Pension Scheme

Published Apr 29, 2024

Definition of Pension Scheme

A pension scheme is a type of savings plan designed to provide individuals with an income after they retire. It allows people to accumulate a portion of their earnings during their working life so that they can receive a regular income once they stop working. There are different types of pension schemes, including defined benefit and defined contribution plans, each with its own set of rules regarding contributions, investment options, and benefits.

Example

Consider Sarah, who works for a large corporation that offers a defined benefit pension plan. Under this plan, the company promises to pay her a specific monthly amount upon retirement, based on her salary and the number of years she has worked for the company. As she progresses through her career, Sarah does not need to make investment choices; instead, her employer contributes to the plan on her behalf and takes on the investment risk to ensure the promised benefits are delivered upon retirement.

Alternatively, if Sarah were part of a defined contribution plan, she and her employer would contribute a fixed amount or percentage of her salary to her pension account. The future benefits would depend on the contributions made and the performance of the investments chosen by Sarah from the options provided by the plan. Upon retirement, Sarah would have several options for withdrawing the accumulated funds, such as purchasing an annuity or making lump-sum withdrawals.

Why Pension Scheme Matters

Pension schemes play a crucial role in ensuring financial security for retirees, allowing them to maintain a comfortable standard of living even after they have stopped working. For employers, offering a pension scheme can be a strategic component of a competitive compensation package that attracts and retains high-quality employees. On a broader scale, pension schemes contribute to the stability of financial markets by acting as major institutional investors. They also relieve pressure on government social security systems by providing individuals with the means to support themselves in retirement.

Frequently Asked Questions (FAQ)

What are the main differences between defined benefit and defined contribution pension schemes?

Defined benefit plans promise a specific retirement benefit amount, which is usually based on salary and years of service. The employer bears the investment risk and is responsible for funding the plan. In contrast, defined contribution plans do not guarantee a specific benefit at retirement. Instead, the retirement benefit depends on the contributions to the plan and the performance of the investments. The investment risk is borne by the employee, who must make choices about how their contributions are invested.

Can individuals have more than one pension scheme?

Yes, individuals can participate in multiple pension schemes. For example, an individual may have a workplace pension from their employer and a personal pension that they set up independently. Having multiple pension schemes can provide a larger total pension pot and more income sources in retirement. However, it’s essential to manage these schemes effectively to maximize retirement benefits.

What happens to a pension scheme when an individual changes jobs?

The treatment of a pension scheme when changing jobs depends on the type of plan and its rules. For defined contribution plans, individuals can often transfer their pension pot to their new employer’s scheme or into a personal pension plan. For defined benefit schemes, the options may include leaving the accrued benefits in the former employer’s plan until retirement (a “preserved pension”) or transferring the value to a new employer’s scheme, if allowed and if advantageous. It’s important to seek financial advice when making decisions about pension transfers.

How are pension schemes funded?

Pension schemes are funded through contributions from employers, employees, or both. In defined contribution plans, the contributions are invested in a variety of assets, and the eventual pension benefits depend on the investment returns. Defined benefit plans are also funded by employer and sometimes employee contributions, but the employer is additionally responsible for ensuring that there are sufficient funds to meet the future pension benefits promised to employees, requiring actuarial calculations and potentially additional funding.

Are pension schemes protected against inflation?

Some pension schemes, particularly certain defined benefit plans, include provisions to protect against inflation, such as annual increases linked to inflation indices. With defined contribution plans, the ability to offset inflation depends on the investment choices and the performance of those investments. Individuals concerned about inflation eroding their retirement savings should consider investment options that have the potential to grow at a rate that outpaces inflation.