FAQs

A pension scheme is a long term saving plan designed with the intention of building up, over an individual's working life, a fund that is expected to be sufficient to provide a flow of income from the date of retirement and continuing for the rest of the individual's life. Pension fund savings can be distinguished from other saving vehicles in that contributions to pension schemes normally enjoy full tax relief, and withdrawals from pension funds are not permitted until age 50, at the earliest.

When setting up pension scheme arrangements it is important to consider the level of income you require during retirement and the pension scheme vehicles that are available to you (employer's DB or DC scheme, personal pension, stakeholder).

Opportunities to join DB schemes are becoming fewer, but where that is an option it should be seriously considered. An indication of the level of retirement benefit that can be expected from a DB scheme is a function of the expected number of years membership in the scheme and the salary (usually the average salary during the year or so before retirement) on which the benefit will be based. Pension scheme contributions are normally expressed as a percentage of annual earnings. Where estimated benefits are lower than what you would wish, your employer's DB scheme may allow you to pay additional contributions in exchange for which you will be credited with added years scheme membership or, alternatively, additional contributions might be payable into a complementary AVC (additional voluntary contributions) arrangement. The latter operates as a money purchase arrangement.

Retirement benefits provided by DC schemes, personal pensions and stakeholder pensions are not salary-related but are dependant on the value of the accumulated fund at retirement and the retirement income that an annuity (purchased with the pension fund - after any lump sum has been taken out) provides. To estimate the level of retirement benefits that can be expected it is necessary to project the expected value of the pension fund at retirement date (by making assumptions about retirement date and investment returns over your working life), and the income stream that an annuity (purchased with the fund - less any lump sum taken) will provide.

By defining expectations on retirement income and making assumptions on retirement age (and, therefore, the length of the period over which contributions into the pension scheme will be made) and investment returns, it is possible to calculate the level of contributions that are likely to be needed to generate the target pension. It then becomes a decision on the extent to which you can meet the suggested contribution level out of your current income.

When setting up pension scheme arrangements, it is important to have regard to the applicable taxation regimes. Almost all pension schemes enjoy a number of tax breaks. Contributions enjoy full tax relief provided they do not exceed a certain percentage of annual income. Pension schemes do not pay tax on interest or capital gains. Pensions are taxed as personal income in the hands of the individual - though, a proportion of the fund (often up to 25%) can be taken out of the fund free of tax upon retirement.

Having defined an overall pension strategy - type of pension scheme vehicle, expected retirement benefits and contribution level - it is necessary to consider prospective pension vehicle providers and their costs and, for money purchase type arrangements, the investment risk and asset allocation appropriate both now and at various stages throughout your working life.

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The current tax regime limits DB scheme retirement benefits to two-thirds of final salary.

A pension of two-thirds final salary is commonly offered by occupational DB schemes (normally upon completion of 40 years membership), in addition to a lump sum. However, the number of members that accrue maximum scheme membership and enjoy full pension is relatively low.

A criticism of DB schemes is that members who leave early (upon changing jobs) lose out. If they become deferred members, their pension will be based on the salary level at the time they leave the scheme (albeit adjusted for inflation over the period between leaving the scheme and reaching retirement age) and on the number of years of membership (ie, not the full 40 years). If they take a transfer value into a DB scheme of their new employer, the number of years membership is likely to be discounted by the new employer (eliminating the possibility of achieving maximum scheme membership and pension).

The level of pensions produced by money purchase arrangements is dependant on contributions made throughout the working life, management costs, investment returns and annuity rates at the time an annuity is purchased (currently annuities can be purchased between the ages of 50 and 75).

Illustrative figures published by the FSA suggest that contributions to a money purchase scheme at the rate of some 15% of annual income throughout a working life, from the early 20s to, say, 60 - and making assumptions on returns (7%pa) and costs (1%pa) - could, at best, generate a pension of some 50% of final salary. But delay starting pension contributions to your mid thirties, and the contribution rate necessary to achieve some 50% of final salary doubles to nearly 30% of annual income. Alternatively, starting contributions at 15% of annual income in your mid 30s is likely to generate a pension of some 25% of final salary.

The key message is the importance of appreciating the relationship between the level of contributions, the period of time over which contributions are made (as well as investment risk, return and costs); and the pension that might result? and to start saving as early as possible.

