor rather than to the typical, pure generational
variance. Notwithstanding, Baby Boomers receiving a good or high income, especially
whether these have also made particular plans for their future, like retiring abroad or
establishing and running their own business, represents the generation of worker
potentially most interested in early retirement pay packages (Parry and Urwin, 2009).
Many pension systems around the globe have been, and in some cases are still, exposed
to the risk of implosion by reason of being not sufficiently funded. Albeit in some cases
this might mostly be due to the mismanagement of funds, whose origins date back well
in the past, there have been two other relatively more recent factors which have
accounted for this trend to sensibly worsen during the last decade. On the one hand, in
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fact, the ageing population phenomenon has caused pension funds having to provide
retired people with an income for, on average, a definitely longer period of time than
originally expected; on the other hand the sustained unemployment rate characterizing
many economies across the globe has accounted for pension funds to receive reduced
sums of money, in terms of employees and, where applicable, employers contributions,
whereas having to continue to provide an income to an increasing number of retired
people. As stressed by Torrington et al (2008), the latter phenomenon is causing a
sustained rise in the dependency ratio, which is based on the relation between the
(growing) number of retired people and the (declining) number of people still working
(and paying contributions to the funds). This trend has prompted in turn many
governments to postpone employee retirement time, by rising both male and female
retirement age.
The worth of the sum paid monthly by pension funds to employees after retirement
depends on the contribution made by each individual and, where applicable, his/her
employer during the employment relationship. As often as not contribution to individual
pension plans are made by both the employer and the employee.
Pension plans can be usually grouped into two main categories: state and occupational
pension plans. Notwithstanding additional types of schemes might be available in some
countries according to the local legislation.
State pension plans
In the UK a new state pension plan has recently been introduced for individuals reaching
State pension age on or after 6 April 2016. This scheme replaces the old system centred
on a “basic” and an “additional” state pension scheme, which is still operating for
employees reaching state pension age before 6 April 2016 only.
Occupational pension plans
Typically, occupational schemes can be offered by employers to employees in the form of
defined benefit schemes (DB), defined contribution schemes (DC) or in the form of a
hybrid scheme based on a combination of both.
Additional pension plans
Besides these schemes, there are other forms of plans that individuals can join according
to the circumstances. Amongst these: stakeholders and group or personal pension plans
are the most common.
State pension plans
State pension schemes are basically plans run by national governments in order to
ensure that every employee will receive a minimum income after retirement. These
plans, which are normally mandatory, are clearly differently designed and managed by
governments, but basically all of them more often than not provide retired individuals
with more basic benefits. Employees typically contribute to state pension plans by means
of the National Insurance payments.
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In the UK a new system, called new State Pension scheme, has recently replaced the old
arrangements formed by the Basic State Pension and the Additional State Pension
schemes.
The Basic State Pension
Men born on or after 6 April 1951 and women born on or after 6 April 1953 are eligible
to the Basic State Pension whether these reach pensionable age before 6 April 2016. The
maximum payment an individual can receive under this scheme is of £113.10 per week,
provided that the individual concerned has worked and paid national contributions for at
least thirty years (including National Insurance Credits accrued during unemployment,
illness or as a parent or carer).
Individuals having worked and contributed to National Insurance for less than thirty
years would receive a weekly payment lower than £113.10 per week, but have the
possibility to increase their basic pension by means of voluntary National Insurance
contributions payments.
In order to be eligible to the £113.10 weekly payment an individual, during his/her
working life, should have received from his/her employer (considered as a single
employer) a weekly pay of at least £153.
In the UK, State Pension of transsexual individuals is not affected by any means whereas
the individuals concerned have legally changed their gender and started to claim State
Pension after 5 April 2005. Differently, some problems, which should be eventually
settled with the relevant Authorities, are likely to arise.
The Additional State Pension
This scheme, providing retired people with an additional income besides that ensured by
the Basic State Pension plan, basically complements this. The supplementary amount
received by the retired individual is not subject to any regulation strictly defining or
limiting it, but it rather depends on the National Insurance payments made by the
individual during his/her working life and his/her earnings.
Since this scheme in parallel to the Basic State Pension plan, the criteria to access this
plan are essentially the same as those listed above for the Basic State Pension plan. The
moment arrived, there is no need to separately claim the payment of the sum associated
with the additional pension. The payment in fact will be automatically made to the
entitled people by the state.
The addition will be granted to individuals who have been employed, earned at least
£5,668 a year and have clearly made contributions to the scheme by means of National
Insurance payments. Also in this case, employees can gain Additional State Pension
credits.
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The New State Pension
The new scheme will apply to individuals reaching the state pensionable age on or after
6 April 2016. At the moment in time, the minimum weekly amount which will be paid to
retired people has not yet been set (it is expected to be communicated in autumn 2015),
but it is not estimated to be lower than £148.40 per week.
