Types of pension explained
There are several different pension types available and the terminology can be confusing. Here we explain the main differences between types of pension.
Defined Benefit
These are pensions that guarantee you a specific income when you retire, based on what you earned while you were working. They are two main types.
Final Salary Pensions
Final Salary pensions agree to pay you an income based on your salary when you retired, usually a fraction of your final salary multiplied by the number of years you’ve worked for them.
Career Average Pensions
The other type are Career Average pensions where you accrue benefits based on a fraction of your salary each year.
Benefits
Both types of Defined Benefit pensions have similar benefits. The pension you are paid is index linked, which means it goes up each year in line with inflation, so the purchasing power of your pension shouldn’t get eroded over time.
The bad news is, unless you’re very lucky, or you work in the public sector, you’re unlikely to have one of these pensions. Most private companies have closed their private pension schemes to new employees.
The reason for this is that when many of these schemes were set up, they were based on calculations that were unrealistic.
In 1980 the average life expectancy in the U.K. was 74 years. In 2015 it’s almost 82 years. Taking into account an expected retirement age of 65, that means in 1980 they might have expected to pay 9 years pension vs an average of 17 years now. So these pension schemes are paying out for considerably longer than expected.
Another issue with these pensions are the interest rate calculations. In 1980 the interest rate was 16% and didn’t drop below 7% until 1992. In contrast the current interest rate (at time of writing) is 0.25%, and has been less than a percent for 8 years.
For a pension scheme to pay out £1000 a year regularly when the interest rate is 16%, they would need to hold £6250 in cash. In order to pay out £1000 a year at an interest rate of 0.25%, they would need £400,000 in cash. Obviously, this is an oversimplification, as schemes have other ways of achieving better interest rates, however it highlights a massive problem.
There have been several high profile companies (like BHS and Tata Steel) that have got into trouble because the sheer amount of cash they are required to pay into their pension schemes to fulfil promises made many years ago is causing them to go bust.
Defined Contribution
The most common type of pension now is the defined contribution pension. So-called, because you define the contribution you put in, and that’s it. It’s essentially just a savings account with tax benefits.
Unlike a Defined Benefit scheme, the company has no liability to pay you anything when you retire. It’s only obligation is to put some money in now (if you’re eligible for auto enrolment). When you retire, you have a pot of money to either buy an annuity (a regular income for the rest of your life), or withdraw and spend it.
There are three main types of defined contribution pension, all with subtle differences.
Personal and Stakeholder Pensions
Personal Pensions and Stakeholder Pensions are the most common type. You pay a certain amount of money in each month, which is then invested in one or more different investment funds (see What is an Investment Fund?).
The difference between a Personal and Stakeholder Pension, is that there is a limit on the fees that can be charged on a Stakeholder Pension. This was touted by the government as a way to make pensions fairer and more transparent. However, in my opinion, pension companies have funded lower charges for Stakeholder Pensions by reducing the choice and quality of investments available.
The money you pay normally goes into a generic investment fund. Depending on the scheme they may automatically move this into less risky funds as you get closer to retirement (this is called lifestyling). However, you don’t have to keep to this default fund and you can take more active control of your pension by investing in different funds.
The pension company will normally charge a monthly or yearly fee for managing your investments (normally a percentage of your invested money). And each fund you are invested in may have several charges, including a purchase fee (charged when the fund is purchased), and an ongoing charges fee (charged yearly).
SIPPs (Self Invested Pension Plans)
A SIPP is similar to Personal and Stakeholder pensions, but the difference is any contributions are held in cash until you invest them (although some SIPPs may have auto purchase features). SIPPs have a much wider range of investments and allow you to hold traditional investment funds, but also, cash, stocks and shares, and more exotic investment types like property, gold bullion and peer-2-peer investments.
Not all SIPP providers allow you to hold all investments, so it’s important to understand what you want to invest in before you choose a SIPP provider. You can move your pension can between a SIPP’s and personal/stakeholder pension and vica versa.