Private pensions have developed partly because of the low level of pension provision offered by the state. Many recognised that upon retirement, the state pension, and soon to be “new state pension” does not provide sufficient to live on.
Lots of employers now offer an occupational pension scheme. This is set up directly by the work place for the benefit of their employees. Alternatively, those who are self employed or who chose to contract out of a scheme offered by their employer, may set up an individual personal pension scheme.
Types of benefit provision
Private pension schemes can also be described by the type of benefits they provide to their members. There are two basic types:
A defined contribution scheme (sometimes known as a money purchase scheme).
Personal pension schemes are always defined contribution schemes, but occupational pension schemes can either be defined benefit or defined contribution schemes. Sometimes they are a hybrid of both.
Defined benefit schemes
Under this scheme, the benefit the member will eventually receive is fixed at the start, when the member enters into the pension contribution arrangement. The most common type is a final salary scheme. In a final salary scheme, the member’s pension is calculated as a percentage of their salary for each year of service. Alternatively, the scheme could also provide a pension based on the average salary of the member over their working life.
Defined Contribution Schemes
Under these schemes, the final benefits or payments are not known until retirement. A specified or defined level of contributions are payable into the scheme from the employer and quite often, the employee. When a member/employer makes contributions, they are invested and a record is kept of each member’s investments. Upon retirement, the total of the contributions paid and the investment returned on those contributions is calculated and often used to purchase an annuity. An annuity is a product which provides an income stream from that member’s pension pot. The income therefore depends entirely on the amount the member has paid in and how well the investment has performed. Naturally, there is more risk in a defined contribution scheme.
It is vitally important to understand the value of a pension as divorce law allows pensions to be shared upon divorce.