What species of pension is this?
Photo by Ian Parker on Unsplash
Pensions, like penguins, come in different species. Join our intrepid adventurer as she examines her pensions to find out what species they are.
Boring-but-necessary disclaimer. I'm not a financial adviser and no-one should assume anything I write here is financial advice. It only reflects my experience of looking into my pension.
If you’ve been following my #PensionAdventure, you’ll know I’ve now got all the pieces of my pension. I need to decide what I’m going to do with them, but first I need to look more closely to find out what they are.
First of all, the rare beasts … defined benefit (‘DB’) pensions
These are pensions where the benefits are set out or set out or defined in the pension scheme’s rules.
The lesser spotted final salary pension
I did a stint of working in local government. As a result I have five years of final salary pension.
This is what almost all pensions used to be. They’re based on:
part of your salary - for example, 1/60th or 1/80th, and
the number of years you build up the pension.
It’s called final salary because it uses your salary near the date you retire or stop building up benefits (for example, because you leave your employer or the scheme closes to future benefit build-up). As I was in my final salary scheme for five years, my calculation is 5 x 1/60th (or whatever) of my salary at the date I left.
How do I spot a final salary pension?
Your pension statement will show a yearly pension amount rather than a total pension ‘pot’.
Every year you should also get a summary funding statement which tells you how healthy the pension fund behind your pension is.
Summary what now?
It shows the funding level - the balance between the money building up in the pension fund, and the pensions to be paid out - as a percentage. If this is less than 100%, the statement should talk about a recovery plan to get the funding level back to 100%. This could include things like the employer paying more money into the scheme.
It’s fairly common for the funding level to be less than 100%. This isn't usually something to worry about.
To be extra confusing, the statement will show two percentages:
one for the ongoing funding level assuming the scheme carries on, and
one assuming the scheme ends and is wound up - often called the solvency or full solvency funding level.
If this happened, the money in the scheme would be used to buy insurance policies to pay your benefits. This is an expensive way to provide benefits, so this winding-up funding level – often called the solvency level – is usually lower than the ongoing funding level.
The seldom seen career average pension
This is another type of defined benefit pension. I have a small one of these from my most recent job.
You build up a piece of salary each year, but
based on the amount of your salary for that year,
not your salary when you leave or retire.
So the amount you build up over the years is based on your average salary while working for that employer. The technical name for these pensions is Career Average Revalued Earnings which you may see shortened to ‘CARE’ (but has nothing to do with any kind of care).
How do I spot a career average pension?
It’s tricky - they look similar to final salary pensions.
Your statement will show a yearly amount of pension and possibly a tax-free cash amount.
You should get a summary funding statement each year.
It may say CARE somewhere on your statement.
Why are DB pensions so rare nowadays?
It’s the risk.
With DB pensions, the employer takes on most of the risk. They’ve promised to pay a certain amount of pension and pay it they must, however much it costs. As a result, increasing numbers of employers can no longer afford to keep their DB schemes open, mainly due to a double whammy of:
people living longer, so pensions have to be paid for longer, and
investment returns and interest rates, which help pension funds to grow, being lower than they once were - and had been for a long time before Covid-19 was a thing.
The common defined contribution (‘DC’) pensions
They may be common, but they’re still pensions. I’ve got two separate bits of DC pension from the same employer, but with different providers.
In a DC pension you pay contributions into a pension pot and choose investments to help your pot grow. If it’s a workplace pension, your employer usually pays contributions too.
DC pensions are sometimes called money purchase pensions.
How do I spot a defined contribution pension?
Your pension statement will show a total pension pot amount.
It will talk about your investment choices.
Your statement will also include a section called a statutory money purchase illustration. (‘SMPI’ – don’t pension people love acronyms?) This shows an estimate of how much pension you might be able to buy with your pension pot in the future, based on rules set by the government.
Buying a pension isn’t the only thing you can do with your pot, but that’s a subject for a future blog post.
Personal pensions are DC pensions. Which takes me right back to …
My first ever pension
I took out a personal pension when I was 26. Yes, I have always been this sad. It seemed like a good idea because my employer at the time didn’t let you join the pension scheme until you were 32. Guess how old I was when I left that employer?
So I got six years of pension saving I otherwise wouldn’t have.
I’ve kept the personal pension going but I haven’t paid into it for a while, so its value could be going down because of charges. I need to do something about this - in a future blog post.
Choice = risk
You get a lot of choice with DC pensions.
You can choose how much you want to save. You get to choose your investments, although there should be a default option you go into if you don’t make another choice. You also get a choice of how to take the money when you retire (which there’ll be a future blog post about).
But – you take most of the risk involved in making sure you’ll have enough income when you retire.
You risk not saving enough, your investments not doing well enough, your pension savings not growing enough.
Plus, it’s almost impossible to estimate how much income you’ll actually get from a DC pension.
This doesn’t make DC pensions bad. But it does mean you need to pay attention to them. Another blog post, I think!
Hybrid species
You might have different types of benefits in the same pension scheme, making it a hybrid pension. This is what part of my previous employer’s pension looks like - I’ve got some career average pension and some DC pension in the same scheme.
There’s an extremely rare type of hybrid scheme known as cash balance, where pension builds up based on salary (like DB) but involves an invested pension pot (like DC). In almost 20 years as a pensions copywriter, I only remember writing one booklet for a cash balance scheme.
For some years there have been discussions about defined ambition pension schemes which aim to share the risk more equally between employers and scheme members than the two extremes of DB and DC. The Pensions Act 2021 introduced the possibility of collective defined contribution pensions which would pay a pension like a DB scheme - but the amount of pension could vary each year depending on investment performance. The Royal Mail is going ahead with introducing this kind of pension. I will be keeping a close eye on it, and there may be another blog post in the future.
Get your binoculars out
I hope this blog inspires you to turn the binoculars on your own pensions and find out what species you have. Remember, the more you know, the better the decisions you’ll make about your future.
Coming soon … what am I going to do with my pensions?
#PensionAdventure #LoveYourPension