Pensions and retirement planning

R04 Study text: 2016 –17

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Updates and amendments to this study text

This edition is based on the 2016/17 tax year and examination syllabus which will be examined from 1 September 2016 until 31 August 2017.

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© The Chartered Insurance Institute 2016

All rights reserved. Material published in this study text is copyright and may not be reproduced in whole or in part including photocopying or recording, for any purpose without the written permission of the copyright holder. Such written permission must also be obtained before any part of this publication is stored in a retrieval system of any nature. This study text is supplied for study by the original purchaser of the book only and must not be sold, lent, hired or given to anyone else.

Every attempt has been made to ensure the accuracy of this study text, however no liability can be accepted for any loss incurred in any way whatsoever by any person relying solely on the information contained within it. The study text has been produced solely for the purpose of exam preparation and should not be taken as definitive of the legal position. Specific advice should always be obtained before undertaking any investments.

Print edition ISBN: 978 0 85713 994 8

Electronic edition ISBN: 978 0 85713 995 5

This revised and updated edition printed in 2016

The authors

Helen Savage BSc (Hons), MSFA started in financial services in 1988 after university. She initially worked for Provident Mutual as an actuarial trainee and then in 1996 she joined Canada Life as a technical trainer, moving on to NPI, as a pensions trainer. Helen became self-employed in 2000 and works predominately as a technical author writing and updating text books and CPD material, mainly in the area of pensions.

Helen was responsible for chapters 1, 2, 4 and 5 and acted as reviewer for the remaining chapters written by Maria.

Maria Shortland FPFS has worked in financial services for over 20 years. She started as a sales consultant with Scottish Equitable in 1989 and moved into training when she joined NPI in 1998. She is now self-employed and specialises in producing a variety of material for the purposes of CPD and exam preparation in the areas of pensions, tax, later life planning and financial planning.

Maria wrote chapters 3, 6, 7 and 8 and acted as reviewer for the remaining chapters written by Helen.

Acknowledgement

The CII thanks the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) for their kind permission to draw on material that is available from the FCA website: www.the-fca.org.uk (where the FCA Handbook is available: www.handbook.fca.org.uk/handbook) and the PRA Rulebook site: www.prarulebook.co.uk and to include extracts where appropriate. Where extracts appear, they do so without amendment. The FCA and PRA hold the copyright for all such material. Use of FCA or PRA material does not indicate any endorsement by the FCA or PRA of this publication, or the material or views contained within it.

Typesetting, page make-up and editorial services CII Learning Solutions.

Using this study text

Welcome to the R04: Pensions and retirement planning. The aims of the examination syllabus are that students should be able to demonstrate an understanding of and ability to analyse:

- main tax and legal frameworks that govern retirement benefits under registered pension schemes;

- features of defined contribution and defined benefit pensions;

- State retirement benefits available, including the risks and suitability of contracting out of the State Second Pension.

The study text follows the order of the examination syllabus learning outcomes. Each chapter has specific learning objectives and the syllabus learning outcomes being covered are listed on the individual chapter title pages.

Contained within the study text are a number of features which we hope will enhance your study:

Key terms introduce the main ideas covered in each chapter

Be aware boxes highlight areas that may need clarification or additional detail

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Examples illustrating points made in the text

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At the end of each chapter you will find some short self-test questions. Please note that these are intended to be used to test your understanding of the material in this study text and should not be used as a substitute for the exam standard questions contained in the R04 specimen exam paper, available from the CII’s website www.cii.co.uk (these questions are also available on RevisionMate (www.revisionmate.com), the CII’s online study support tool). An online question pack, consisting of three mock style exams, is available from the CII website.

You should supplement your study by reading around the subject using other sources and the examination syllabus contains a suggested Reading list for this purpose – please note that only CII/PFS members can access the CII Knowledge Services fact files and other Knowledge Services material.

Web links correct as at July 2016.

Examination syllabus

General study techniques

You will need to put in time and effort if you are to master the contents of the study text and apply it to different situations. This should not worry you but you should recognise that your preparation needs to be thorough.

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Make a timetable covering when you will study and for how long, and try to adhere to it. Try to make up for any lost time as you go along.

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Know how many days you have available for studying, and allocate them according to the number of learning outcomes/chapters you have to study. Make a realistic timetable and stick to it! Break down your study programme into small, manageable units.