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It is sensible to review your pension arrangements from time to time.

An approach is to start with a target retirement income and work backwards, taking into account the pension interests you have already accrued. You will then be in a position to estimate the level of contributions (and identify the pension scheme vehicle) appropriate to you to bridge any gap between estimated pension benefits and your retirement income expectations.

As regards the retirement benefit value of pension fund interests already accrued, for interests in DB schemes the scheme administrator will be able to provide an estimate by reference to the scheme rules; for money purchase arrangements it is necessary to make assumptions about future investment returns, management costs, and annuity rates.

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With-profits products have been the subject of recent criticism and concern. The Sandler review of the investment industry and savings products, published in July 2002, highlighted a number of issues regarding with-profits products.

They are offered by insurance companies and are invested in a range of investment sectors - equities, bonds, cash and property - normally through unit funds. A key feature is a smoothing mechanism that has the effect of producing an investment return that is seemingly protected from the volatility of the underlying markets. In periods of high investment returns, a proportion of the return is held back by the provider as a reserve against periods when investment returns are lower. Investment returns credited to policies become an obligation on the provider, irrespective of future investment performance.

Policies are sold on the strength of the smoothing mechanism. However, it is the opaqueness of the policies - arising from the smoothing mechanism - that has given rise to most concern.

Critics, including Sandler, are calling for transparency, so that investors and prospective investors can assess the performance of the underlying investment portfolios at reasonable intervals (rather than just at maturity), can understand the effect that the smoothing operation is having on performance, and any cross subsidy between leavers, ongoing investors and the provider's shareholders, and the ability of the provider to honour the returns credited to policies.

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Over the last twenty years pensions policy has gradually moved up the government and public's agenda as events (personal pension mis-selling, Maxwell), changing life-styles (preference for early retirement), increasing longevity, investment market volatility and low savings have conspired to underpin the view that all was not well with pensions.

The Sandler and Pickering reviews were set up in 2001 to review, respectively, (a) the retail savings industry and how well consumers were served, and (b) how good quality pension provision can be secured in the future. Their reports were published in July 2002.

They recommended that the number of pension scheme regimes be reduced, regulations and taxation be simplified, a range of simple regulated savings products be developed (along the lines of stakeholder pensions), greater transparency in respect of costs and commission, more independence in respect of financial advisers, improved education of consumers regarding financial products and improved information flows to pension scheme members. Importantly, Sandler raised the question whether there should be an element of compulsion regarding private pensions.

In the main, the recommendations were well received, though concern was raised by the government and employees' representatives in respect of Pickering's proposal to relax the requirement for occupational pension schemes to index pensions and provide widows' pensions as well as a proposal to reduce the accrual rate.

A pensions bill was published in February 2004. This includes provision for a new Pensions Regulator (to absorb the powers of OPRA, but with a more proactive approach), a Pension Protection Fund, replacement of the Minimum Funding Requirement with a requirement for schemes to set up their own Statement of Funding Principles, reduction of the indexation of pensions from 5%pa to 2.5%pa. and provision for improved information and advice on pensions (including combined state and private pension forecasts).

The government has recognized there is a need for consumers to have a suitable choice of products, and promised more consultation on this. It has also set up a group to review whether the current voluntary regime is working sufficiently well.

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If property is to be a part of a long term savings plan, it is important to take advice. Consideration should be given to taxation and bringing the property within a pension scheme vehicle.

Key issues for any long term savings plan must include diversification, liquidity and marketability of the investments held.

Diversification addresses the risk factors inherent in each class of investment. It is sensible to spread exposure to risk to manage the impact that an under performance in a particular investment class might have on the overall investment portfolio. A portfolio comprising only property would lack diversification.

Liquidity addresses the extent to which an investment holding can be realized. Cash is the most liquid asset, whereas investments in unregulated markets (eg fine art) tend to be the least liquid. Property is not particularly liquid.

Marketability addresses the extent to which an investment holding can be traded - in whole or part. It might be difficult to adjust weighting in a portfolio where a marginal change to a sector holding is not possible.

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There are currently eight pension scheme regimes. The government has announced a simplified taxation regime (Finance Bill 2004) which will come into force on 6 April 2006 .