The actual amount of the weekly payment may be higher or lower vis-à-vis that
identified by the regulations (£148.40 per week) depending on the findings of the
National Insurance record.
Under the new scheme, individuals might decide not to claim the pension as soon as
they gain eligibility for the payment. They can in fact decide to defer, that is, to
postpone the pension payment at a later time in order to receive a higher sum. However,
the government has already decided that in order to obtain a higher payment a
minimum deferring period should be introduced, albeit this is has not yet, at the time of
writing, been set.
Since the new scheme will practically be effective from 6 April 2016, this date represents
somewhat of a landmark for the pension calculation. The National Insurance contribution
paid before that date is called “starting amount.”
The starting amount is determined by the comparison between the amount which would
have been paid to an employee applying the current mechanism, that is, basic state plus
additional state pensions, and that calculated according to the new method also to the
period preceding 6 April 2016. It will be considered as the starting amount the highest
between the two sums.
Whether the calculated starting amount is lower than the full new state pension weekly
payment, the qualifying years worked after 6 April 2016 will enable individuals to accrue
the weekly pension payment; each year accounts for a weekly payment increase of
approximately £4.25. In those cases in which the starting amount should already be
larger than that which would be received applying the new full State Pension, the
difference will represent a “protected payment.” Protected payment will be paid in
addition to the new full State Pension payment and is subject to be revaluated from year
to year according to the inflation trend. In this case, however, the additional qualifying
years eventually accrued after 6 April 2016 will not contribute to any increase in the new
full State Pension.
To receive any new State Pension individuals will need to have at least 10, also non-
consecutive, qualifying years on the UK National Insurance record. In order to receive
the new full State Pension individuals need thirty-five qualifying years. Whether an
individual should have in his/her record a number of years in between ten and thirty-five,
a proportion will be applied.
Individuals participating in other types of pension plans (occupational, stakeholders,
personal, group, etc.), are likely to have paid lower National Insurance contributions in
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favour of State Pension schemes. This circumstance is considered as an individual having
been “contracted out” from Additional State Pension. This occurrence can be ascertained
by checking the payslips. Whether in correspondence of the item “National Insurance
contribution” is placed the letter “D” or “N”, this means that the individual has been
contracted out; by contrast, whether the letter “A” is placed in correspondence of the
National Insurance contribution item, this entails that the individual has not been
contracted out.
On 6 April 2016 rules will change and no employee will be contracted out; however, this
clearly implies a higher contribution to National Insurance compared to that paid
presently.
Individuals will gain qualifying years to the extent of the new full State Pension scheme
whether during each year of their working life have received from one employer a
weekly pay of at least £153 and have paid National Insurance contributions. The
mechanism of the National Insurance credits applies also in this case.
Occupational pension plans
Pensions should aim at providing retired employees with an income enabling them to
maintain after retirement a standard of living as far as possible similar to that preceding
retirement. Indeed, state pension plans hardly enable individuals to achieve this
objective so that, as suggested by Torrington et al (2008), occupational schemes are
actually offered by employers to employees, besides state pension plans, in order to
offer these more valuable and wider-ranging benefits. It can therefore be argued that
occupational pension schemes basically complement state pension plans.
Occupational pension plans are usually not directly operated by employers, but by
means of ad hoc established pension funds. This clearly represents a protective measure
in favour of employee contributions and more in general of the money contributed by
both employees and employers to these funds. Whether a company should experience
cash shortage or being in a state of insolvency, these funds could not be by any means
used by the employer to face the adverse circumstances. The objective is clearly that to
protect the money contributed to pension plans from the risk that, once used by
employers for different scopes, this could not be subsequently recovered.
The money contributed to the funds by employees and employers is invested and held in
trust on behalf of employees till their retirement. Employers can either opt to set and run
their own pension fund or entrust this activity to a third party, usually an external
financial institution. Notwithstanding, this solution is not completely immune from
problems, too. Whether an employer should become insolvent and its pension fund
should simultaneously be in deficit employees could lose part or all of their pensions
(Torrington et al, 2008). The same result could be produced also in the aftermath of the
financial institution in charge of the pension fund management being forced into
bankruptcy. Governments usually establish specific institutions to protect employees
from such occurrences; but it is hardly supposable that, the case being, these
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institutions could enable employees to entirely recover the sums of money contributed to
the funds.
Occupational pension plans can be basically designed and developed according to three
approaches: defined benefit schemes (DB), defined contribution schemes (DC) and
hybrid schemes, which essentially derive from a combination of both defined benefit and
defined contribution schemes.