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Wider reading

Supplement your study with wider reading. See the Reading list at the end of the examination syllabus for suggestions.

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Make full use of your own notes. This means keeping them in an orderly way, and ensuring that you are able to find particular topics easily – perhaps by using different coloured markers. Write down important facts and carry them around so that you can test yourself when you have a few spare moments. Test your understanding by thinking the material through in your head and by talking it through with other people. You can also obtain the specimen examination paper with answers from the CII’s website.

Don’t leave revision until the day before the examination, and don’t revise right up to the last minute!

1  Context of pensions planning

Chapter section

Syllabus learning outcomes

Learning objectives

Introduction

Key terms

A Role of Government

1.1

B Demographic trends

1.3

C Corporate environmental factors

1.2

D Incentives, disincentives and attitudes to saving

1.4

E Main pension scheme types

1.5

Key points

Question answers

Self-test questions

Learning objectives

After studying this chapter, you should be able to:

- describe the role of Government, policy direction, challenges and proposed reforms;

- demonstrate the impact of demographic trends, longevity and an ageing population;

- explain the impact on pension provision of corporate responsibilities and challenges;

- show how the incentives, disincentives and attitudes to saving affect the choice to save for a pension;

- describe the main scheme types and methods of pension provision.

Introduction

A pension is simply a method of saving for retirement. What makes it different from other methods of saving is the tax advantages offered by the Government to encourage individuals and companies to make provision for retirement. The concept of a pension as a means of providing an income in retirement and benefits on death is hardly new and the issue of pensions and pension security is one of the most urgent political issues in Britain today.

In this chapter we will consider the political, economic and social environment factors relating to pensions.

Key terms

This chapter features explanations of the following terms and concepts:

Corporate responsibility

Defined benefit schemes

Defined contribution schemes

Demographic trends

Final salary schemes

Income in retirement

Money purchase schemes

Pension policy

Pensions

Saving

State Pensions

A  Role of Government

A1  Role of the Government and policy direction

Most people will depend on a pension to provide them with their income in retirement. Their pension may come from the State, from a company sponsored pension scheme or from a private pension arrangement.

The Government has been involved in shaping pension provision in the UK for many years and there have been many changes to the rules and legislation applicable to pensions. We look at these rules in more detail in the later chapters of this study text. However, to give you an overview, table 1.1 describes some of the main changes made to pension legislation over the last 30 years along with some of the future changes that have been announced.

Table 1.1: Developments in pension legislation over the last 30 years

Greater protection for members of occupational pension schemes

- The Pensions Act 1995 set up regulatory and compensation schemes to ensure that greater protection was given to members of occupational pension schemes. In particular schemes had to meet a minimum funding requirement and mandatory increases to pensions in payment were introduced.

- In 2001 accounting rules, called FRS17, were introduced which required companies to report pension deficits and surpluses in the year that the deficit/surplus occurred.

- The Pensions Act 2004 introduced the Pension Protection Fund (PPF), which ensures members receive some protection should their employer become insolvent, leaving a defined benefit (final salary) pension scheme that is unable to provide them with a certain level of promised benefits.

Support for the poorest pensioners

The Government has put in place various measures to ensure that all pensioners receive a minimum level of income in retirement:

- the first measure was the Minimum Income Guarantee, which came into force in 1999; and

- then in 2003 the State Pension Credit was introduced, which is a means tested benefit that tops up the income of the poorest pensioners.

Changes to State Pensions and State Pension age

- Before April 2016 the State Pension was made up of the Basic State Pension and a number of Additional State Pensions. The Additional State Pensions were generally only available to employees and changed several times, with the final change being the introduction of the State Second Pension (S2P) in 2002. The S2P was available to certain low earners and individuals receiving certain State benefits, such as Carer’s Allowance.

- In April 2016 all of the previous State Pensions (apart from the State Guarantee Credit) were replaced by the single-tier State Pension. To be eligible to receive it an individual must pay (or be credited with) National Insurance contributions (NICs) for 35 years.

- Until 6 April 2016, when it was abolished, it had been possible to ‘contract out’ of the Additional State Pensions via a defined benefit pension scheme, meaning the member did not receive any Additional State Pension (most recently the S2P) for that period of service. Instead the scheme had to provide a certain minimum level of benefits.

- Until April 2010 the State Pension age (SPA) was 65 for men and 60 for women. In 2010 the SPA for women started to increase from 60 to 65.