On the current regimes, advice should be obtained on whether the proposed schemes are compatible with each other in terms of a retirement savings plan and taxation. Certain regimes cannot work together and there are limits on the level of contributions that are permitted in any one year.

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A SIPP is a self invested personal pension. SIPPs operate under the personal pension tax regime (ie in terms of level of contributions and timing of benefits) but with the difference that fund management is under the control of the individual or someone appointed by her/him. A SIPP is able to invest in a wider range of assets than a personal pension.

SIPPs are set up by insurance companies, who may provide administration services.

SIPPs are appropriate for those who have already built up a significant pension fund. Some £25,000/£50,000 is needed to set up a SIPP - in view of the administration and transaction costs involved.

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A State Pension Offset is used by occupational pension schemes that seek to integrate scheme benefits and the state pension.

A pension scheme's objectives and rules might provide that a member's aggregate pension - occupational pension plus basic state pension - shall be, say, 1/60 th for each year of scheme membership and that the pension payable by the scheme shall be the pension calculated by the 1/60 th rule less the basic state pension. The deduction is termed the State Pension Offset, and it is generally made whether or not the scheme member's NI record entitles her/him to a full basic state pension.

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Occupational pension schemes are normally formed under a Trust Deed and operate under scheme rules. If pension schemes and their members are to benefit from available tax breaks, schemes must also comply with regulations set down in tax legislation.

Scheme trustees are able to change scheme rules provided they act within trust law, the pension scheme tax regime and the scheme trust deed and rules.

From time to time the question whether or not pension scheme trustees have acted lawfully in a particular set of circumstances is tested in the courts.

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The answer to this question lies partly in comparative public spending priorities on the part of governments, but also in the fact that the UK , despite current problems, still has one of the most highly developed systems of non-state pensions in the EU.

The UK currently spends less than most other countries on state pensions - under 5% of GDP. This compares with Netherlands, Denmark, Sweden and Spain - 5-10% of GDP and Germany, France and Italy - over 10% of GDP.

The UK's average state pension (basic plus second) represents about 30% of national average earnings. This compares to Netherlands and Denmark - 45-50% of NAE, Sweden - 50% NAE, Spain - 65% NAE and Germany, France and Italy - 70-75% NAE.

A number of countries that have a more generous state pension provision are currently seeking to reform their unfunded state arrangements. These include Denmark, Sweden and Italy. Restructuring, by promoting private funding, is a long term objective in France and Germany.

The UK's basic state pension became indexed to the growth in earnings in 1975. However, the link was switched to the consumer price index in 1980. Accordingly, the adequacy of the UK state pension is set to get worse over time.

It is UK government policy not to change the basic state pension provision arrangements, but to focus additional means-tested state help on low income groups and, otherwise, to promote private pensions.

The UK is considerably advanced in terms of the level of private funded pension provision.

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In recent surveys pension scheme trustees report that Socially Responsible Investment (SRI) is expected to have a positive impact on the market value of quoted companies over the next 5 - 10 years. The change in the practices of companies is in part due to the activism of the pension fund investment industry.

However, there are concerns over the costs investors incur in implementing SRI policies and the quality of the techniques that are available to their investment managers. Many listed companies could improve the information they make available on progress against the markets' SRI objectives.

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Pension scheme trustees consider the overall funding plan of a scheme. This comprises the contributions base, scheme net assets and benefits in payment and promised.

From this will arise an asset allocation plan for the scheme's net assets which on the one hand takes account of the scheme's investment return target and risk appetite; and on the other hand takes account of the pension liabilities and when they will arise - seeking to match scheme assets to scheme liabilities.

In respect of scheme liabilities arising over the short term, the trustees will place emphasis on ensuring that assets will be available to meet them (this suggests holdings in cash and short term bonds); and in respect of liabilities that are more distant - say 20/25 years into the future - the trustees will place more emphasis on maximizing investment return (suggesting holdings in a range of equity-based investments).

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Reviews of pension arrangements undertaken in 2001/2002, arising from concern about the extent to which there was a general under provision for pensions, included a number of recommendations calling for clarity, transparency and simplification of pensions. A green paper issued by the DWP in December 2002 set out proposals to replace the existing eight pension scheme regimes with one universal framework. The finance bill 2004 includes provisions to give effect to the new framework.

