Almost half the working population is thought to belong to a company pension scheme, and over half of those who have retired in recent years benefit from some kind of occupational pension. 

Having this additional income when you retire can make an enormous difference to your standard of living as you grow older, and a company pension is rightly regarded as a great perk.

The unique advantages common to all occupational pension schemes are the tax incentives.  Your contributions are paid out of your gross salary (i.e. before the deduction of income tax), money invested in a pension builds up largely tax-free, and on retirement you can take part of your pension as a tax-free lump sum (although pension income in retirement is subject to income tax).  Add to this the fact that your employer normally also makes contributions on your behalf and occupational pensions become very hard to beat as a means of saving for retirement.

Types of occupational pension schemes

There are two main types of occupational pension.  Final salary schemes (also known as earnings related or defined benefit) and money-purchase schemes (also known as defined contribution).

Final salary schemes

Conventional wisdom is that final salary schemes are the ‘Rolls Royce’ of pensions, but they are expensive for employers to run, which is why their number is diminishing.  Some employers are closing their final salary schemes to new members, others are ‘freezing’ them and/or switching to a money purchase scheme, so that existing members cannot build up any further entitlement under final salary rules.

However, the National Association of Pension Funds (NAPF) estimates that some 7.8 million people still have rights in final salary pension schemes in the private sector alone, and this type of scheme is commonplace in public sector jobs. 

In most schemes the pension you receive is linked to your earnings at, or in the years immediately leading up to, retirement, and is based on the number of years you have been a scheme member.  Occasionally, schemes base your pension on average earnings throughout the period of membership.

How is a final salary pension worked out?

Your pension is worked out by multiplying your final pensionable earnings by an ‘accrual rate’ and then by the number of years you have been in your job.  Pensionable earnings may just be your salary, but in more generous schemes may include overtime pay, bonuses or commission.

The accrual rate is usually expressed as a fraction.  Most jobs pay either 1/60th or 1/80th of earnings for every year worked.  For example, if you worked for 30 years in a job where the accrual rate was sixtieths, you would expect to receive a pension of half your final salary (30/60th or ½). 

Once you retire your pension will increase annually to take some account of the rising cost of living, but the maximum increase will be capped and may not keep pace with future inflation.

Money-purchase schemes

Money purchase schemes are generally run on behalf of employers by large insurance companies.  The amount of pension you receive is based on the amount of money that has been contributed by you and on your behalf by employers, and the investment performance of the funds into which it has been invested.

You can generally choose a selection from a range of managed funds in order to spread the risk and you usually have limited options to switch funds from time to time.

If you prefer not to make you own selection your contributions will be invested in a ‘default’ fund.

On retirement the money is used to buy an annuity, either from the insurance company that ran the pension or from another insurance company of your choice that provides you with a pension for the rest of your life (see Guide to annuities) 

You cannot accurately predict what your pension will eventually amount to in a money purchase scheme, because you do not know how well your fund will perform and annuity rates also change on a regular basis.

Should you join a company pension scheme?

If you are given the opportunity to join a company pension it is almost always a good idea to take it up.  Some large companies have a lower age limit, so school leavers or new graduates may not be able to join straightaway, but the sooner you join the better pension you are likely to receive on retirement.

How much can you invest into a company pension?

Typically, employees invest around 5% to 6% of their salary in an occupational pension, although some large organisations and public sector schemes are non-contributory for employees.  The NAPF says that the average employer contribution is around 16 % for final salary schemes and just over 6% for money purchase schemes. 

However, the law allows you to invest much more. In April 2006 legislation was brought in to harmonise the different rules that had previously existed for different types of pension scheme and replace them with one simpler set of rules that apply to all types of pensions.

The new system means that each individual has an annual contribution allowance (funded by themselves, their employer or both) tax-free in any given tax year.  In 2008-09 this allowance is £235,000 or 100% of an employee’s earnings, whichever is lower. 

In the year before retirement you can contribute as much as you like, provided you remain within the overall lifetime limit, which is £1,650,000 in 2008-9.