- Further legislation has been implemented to increase the SPA to age 67 for both men and women by 2028. In addition, the SPA will be reviewed at least every five years. It is estimated that each review could lead to a further one year increase in SPA, meaning that a 16 year old today could have a SPA of 77 or 78.

Encouraging private pension provision

Various measures have been introduced to encourage individuals to contribute more towards their retirement:

- in 2001 stakeholder pensions were introduced and employers had to offer their employees ‘access’ to one, although they were not compelled to contribute;

- these failed to encourage private pension provision, so automatic enrolment was introduced in October 2012; and

- from a company’s staging date, all eligible workers (or ‘jobholders’) who do not have access to an adequate workplace pension scheme must be automatically enrolled into a qualifying pension scheme with a required minimum level of contribution each year. These requirements are being phased in between October 2012 and April 2019.

The introduction of a single pension tax regime

- On 6 April 2006 (A-Day) a single pension tax regime was introduced, which replaced all of the previous regimes.

- This regime introduced the annual allowance and the lifetime allowance, although both of these have been reduced since A-Day. As a result of the reductions a number of transitional protections have been put in place.

- Further changes came into force on 6 April 2016, such as a tapered annual allowance for those with high earnings.

Pension flexibilities

- On 6 April 2015 major changes to the ways in which pension benefits can be taken came into force.

- The flexible benefit options apply to money purchase schemes and so some changes were made to the transfer rules to ensure that those considering a transfer out of a defined benefit scheme obtain independent advice before making the decision.

- A guidance service, called Pension Wise, was also introduced to provide guidance to those wishing to access their retirement savings.

A2  Challenges

It has become apparent that there are a number of problems relating to the provision of an adequate retirement income in the UK, although in recent years some improvement has been seen in the amount being saved. Some of the findings can be summarised as follows.

People are living longer

The UK has an ageing population because we are living longer and this increase in life expectancy has had an effect on pension provision. One effect is that the proportion of people paying tax and National Insurance is falling while at the same time more people are receiving State Pensions. This is a problem because the State Pension is funded on a pay-as-you-go basis, which means that the National Insurance contributions of the current working population pay for today’s State Pensions.

Amount of pension savings

There is a shortfall between what we should be saving for our old age and what we are actually saving. The Scottish Widows Retirement Report 2015, made the following findings:

- one-fifth of people are not saving anything towards their retirement and, of those, two-thirds say that they cannot afford to save anything;

- on average people think they need an income of £23,000 per annum to be comfortable in retirement;

- the average amount saved per month is £142; and

- 56% of Britons are saving ‘adequately’ for retirement; this is the highest level ever recorded in the UK.

The improvements in the amounts being saved are as a result of automatic enrolment, with far more people now contributing to a workplace pension scheme.

In September 2015, the Office of National Statistics (ONS) published an occupational pension schemes survey, the findings of which can be summarised as follows:

- in 2014 there were 10.2 million active members of occupational pension schemes, 9.6 million pensions in payment and 10.6 million preserved pension entitlements;

- there has been an increase in active memberships of such schemes, likely due to the introduction of automatic enrolment;

- this survey only covered occupational pension schemes and workplace pensions consist of both occupational and group personal pensions, but membership of occupational workplace pension schemes accounted for nearly three quarters of workplace pension membership in 2014;

- active membership of money purchase schemes increased to 3.2 million in 2014; and

- active membership of private sector defined benefit schemes remained at 1.6 million in 2014.

Companies are changing the type of scheme they offer

Many companies are closing their defined benefit schemes (also known as final salary schemes) and replacing them with money purchase alternatives, where the risk is borne by the member and all guarantees are lost. The Pensions and Lifetime Savings Association’s annual survey 2015 is based on 63 of its fund members (representing 2.8 million members). This survey, which looks at trends over the last five years, concluded:

- 40% of the sample’s active membership are in defined benefit schemes, whereas five years ago this figure was 68%; and

- 48% of defined benefit schemes are closed to both new employees and future accrual, compared to 31% in 2011.

Final salary schemes in the private sector are closing to new members at the fastest rate on record. According to the National Association of Pension Funds (NAPF) only 8% of final salary pension schemes were open to new members in 2014 (compared to 12% in 2013, 13% in 2012 and 43% in 2005). In addition, private sector final salary schemes are also ceasing future accrual for new members at a faster rate than ever before; in 2014 only 53% of existing private sector final salary pension schemes were open to future accrual.

