Employee Benefits - Issues for Defined Contribution

Defined Contribution Pension Schemes account for over 6 in 10 members of pension schemes in the Private Sector, with the figure growing year on year.  This reflects the growing demise of Defined Benefit Pension Schemes in this employment sector as the costs and complexities of such arrangements continue to impact on sponsoring employers.

With more and more Defined Benefit schemes closed or closing, employers have embraced Defined Contribution pension plans as the most appropriate way of providing their employees with pension benefits at a cost which is able to be accurately predicted and budgeted for.

What does Defined Contribution mean?

In a Defined Contribution scheme the rate of contributions from the employer and/or the employee is set, either as a percentage of salary or as a monetary amount. While this may change from one payment to the next, and be different for different members, it is always the payment which is fixed as opposed to the final amount of pension.

The final benefit payable from a Defined Contribution scheme will depend on a number of factors, including; the amount of contributions paid in, the investment returns and the age at which benefits are taken. (For further details on the available options at the time of taking benefits please see our section on Retirement Options).

The majority of these influencing factors are able to be controlled either fully or partially by the plan holder rather than the employer or, in the case of Defined Benefit schemes, the Trustees, and so it is imperative that the pension saver knows the options available to them and the decisions they should take during the period of their pension plan membership.

How long have Defined Contribution pensions been in existence?

The plans have been around for many years, initially as a way for the self employed and employees not in a company pension (or those wanting to pay Additional Voluntary Contributions) to save in a pension.

Personal Pensions were introduced by the government in 1988 and since that date have grown in popularity as either replacements to the older plans used by the self employed or to Occupational Pension schemes used by employers, to such an extent that over half of all people saving in a pension scheme now do so through a Defined Contribution scheme.

Does this mean that over half of people have a Personal Pension?

Personal Pensions are just one of many different types of Defined Contribution scheme and so not everyone with Defined Contribution savings has a Personal Pension plan.

Generally there are two forms of Defined Contribution plan: Occupational schemes and Contract based schemes like Personal Pensions.  Occupational schemes are operated by some employers and as with Defined Benefit schemes must have a board of Trustees in place to run the scheme in line with the Trust Deed and Rules.  With the high level of management time this can take, and the amount of legislative change that continues to affect such schemes, the number of Occupational Defined Contribution schemes continues to fall in much the same way as the number of ongoing Defined Benefit schemes.

However, for some companies, an Occupational Defined Contribution scheme is the perfect way of providing pension benefits for their staff, given either their size and philosophy or their particular employee demographics and so this market will continue into the future, and may even see a renaissance (see What is the Future for Defined Contribution).

Within the Contract based arena there are many different alternatives ranging from Retirement Annuity Contracts (which are no longer sold but are still held by some people), to Personal Pensions and Stakeholder Pensions and through to fairly complex policies such as Self Invested Personal Pensions.

Each of these can be operated as either an individual policy that the individual pension saver pays into (or someone does on their behalf, e.g. their employer) or can be operated as a ‘Grouped Arrangement’.  In this case an employer may offer such plans to all of their staff and for the purposes of contribution payment and administration all plans are grouped together although each employee still retains their own identity and individuality with regard to plan ownership.

How are payments into Defined Contribution schemes made and invested?

Under a group scheme, payments are made by the employer to the insurer without any interaction from the employee, except to set the level of any personal contribution and the funds into which the payment is invested.

Under a contract based scheme, basic rate tax relief is added automatically. Higher rate tax payers can simply claim their extra tax relief through their self assessment tax return. With Occupational schemes the payroll deduction process provides full relief.  Note that members may be able to pay their contributions through Salary Exchange which then means no tax relief claim is necessary. (see Salary Exchange for further information).

Under an individual or personal arrangement, and in the case of group members wishing to make ad hoc additional payments, contributions are typically made by Direct Debit payment or Cheque.

Once the payments are received by the pension provider, they are invested in line with the member’s instructions.  With most providers now offering a multitude of funds within their policies the process of fund selection can in itself be confusing and as such it is always something on which Independent Financial Advice should be sought.

Under a group scheme it may well be that the scheme has a default investment option but it should always be checked that such investment is appropriate to the risk profile of the investor before being selected.

Once invested, the pension provider usually deducts a regular management charge from the policy for the coverage of costs associated to the investment and plan management, with the base level of such charge typically being between 0.4% and 1.0% of the funds held on an annual basis, although exceptions apply especially within Self Invested Personal Pensions.

What is the Future for Defined Contribution?

The Defined Contribution market is about to go through it’s most radical overhaul with the introduction from October 2012 of Auto Enrolment and the National Employment Savings Trust.

With employers being compelled to put all qualifying employees into a pension scheme, the existing Defined Contribution market is set for significant expansion and change.

Employer’s will need to ensure that they have the right pensions plans in place for their staff prior to their ‘staging date’, and this could mean having different types of plan for different employees.  It might be appropriate to continue with an existing Contract based scheme for some staff, for others it might be best to put in place a new Occupational scheme while for a third set of employees the National Employment Savings Trust may be the best alternative.

With the clock ticking on this topic it is imperative that all employers act now to set their pension strategy for now and the future. More details can be found in our Auto Enrolment section within this site.