Under the existing regimes tax benefits enjoyed by approved pension schemes were dependant on compliance with a range of Revenue limits. The main limits were in respect of the level of members' contributions, tax free lump sums payable upon retirement, the age from which benefits became payable, and - in respect of DB schemes - the level of pensions payable and scheme funding.

The new regime sweeps away these historic limits, and replaces them with a lifetime allowance (2006/07 £1.5m) - in respect of the size of an individual's pension fund - and an annual allowance (2006/07 £215,000) - in respect of the increase in an individual's pension fund interest each year. Allowances through to 2010 have been announced, and will be reviewed thereafter at intervals not exceeding five years.

The new regime comes into force on 6 April 2006 . This has been called A-day. Existing pension fund interests of individuals as at 6 April 2006 will be established, and interests exceeding £1.5m will be protected.

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An annuity is an arrangement whereby, in exchange for a one off non-returnable payment from an annuitant, a finance company (normally an insurance company) undertakes to make regular payments to the annuitant, usually for the rest of her/his life.

The total amount that the annuitant will receive over the period the arrangement lasts will depend upon how long she or he lives. This is the risk element that the finance company must bear. Funds received are pooled by the company in financial instruments (mainly bonds, equities and property) to generate the returns necessary to meet the annuity payments promised. The company manages this risk by calculating annuity rates on the basis that some people will live longer than others, and on projected financial returns, including interest rates.

A range of annuity rates are generally on offer, taking account of life expectancy. Some provide for payments to be increased (by, say, 5% pa or by reference to RPI), and/or to provide for payments to a surviving partner after the death of the annuitant.

Money purchase pensions build up a fund of assets during an individual's working life. At retirement a proportion of the fund can be used to pay a tax free lump sum. The balance must be used, by age 75 at the latest, to purchase a regular stream of retirement income by means of an annuity.

Regarding the compulsion to purchase an annuity with funds accumulated in a money purchase pension scheme, the government's logic is that (i) sums accumulated within the pension scheme have benefited from tax relief which has been given to encourage individuals to provide for themselves in old age, and for no other purpose, and that (ii) an annuity is currently the only financial product that provides a guaranteed pension for life.

The government has recognized that the market for annuities could work better and that consumers could be better informed. It has announced that it is working with the Financial Services Authority and providers to ensure that people are able to make the right choices at the right time.

Past tax rules about when annuities must be purchased have been even less flexible than they are now. Originally annuities had to be purchased upon retirement (after allowing for the tax free lump sum). From 1979 small self administered pension schemes were able to postpone the purchase of an annuity for up to five years after retirement. Since 1995, persons with personal pension funds have been able to delay the purchase of an annuity until age 75, provided that in the meantime they draw a minimum income from the fund.

Many argue that the obligation to purchase an annuity should be further relaxed. A private members bill laid before parliament in January 2004 provided that an annuity need only be purchased to the extent that it provided income sufficient to ensure the recipient did not fall back on the state at any time in retirement. Subject to meeting this requirement, the individual would have freedom with regard to how the accumulated fund was applied. The bill did not have the support of government, and was subsequently withdrawn.

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The minimum funding requirement (MFR) was introduced by the Pensions Act 1995 and became effective from 6 April 1997 . It was a response to the Maxwell affair and was intended to help improve security for members of defined benefit occupational pension schemes.

Scheme trustees are required to operate pension schemes so that scheme liabilities are 100% funded by scheme assets. Thus, if an employer became insolvent, pensions already in payment would be funded in full, and younger members would receive a transfer value that would enable them to replicate scheme benefits if they transferred to another scheme.

If a scheme's funding falls below 100%, trustees must - within certain time limits - put in place measures to restore 100% funding.

MFR reviews are required to be carried out by scheme actuaries, in accordance with published regulations, at intervals not greater than three years.

The statutory MFR valuation method discounts pensions in payment by reference to fixed interest and index linked bond yields. In some cases this has encouraged scheme trustees to pay too much regard to short term bond markets, rather than focusing on long term funding and has caused them to reduce equity weightings in favour of bonds when they would not otherwise have done so. The extra demand on the bond market has - it has been argued - depressed market yields.