Pension scandals

In the past scandals have damaged the reputation of the UK pensions industry:

- In the late 1980s and early 1990s many people were wrongly advised to move away from their companies’ occupational pension schemes into personal pensions.

- In the early 1990s Robert Maxwell illegally used funds from the Mirror Group’s pension funds, leaving workers who had saved for many years with significantly reduced pensions in retirement.

- Equitable Life, a well-respected pension provider, reneged on its promise to pay valuable guaranteed annuities to its members, meaning that they lost large amounts of money.

Falling stock markets, gilt yields and annuity rates

Falling stock markets and falling gilt yields have decimated annuity rates and thus pension income over the past few years. Annuity rates are based on gilt yields and so reductions in gilt yields has had a significant impact.

Annuity rates fell to record lows over the last year. A Moneyfacts survey revealed that in January 2015 a 65-year-old man with a pension fund of £50,000 could purchase (on average) a single life annuity of £2,727 p.a. By January 2016 this had fallen to (on average) £2,573 p.a. – a fall of 5.6%. As gender specific annuity rates are no longer permitted, the annuity rate for a woman of the same age would be identical. Overall income from a typical annuity has fallen by 56% since Moneyfacts began surveying the market in 1994 and annuity rates have fallen in 17 out of the past 21 years.

Increasing longevity has contributed to the fall in annuity rates in recent years, but Moneyfacts concluded that the recent fall in annuity rates has been driven by three main factors:

- there have been further falls in the yields from gilts;

- as a result of the pension flexibilities there has been reduced customer demand, which makes providers charge more to compensate for the loss; and

- new Europe-wide rules mean that annuity providers are required to hold more cash on their books, which cannot be used to provide annuity income.

Pensions are complex

The majority of people struggle to understand the different types of pension arrangement and what will be provided by the State. Too many people still believe that the State Pension will provide them with an adequate level of income in retirement. The pension flexibilities have increased the amount of choice available, but some of these options are quite difficult to understand and often financial advice is needed to recommend the best course of action for someone at or close to retirement.

B  Demographic trends

The UK’s ageing population means that the proportion of people who have retired is growing whilst the working population is reducing. This obviously has a huge impact on the cost of providing pensions for those in retirement because they will have to be provided for more people. The changes are significant:

- there are currently 11.4 million people aged 65 or over in the UK: this is projected to rise by over 40% in the next seven years, to over 16 million and by 2040, it is expected that nearly one in four people will be aged 65 or over;

- the fastest increase is in the number of people aged 85 and over: there are currently 1.5 million people aged 85 or over in the UK and this figure is expected to more than double in the next 23 years to over 3.4 million; and

- the proportion of the population reaching the age of 100 is also increasing: the number of centenarians living in the UK has risen by 72% over the last decade to 14,450 in 2014.

Life expectancy has also increased, meaning that pension income will have to be provided for a much longer time. Life expectancy at birth in the UK, based on 2012–14 statistics, is currently 79.1 years for a boy and 82.8 years for a girl. However, one of the most important factors for determining the cost of providing a pension is how long someone is expected to live once they have reached a certain age, e.g. in 2012–14 a man aged 65 could expect to live for another 18.4 years and a woman aged 65 could expect to live for another 20.9 years. To see how this has changed, let us compare 1997–99 with 2012–14:

Expected to live another:

Man

Woman

Age

1997–99

2012–14

1997–99

2012–14

65

15.2 years

18.4 years

18.5 years

20.9 years

(Source:   Office for National Statistics.)

Useful websites

Visit the website   www.ons.gov.uk. This site will give you lots of useful statistics relating to the population as well as other economic statistics such as inflation and earnings.

B1  Impact of demographic trends on pension provision

These two key demographic trends: the increase in the retired population as a percentage of the total population and the fact that people are living longer have a significant impact on the cost of pension provision in the UK. Although there are several other reasons, increased life expectancy has contributed towards the recent trend away from final salary schemes. We have already seen how the growth in life expectancy has increased the cost to the Government of providing State Pensions.

Impact on annuities

The impact of increasing life expectancy on annuity rates can be demonstrated by looking at a male, aged 65, looking to buy a single life annuity:

- At the start of the 1990s he could achieve an annuity rate in excess of 15%, so a pension fund of £100,000 could provide an annual income in excess of £15,000 p.a.