Defined benefit pension plans
As suggested by the same schemes’ name, these plans are intended to determine the
benefits which will be payable to employees upon retirement. The worth of these
benefits broadly depends on individual pay and length of service.
The formula used to determine the value of pensions according to these schemes, also
known as salary-related pension schemes, is based on:
- The number of pensionable years - that is, the number of years an employee has
participated and contributed to the scheme;
- The pensionable earnings - which have most recently been identified with the concept
of “career average” rather than, as more typically occurred in the past, with that of “final
salary.” According to the career average approach, pensionable earnings are identified
on the basis of the calculation of the average earnings received by an individual over
his/her career or over a number of years. Final salary, by contrast, refers to the level of
pay an individual receives just before retiring;
- The accrual rate - that is, the rate of the earnings per year which need to be taken into
consideration for calculation. The most widely used accrual rates in defined benefits
pension calculations are 1/60th and 1/80th. This means that, to the extent of the
pension calculation, for each year of service of the overall pensionable earnings it will be
considered only 1/60th or 1/80th of the total amount.
Since the determination of the pension value is associated with different variables and it
is impossible to determine in advance, according to the circumstances, the final salary or
the average career salary, it is in turn practically impossible to predict in advance the
exact value of the benefits for employees and the related cost for employers. This
circumstance does not usually represent a problem for governments and public sector
employers at large, which not being normally subject to insolvency problems make
payments to retired employees without any particular need to pre-determine the exact
costs at an earlier stage (Irish Association of Pension Funds, 2014). This approach,
known as “pay as you go”, however, is not appreciated by the vast majority of
employers and let alone by employees, who want to be sure that, the moment arrived,
the employer and its pension fund will be able to pay the benefits accrued over time.
The largest part of these schemes is contributory. Contributions to the fund are made
directly by the employees participating to the scheme during their pensionable working
life, usually on the basis of a pre-set percentage of their salary. Employers’ contributions
on the other hand are required and become necessary to ensure that the fund can be
operated properly and that it constantly remains in the black. According to Armstrong
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(2010), employers’ contribution varies from 3 per cent to 15 per cent, with a median of
approximately 8 per cent. The amount to be paid to the fund is identified by the pension
fund actuaries, who determine it on the basis of the employees’ life expectancy and the
likely financial performance of the fund. These hypotheses are periodically reassessed
and, whether appropriate, a new payment rate recommended by actuaries (Irish
Association of Pension Funds, 2014). Both employers and employees usually benefit of a
tax relief on their contribution payments (Torrington et al, 2008).
Defined benefit schemes may also offer individuals the opportunity to receive a lump
sum, exempt from tax, in lieu of part of the pension. Some plans also allow the payment
of part of the employee pension to his/her dependants in case of the employee death
either before or after retirement.
Defined benefit scheme pension calculation
Accrual rate 1/60th
The employee retires at 65 with a final salary of £28,000 a year and a scheme
membership of 30 years.
His/her pension is 30 x 28,000 / 60 = £14,000 a year (excluding the case that the
employee may have changed part of his pension for a lump sum)
Accrual rate 1/80th
The same employee, retiring at 65 with a final salary of £28,000 a year and a scheme
membership of 30 years will receive:
30 x 28,000 / 80 = £10,500 a year (excluding the case that the employee may have
changed part of his pension for a lump sum).
It is unlikely that employees may be still offered the chance to join such schemes in that
the existing ones are mostly operated in favour of employees having joined these in the
past. However, the advantage of this type of schemes is that benefits are linked to
employees’ salary so that these are due to increase as a consequence of pay increases.
Yet, their value does not depend on stock market performance and rises of a pre-set
amount, depending on the inflation rate, year after year (Money Advice Service, 2014).
Defined contribution pension plans
Differently from defined benefit schemes, where employees contribute with a fixed
percentage of their salary and employers contribute with the sum required to ensure the
proper functioning of the pension fund, defined contribution plans, also known as
“money purchase schemes”, transfer risks entirely to employees.
According to the mechanism of this type of schemes, employers and employees
contribute to the scheme in the same fashion, namely according to a pre-identified
percentage of employee pay. The final pension is thus entirely calculated on the basis of
the combination of these contributions. However, in this case, the financial performance
attained by the pension fund has a remarkable impact on the final benefits received by
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employees and is therefore of crucial importance. The fund bad performance would
negatively impact employee pension value.
An additional potential risk for employees derives from the use of the final sum received
by these at retirement. This amount of money will be used to buy an annuity, normally
from an insurance company, which essentially represents the monthly income that the
retired individual will receive during his/her life. Annuities are subject to change from a
year to another (Torrington et al, 2008); moreover, insurance companies offer different
options and individuals may find it difficult to choose the most reliable and suita