In the light of these concerns, a review of the MFR was initiated by the government in 1999 leading to an announcement in March 2001 that the MFR would be replaced by scheme-specific funding standards. Periodic reviews would continue, but they would focus on scheme trustees' specific funding strategies and the extent to which they could be expected to deliver the pensions promised.

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An actuary provides financial and prudential advice on the management of assets and liabilities, particularly where long term management and planning are critical factors.

This involves using statistical and mathematical methods to analyse the past, identify and measure risks, and model the future.

These skills are used extensively in the insurance, pensions and investment industries.

Actuaries have a statutory role in the supervision of pension funds and life insurance companies.

As regards funded pension schemes, in carrying out a valuation an actuary estimates the scheme's total

• liabilities (pensions and lump sums payable in the future) drawing upon known information about the scheme membership (eg number of years service, age profile) and scheme benefit rules (lump sums, pensions, survivor pensions), making assumptions about factors that will affect the level and duration of future liabilities (eg salary levels, inflation, longevity of members and, as appropriate, their spouses), and
• assets, taking into account the assets currently held by the scheme, future investment returns and scheme contributions.

The actuary will then draw conclusions, on the basis of the calculations and estimates, regarding the extent to which the scheme is funded (ie the extent to which liabilities are covered by assets).

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Defined benefit occupational pension schemes are, in the main, set up by employer companies under a deed of trust. Such schemes have a legal identity separate from the sponsoring employer company. The schemes are managed and administered by trustees. One or more trustees are likely to be nominated by the sponsoring employer. But other trustees will be nominated by employees.

In most cases pension scheme trust deeds and rules provide that the employer company will financially underwrite the scheme. In some instances this liability is shared with the employees. For example, an employer may undertake to contribute up to, say, 60% of the pension scheme costs with the employees contributing the balance.

FRS17 (introduced in 2002), and its predecessor standard SSAP24, apply to companies that have a commitment to underwrite their pension schemes. The objective of the standard is to disclose in the employer company accounts the full extent of the employer's pension scheme costs.

SSAP24 was primarily concerned with reporting annual pension costs through employer P&L accounts. Changes to costs (e.g. an increase in benefits) could be spread forward over the balance of the working lives of employees - smoothing the employer's P&L charge.

FRS17 focuses on the balance sheet presentation. An asset is recognized in the employer company balance sheet if a scheme is in surplus (to the extent that the employer can benefit from the surplus), and a liability if a scheme is in deficit (to the extent that the deficit must be made good by the employer). The analysis of the change in the balance sheet values is reported through the employer company's P&L and STRGL when they occur - there is no provision to spread additional costs over future years.

There are concerns that FRS17 might influence pension scheme trustees' investment strategies to the detriment of the long term prospects of schemes and costs (because the accounting standard discounts pension liabilities by reference to corporate bond yields whereas schemes' assets tend to include exposure to equities) and deter employers from sponsoring defined benefit arrangements altogether (in view of the possible volatility of reported costs from year to year). The issue behind these concerns is that employer company financial statements are reporting on periods of one year, whereas the period over which a pension scheme's liabilities materialise can extend to half a century and more.

Whatever the views are on these concerns, the legal separation of pension scheme trusts, on the one hand, and employer companies, on the other, is unchanged. The objective of FRS17 is for employer companies to report their pension costs and liabilities on a year by year basis. Pension scheme members can satisfy themselves on the effectiveness of this process by making a point of reviewing the accounts of their pension scheme and the associated FRS17 disclosures in the accounts of the sponsoring employer company.

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During the course of the year an employer company will account for pension contributions liabilities as they arise. Liabilities will be settled by the due dates - normally by a cash payment to the pension scheme.

In addition FRS17 requires that at the start of each year the employer company estimates the amount by which the discounted pension scheme liabilities will increase over the year by reason of the additional year's service of the pension scheme members. This figure is known as the current service cost . Also, if changes to benefit entitlements have been agreed in respect of the past service of scheme members (e.g. to use part or all of a surplus), the amount by which the discounted scheme liabilities will increase by reason of the benefits change is estimated. This figure is known as the past service cost.

(1) Current service cost (which is inclusive of pension contributions actually falling due for payment in the year) and (2) past service cost are debits to operating profit in the P&L.

