Powerful alternatives to Final Salary pension schemes
Posted on: 24th July 2017 in
Are Defined Benefit (DB) pension schemes really becoming a thing of the past? It seems so.
A Telegraph article last year
used JLT Employee Benefits data to show that only 23 of FTSE100 companies still fully offer DB pension schemes (also known as “Final Salary” schemes).
And it is the low-cost, outsourced Defined Contribution (DC) schemes that ran alongside them that are now replacing the DB schemes that offered high cost to the employer and high reward to the employee.
This move to DC schemes has meant consumers need to have a more hands-on approach to their long-term savings. With DC schemes, you need to get involved in your pension. Get informed. And be aware that there are alternatives to DB schemes other than DC schemes. Remember that what scheme will suit you depends centrally on your unique financial position, and that’s why talking to an IFA can be so useful — because, as an independent professional, an IFA can tell you exactly
what schemes could match your unique situation as an individual.
Holborn Assets reviews the alternatives as the final curtain comes slowly down on DB schemes …
Final Curtain for “Final Salary” Schemes?
Defined Benefit schemes used to be a major pull in keeping talent in both companies and public sector institutions. That’s because (compared to DC schemes) they favour employees over the employer:
- Fixed mutual contributions — for example, 5% of monthly salary – by company and employee means that the pension is being topped up more generously as a career progresses and salary increases.
- At the peak of an employee’s earning power, the payout is calculated. At retirement age, a fraction of the employee’s final annual salary before leaving the company — hence the name of “Final” Salary scheme — essentially makes up their theoretical monthly income in retirement (excluding issues about annuity rates).
This became a very expensive method of retirement provision and, today, many UK companies consequently run a scheme deficit where what they owe to retirees exceeds the funds in the pot. The total final salary pension deficit of the 350 largest listed companies more than trebled to £137bn last year, according to Mercer.
Grave new world?
DC schemes are tipped as the brave alternative that has been spelling the death of DB schemes. DC schemes have been, and continue to be a low-cost alternative to Final Salary schemes that offer more risk to the employee. They are provided by life insurance and investment companies, so while employees still have scheme trustees from their own company as their legal representative, the investment and administration are outsourced.
Contributions are invested in units of funds derived from the stock and bond markets, so the value of the pension overall changes day-by-day.
DC schemes do not — as defines DB “Final Salary” schemes — offer a salary-based formula for payout. Rather the value of a DC scheme at retirement is based on a snapshot of its investments, therefore carrying more market risk for savers. DC schemes have also required employees to be engaged with their contributions and retirement schedule like never before.
Other alternatives to DB schemes
The above description is common to all DC schemes. But there are three other alternatives to DB “Final Salary” schemes than DC schemes: Stakeholder schemes, Personal pensions and SIPPs:
Stakeholder schemes offer low-cost flexibility.
Stakeholder schemes seek to minimise their running cost to the member. There are limited charges, including zero charges for transfers, and a limited range of funds from which to choose.
In terms of flexibility, both employers and individuals can set up a Stakeholder scheme; if the latter, they can request their new company to contribute to their scheme. Stakeholder pensions, therefore, have a portable aspect. They offer tax relief at 20% for basic-rate and non-taxpayers, which is collected and added to the pot but is also included in a saver’s annual tax relief total.
What’s more, savers can contribute to stakeholder schemes other than their own — to that of a spouse or child, for example — as well as having other people pay into their own.
Another bonus is that savers don’t have to stop work when drawdown becomes available from 55 years old, so the issue of ‘retirement’ might become helpfully moot for some.
Similar to Stakeholder pensions, “Personal” pensions tend to be dearer in overall charges in return for offering a greater variety of investment funds to choose from.
Originally targeting the higher net worth saver with a lump sum to transfer, SIPPs offer annual charges but the widest flexibility in the marketplace.
SIPPs are on the up. Their competitiveness against other types of personal pension schemes has increased over the last decade (with the demise of QROPs adding to their appeal). Some employers offer group SIPPs, either because the company is new or small, or to replace a DB “Final Salary” scheme entirely.
So how to be hands-on without getting your hands tied?
Your choice of pension will depend on your unique financial profile as an individual and your willingness/ability to run the paperwork/decisions of your own pension:
If you’re a financial whizz …
Are you keen on investing and asset classes? Happy to take on some investment risk with your own two hands and build that pot of gold yourself? A SIPP might be an interesting proposition, therefore — particularly if you happen to own commercial property, an asset class that can be contained in this pension type. A SIPP also offers the key holistic advantage of streamlining your overall retirement fund. How? Via the ability of a SIPP to receive transferred funds from any life company savings plans you may have opened in the past. So get your investment hat on: the 25% lump sum tax-free you are allowed from the age of 55 — what might that be reinvested into?!
If you are a self-starter …
Or maybe, when it comes to pension savings, your focus is on managing the whole thing yourself. The investments may be of interest to you, but you just want to get a firm grip on what is going on at all times. Either a Stakeholder or Personal pension might suit you (with a Personal pension giving you an interesting mix of default and more costly ‘external’ funds). One key task would be to keep your personal details bang up-to-date with both previous and new employers to maximise employer contributions.
If you have more pressing interests …
Your pension is a key feature of your retirement landscape. You know that. But maybe, right now, the focus of your life is elsewhere; on your work, your personal life, or even your very own start-up company. You don’t want too much fuss. A Stakeholder scheme may suit, especially as you can start one for yourself if you’re self-employed and building your own company and may need a contribution hiatus. The default funds available — usually low to low-to-medium risk funds — may be appropriate.
Maybe you don’t need to worry about your pension at all. It could be that your company runs a successful stakeholder or group SIPP scheme, so the idea of ‘choosing’ your product doesn’t right now seem too pressing. Good.
As an overall picture of pensions, a key trend is in schemes of many types requiring more diligence from pension-holders. Keep an eye on what your pension is doing! Over the coming years, savers will be managers and administrators of their retirement like never before.