This money can be invested into one occupational pension, or it can be split across more than one pension.  Since April 2006 there are no restrictions on employees having personal pension schemes in addition to an occupational scheme. (see Guide to personal pensions).

Early retirement

If you have to retire early through ill-health, most final salary schemes normally provide the same pension that you would have received had you stayed on until normal retirement age.  Retiring early through choice, however, will almost certainly mean taking a reduced pension. 

If you are in a money purchase scheme and retire early your pension will be lower.  You will have made fewer contributions, the amount of time the pension fund is invested will be less so you’ll miss out on potential growth and the annuity you buy will provide a lower pension since it will be paid for longer.  However, for employees who retire early through ill-health some companies offer a separate type of insurance instead that pays you an income up to normal retirement age, when you can start to draw your pension as if you had worked in the intervening years.

Your pension can start earlier than age 50, if you retire through ill-health, but if you retire through choice you cannot draw your pension until you are 50 (rising to 55 in April 2010).

Leaving a pension scheme

If you change jobs, give up work for some reason or if you are made redundant you might leave an occupational pension scheme.  You may be presented with three options:

• Cancel your rights in the scheme and take a refund of the contributions paid to date.  This is normally only an option if you have been a scheme member for less than two years, and the scheme rules allow refunds. You can only have a refund of your contributions, not those of your employer, and tax will be deducted. 

If the scheme was contracted out of the second state pension (see Guide to state pensions) a deduction will also be made to cover the cost of buying you back in. However, if you have been contracted out through a money purchase scheme you cannot buy back into the second state pension, nor can you have a refund. 

• Leave your rights in the pension scheme intact so that you can have a reduced pension when you retire.  Provided you have been a scheme member for at least two years your employer must allow you this option.

• Transfer your pension rights to a new scheme. Most schemes allow you to transfer your pension, although with a final salary scheme the transfer value will be based on a calculation by the scheme’s actuaries and may be much less than you have paid in.

If your new employer's scheme does not accept transfers, which they are not obliged to do, you could buy a personal pension or a “Section 32” contract instead.  Section 32 contracts, offered by insurance companies, are specially designed to accept preserved pension rights from an occupational pension scheme and maintain them in their original form, which could be final salary.

Deciding what to do is a very difficult decision, not least because the new benefits will be different from those you are giving up and may not be easily compared. For example, some money purchase schemes offer guaranteed annuity rates when you join the pension scheme.  Owing to the sharp fall in annuity rates in recent years, you would almost certainly lose out by transferring rights out of such a scheme.

It is a good idea to take professional advice on the best course of action from an independent financial adviser specialising in pensions (To find an IFA go to http://www.unbiased.co.uk/).

How safe is an occupational pension?

High-profile cases of firms going bust and employees losing their final salary pensions, pension schemes being wound up and large companies under-funding their schemes to leave a ‘black hole’, have all called into question whether or not your money is safe in a company pension scheme. 

To try to reassure people the government has tightened up pension regulation. Trustees are responsible for seeing that the scheme is run correctly, overseen by the Pensions Regulator.  However, if something does go wrong the Pension Protection Fund (PPF), set up in 2004, compensates members of final salary pension schemes which have failed.  On retirement, people receive 90% of the value of their pension up to a "cap" (currently just under £27,000).  Any benefits built up since 1997 will be increased each year in line with inflation (up to a maximum of 2.5%). 

For final salary pension schemes that failed prior to 2004 compensation is at the same level, but provided through the Financial Assistance Scheme.

If you are in a money purchase scheme and your employer goes bust the amount already invested in your pension would be safe as it is invested with an insurance company, and when you retire your pension is provided by an annuity and not directly from your employer.

CashQuestions Guide to State Pensions
CashQuestions Guide to Occupational Pensions

CashQuestions Guide to Private Pensions

CashQuestions Guide to Pensions for Women
CashQuestions Guide to Annuities

CashQuestions Guide to Drawdown

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