- By 2000 the annuity rate he could achieve had reduced to around 9% and by early 2016 it had fallen again to around 5.0%, meaning that the same £100,000 pension fund would now only provide an income of around £5,000 p.a.

Until April 2015 someone with a money purchase fund usually purchased a lifetime annuity to provide their income in retirement. The number of people purchasing lifetime annuities has fallen since the introduction of the pension flexibilities. However, many people still choose to purchase a lifetime annuity to provide their income in retirement.

Impact on pension flexibilities

The introduction of the pension flexibilities has already seen fewer retirees purchasing annuities and more using the more flexible options such as drawdown. Such individuals are relying on investment arrangements that require ongoing reviews during their lifetime (and possibly beyond if the pension arrangement is passed down to subsequent generations).

These options mean that the issue of longevity has become even more important: there is a danger that someone could run out of money during retirement. Information on the probability of surviving to a certain age can be obtained from various sources. The ONS has a basic calculator on its website and this shows that a man aged 65 has:

- a 75% chance of surviving to age 81;

- a 50% chance of surviving to age 88;

- a 25% chance of surviving to age 94; and

- a 10% chance of surviving to age 99.

Useful website

You can find this calculator here: http://visual.ons.gov.uk/how-long-will-my-pension-need-to-last/

There are more accurate calculators available that take into account the health of an individual. These can be found by using an internet search engine.

These probabilities should be taken into account when considering the risk that someone will outlive their retirement savings and the relative value of annuitising.

Question 1.1

State Pensions are funded on a ‘pay as you go’ basis. What does this mean?

C  Corporate environmental factors

Since October 2012, all employers must comply with the requirements to auto-enrol all eligible workers (or ‘jobholders’) into a qualifying pension scheme. The requirement to offer access to a stakeholder pension scheme (unless they were exempt) was abolished on 1 October 2012.

The main challenge facing the Government in recent years has been to find a way of increasing pension saving in the UK. As we have seen, the introduction of auto-enrolment has increased the amount that people are saving towards their retirement. The introduction of pension flexibility for money purchase schemes may also help because many people were put off saving into a pension by the restrictions that applied to how benefits could be taken.

Another challenge is the decline of the defined benefit scheme. This has largely been due to their growing cost, mainly as a result of increased longevity and falling annuity rates.

On 6 April 2016, the new single-tier State Pension was introduced and on the same date contracting out for defined benefit schemes was abolished. Both employers and members of such schemes now have to pay increased National Insurance contributions (NICs). It is expected that this will result in even more defined benefit schemes being closed.

Where a defined benefit scheme is closed to new members or wound up, it is often replaced by a money purchase alternative, such as a group personal pension plan. Under a money purchase arrangement all guarantees are lost and the investment risk and annuity risk (if applicable) is borne by the member. This is significant because of the key differences between a defined benefit scheme and a money purchase scheme:

Defined benefit scheme

Pension is a proportion of the employee’s final salary at or close to retirement. This is a valuable guarantee as it means their retirement income is unaffected by fluctuations in investment returns or annuity rates as retirement approaches.

Money purchase scheme

Pension is provided from a pension fund and the employee bears both the investment risk and, if an annuity is purchased, the annuity risk. If the fund performs badly and/or annuity rates fall at or close to retirement, pension income could be significantly reduced.

Another change that has affected the level of pension saving is the change in employment trends. In the past, many people worked for the same company for their entire working life: they would join the company’s pension scheme and this would provide them with an adequate income in retirement. This is no longer the case. Most people work for several employers and may also have periods of self-employment and/or unemployment. Consequently, many people have a number of ‘paid up’ or ‘preserved pensions’. It is likely that the sum of these separate arrangements will result in a far lower pension than if they had been a member of a single pension scheme for their entire working lifetime.

D  Incentives, disincentives and attitudes to saving

Incentives

In order to encourage saving via a pension, the Government offers the following incentives:

- income tax relief on contributions made by individuals;

- contributions made by employers are treated as a business expense for corporation tax or income tax purposes;

- the investment profits of the fund are exempt from income tax and CGT;

- the ability to take part of the proceeds as a tax-free cash lump sum, known as the pension commencement lump sum;

- the ability for members to take benefits from money purchase schemes when and how they wish as a result of the flexibilities introduced in April 2015; and

- the ability to pass money purchase pension funds to any beneficiary that the member chooses and more favourable tax treatment of death benefits, particularly where the member (or subsequent beneficiary) dies before the age of 75.

