In a world where pensions and their associated policies and paperwork can be very confusing, I answer some questions that everyone thinking of investing in a defined benefit scheme asks. Questions such as how do they work, how are they calculated and what are the benefits are often those that get posed to me from day 1 so this article tends to some of these queries.
Defined contribution (often abbreviated to DC) pension plans are set up by employers on behalf of employees. There are four key elements to them. Both you and your employer contribute a set percentage from your pay. You can then add to this with voluntary contributions. If the employer matches your voluntary contributions, you will be encouraged to save more.
With DC pensions, you have the power and the responsibility for the investment of the contributions. This is tremendously appealing to those who dislike the old methodology of being powerless to have any say in where their own savings were being invested. However, it does mean that the return on the investment has to be tracked and monitored, and this requires time and attention to make sure the savings are growing. They do not provide a guaranteed income in your retirement.
Depending on how risk-tolerant or how risk-averse you are, you must choose accordingly. It is important to take into account just how close you are to retiring. A single fund portfolio can just be left to run by itself. The important thing to realise about DC is that you, the worker, carry the investment risk. When you retire you can take the lump sun and use it to buy an annuity.
If you work for a multinational company, you are most likely to be asked to contribute to a DC pension scheme. A recent survey of 114 multinational groups found that 97 per cent of them believed in offering them as the main form of retirement provision. 93 per cent felt it added to their reputation as a caring employer who valued their staff. There is a big switch away from the previous model of defined benefit (DB) pensions, which were being closed down by 83% of the respondents. They no longer offered them to new employees.
Farewell to Defined Benefit
It is felt that employees value the flexibility of managing their own savings, and this is why 71 per cent of companies have frozen the old DB schemes and are encouraging the DC model.
Defined contribution is definitely a better way forward than the old defined benefit, which was crippling some institutions and services with its high liabilities and threat to balance sheets. It had become unmanageable. A better way had to be found, and defined contribution, along with increased education and empowerment, is seen as a vital sign of progress in the treatment of workers. It has been called the “new paternalism” and employers accept that loyalty is vital to success so they need to implement effective reward strategies. The employers had to find a model where the risks and the costs to them were sustainable, and where the benefits to their employees were protected. DC pension schemes do offer both those attributes.
Taking Personal Responsibility
Some will be alarmed by the prospect of having to be responsible for their own savings, but all big companies will offer advice, guidance and more often than not an in-house financial manager who will assist. In the case of single funds, they will set them up and leave them to tick over. It takes the worker from a passive to an active role and one where their own choice takes precedence. The matching of contributions is also a great incentive to save.
Choosing a pension is an important decision and employees can often be subjected to a barrage of information that is difficult to digest. My latest article aims to identify and clarify the defined benefits which should help you to choose the pension that is right for you.
Defined benefit negates the need to buy annuity and and guarantees you a level of income that relates directly to the amount of salary you received at point of retirement. The scheme works on an accrual basis meaning that the amount of years you pay into your pension is translated into the fraction of your final salary that you will be entitled to in retirement.
Company pension schemes are an inevitability for the majority. Many will realise that having less of a wage at the end of each month is grossly outweighed by having a comfortable life in later years with contributions that are matched by an employer. Those who don’t realise this are probably unaware that by contributing to a pension, they are in-effect giving themselves a pay rise.
Concerns over decreasing pension pots are ever present for many workers up and down the country. And more so now than ever as public-sector staff see their financial prospects squeezed and private-sector employees suffer with very low saving rates.
But all is not lost. Careful planning and early consideration of all the factors involved can bring the retirement of your dreams back into reach.
How Much Should You Save?
There is no avoiding it: even though rates are less than helpful to savers in the current economic climate, putting money to one side is still the foundation of a successful retirement plan. Work-based pensions, although highly advised, might not be enough to provide real financial peace of mind and as such personal savings come into play.
Knowing your retirement needs can really help organise your monetary goals, in addition to keeping you on track when you are tempted to dip into savings. This last point is essential: if you withdraw retirement savings of any type before the appropriate time, you will lose any interest accrued in addition to missing out on potential tax benefits.
Research suggests that maintaining your pre-retirement standard of living after you finish work will require a minimum of 70% of your usual income, and therefore the more you save, the easier life will be.
Understanding Your Pension Plan
Government guidelines are working towards a world of work in which all employees benefit from a new type of pension plan. The legislation demands that when employees pay into their pension, their employers do too, and is intended to protect what will be an increasingly ageing population.
However, not all businesses are required to follow the initiative and the many work-based pension types and plans available mean that if you are approaching retirement, knowing exactly what you are paying into is absolutely essential. It is vital that anyone with savings linked to a work-based pension investigates details such as the cost of contributions, the amount you are entitled to claim and the potential for tax rebates.
And for those not involved in a workplace pension scheme, seeking independent advice about the options available is advisable.
Not Just the Money
The financial aspect of retirement is important and planning for it must not be ignored. But in addition to economic decisions, the emotional impact of retirement must be considered too.
The huge shift in routine from working every day during the week to a life of leisure can be quite jarring for many. Therefore planning for the transition could include a phased retirement plan coupled with a creation of new interests to fill the days when your working life comes to an end.
Preparing both financially and emotionally for the time ahead can provide you with what you want, what you deserve and what you’ve worked towards: a healthy and happy retirement.
Defined benefit pensions are often referred to as the gold standard of pensions schemes and offer a very traditional solution in the investments industry. From April 2015, employees will be able to transfer from defined benefit schemes to the more modern and more widespread defined contribution schemes.