The employer company must also estimate at the start of the year the expected return on the pension scheme's assets for the year; and calculate the amount by which the net present value of pension scheme liabilities will increase during the year as a result of the discounted period being one year less. The latter figure is called interest cost.

(3) Expected return on pension scheme assets is a credit and (4) interest cost is a debit to P&L (finance charges).

Since figures (1) to (4) are estimated in advance, they are available to be included in an employer company's budget process.

Differences between the estimated and actual return on assets are posted to the employer's STRGL. Where actual return is greater than the estimate, the difference (5) is credited to the STRGL.

Discounted pension scheme liabilities as at the end of the year are also likely to be different from the figure used to calculate the current and past service costs. Differences might arise due to a more up to date actuarial valuation becoming available and/or a change in the assumptions (eg financial, demographic) underlying the liabilities. Where there is an increase in the year end liabilities, the difference (6) is debited to the employer's STRGL.

The balance sheet shows the current pension scheme surplus or deficiency (i.e. the difference between the valuation of the pension scheme assets and the net present value of the scheme liabilities). The postings (1) - (6) above explain the movement in the balance sheet figure from one year end to the next.

Scheme surpluses can be adjusted to take account of any tax liability that would arise if the pension scheme made a payment to the employer company. The potential tax liability is also reported in the employer's STRGL.

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In addition to notes to explain the account entries, outlined in the response to the question "what is the basic level of double entry P&L to balance sheet in respect of pension costs?" (see above), the following disclosures must be included in the notes to the employer company's financial statements:

1. That the scheme is a defined benefits scheme.
2. Date of the most recent full actuarial valuation on which the amounts in the financial statements are based. If the actuary is an officer or employee of the reporting company, this should be disclosed.
3. Contributions made in the period, and any contribution rates that have been agreed for future years.
4. Assumptions used by the actuary at the start of the year and end of the year (balance sheet date) in respect of,
   Inflation
   Salary increases
   Rate of increase in pensions in payment/deferred
   Rate used to discount scheme liabilities
5. Valuation of scheme assets (by class), and expected long term rates of returns - at start and end of year.
   Asset classes are bonds, equities, other (sub analysed, if material).
6. Total market valuation of assets and actuarial valuation of liabilities of the scheme, and the resulting surplus/deficit.
   Explanation of difference (if any) between the scheme's surplus/deficit and the surplus/deficit shown on company balance sheet.
   Analysis of the movement in the scheme surplus/deficit over the year.
7. Five year history of the figures reported through the STRGL - as actual amounts and also expressed as a percentage of the scheme's assets or liabilities at the balance sheet date. (There is no need to back track, but to build up to a rolling five year history)

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The Pensions Bill 2004 establishes the Pension Protection Fund (PPF).

The objective of the fund is to protect members of private sector defined benefit pension schemes whose sponsoring employer companies become insolvent with insufficient funds in the pension scheme. In these cases the PPF will pay to the members all or most of the benefits they were expecting.

The PPF is, therefore, an insurance scheme.

The PPF will be a separately funded entity run by the PPF board. The chairman will be appointed by the Secretary of State. It will be funded by (1) an annual levy on all private sector defined benefit pension schemes and (2) the pension assets of schemes where the employer company is insolvent. The PPF may also borrow on the markets on a short term basis. The PPF will appoint independent fund managers.

Up to 50% of the PPF levy will be calculated on risk-based factors such as the level of pension scheme funding, investment strategy and the employer company's credit rating. The balance of the levy will be based on the number of members, deferred members and pensioners.

The UK pension industry has raised concern about the additional costs that the levy will impose, and that well run schemes will effectively subsidise the others. The government's response is that the risk-based element of the levy will reduce cross-subsidy.

As regards the nature of the levy, employer representatives have referred to it as another tax. Some have also called for the levy to be borne directly by employees.

On the viability of the overall funding of the PPF, there is concern that the ongoing cost of protection will be underestimated. The UK government has stated that it will not be guarantor to the PPF. Commentators point to the US version which has been running for nearly 30 years and which is currently under-funded (in 2003 its assets represented some 76% of liabilities).

The PPF provisions are currently being debated by Parliament. The government hopes that the fund will be operational in 2005.