Many employers offer a work based pension for their employees and, with the introduction of the auto-enrolment rules in 2012, this is becoming more common. An employer may be prepared to pay a financial adviser to give their employees information and advice in this respect. Under HMRC rules such advice costs are not treated as a benefit in kind for the employee, provided:

- similar advice is offered to all employees;

- the advice only covers pensions and does not extend to general financial or tax advice; and

- the cost is no more than £150 per employee per year.

If the cost exceeds £150 per employee, then the whole amount is taxable, not just the excess over £150.

In the 2016 Budget it was announced that the permitted cost of £150 is to be increased to £500 per employee per year. This change is scheduled to take effect from April 2017. The Government has also announced that they will consult on introducing a ‘pensions advice allowance’. This will allow members to withdraw up to £500 tax-free from their money purchase pension arrangement to redeem against the cost of financial advice. The exact age at which members will be able to do this will be determined through consultation.

Be aware

A pension is simply a method of saving for retirement. It is only the tax advantages provided by the Government that make pensions different from other forms of saving, such as ISAs, unit trusts or bank accounts. Whilst some other savings and investment products may have taxation privileges (for example, an ISA enjoys virtually tax-free growth) they do not have all the taxation advantages of a pension product.

Disincentives

Despite the taxation advantages, many people save very little, if anything, towards their retirement. This may be for one or more of the following reasons.

- There is a limit to the amount of the fund that can be taken as a tax-free cash lump sum.

- Although there is no limit on the amount that may be saved in a registered pension scheme, there is a limit on the amount of individual contributions that will be eligible for tax relief.

- Benefits cannot be taken before the minimum pension age (currently 55) unless the individual is in ill-health or has a protected pension age.

- Many people find pensions complex and difficult to understand and prefer simpler savings alternatives such as a bank account or an ISA.

- Many people feel that pensions are expensive due to the charges incurred within pension contracts and the associated advice costs.

- There is a general mistrust of pensions due to past scandals and bad press.

Consider this…

We list the limit to the amount that can be taken as a tax-free cash lump sum and the minimum age at which benefits can be taken as disincentives. Why might these restrictions actually be beneficial (hint: the aim of a pension should be to provide an income for life in retirement)?

D1  Attitudes to saving

Some of the reasons for the lack of pension provision may be due to people’s attitude towards saving.

- Affordability is often cited as the main reason for saving insufficient amounts in a pension arrangement. People often have many demands on their disposable income and other needs may well take priority, e.g. bringing up children, buying a house or providing for other more pressing financial needs such as life assurance or health insurance.

- Many people still believe that the ‘State will provide’, thinking, incorrectly, that the State Pension will provide them with an adequate standard of living in retirement.

- For many people retirement seems a very long time away and so may see saving into a pension as being very low priority. Unfortunately, the cost of providing an adequate standard of living in retirement increases with age, so the longer someone waits before starting to save, the larger the monthly contributions will need to be.

Consider this…

Why is it unlikely that the State will provide an individual with an adequate standard of living in retirement?

E  Main pension scheme types

We will cover the main types of pension scheme in detail later in this study text. Here will simply give you an overview of the key features of the three main types of pension scheme.

E1  State Pensions

An individual may be eligible for one or more State Pension. The amount of State Pension accrued by an individual over their working lifetime depends on their National Insurance contribution (NIC) record.

The eligibility for State Pensions has changed for those individuals who reach State Pension age (SPA) on or after 6 April 2016. Individuals who reached their SPAs before 6 April 2016 receive State Pension benefits based on the rules that existed prior to 6 April 2016.

Those who reached their SPA before April 2016 may receive State Pensions as illustrated in figure 1.1

Figure 1.1: State Pensions

On 6 April 2016, the single-tier State Pension came into force. Those reaching their SPA on or after 6 April 2016 are not entitled to the State Pensions outlined in figure 1.1, but will instead receive the single-tier State Pension. However, existing benefits accrued under the earnings related parts of the State Pension will be accounted for in calculating an individual’s entitlement, to ensure that no-one is worse off under the new system. In addition, any periods when the individual was contracted out under the pre-2016 rules will be taken into account.

Question 1.2

Paul, reached his State Pension age in March 2016. He had always been self-employed. Which State Pensions, if any, did Paul build up an entitlement to?

1. No State Pensions.

2. Basic State Pension only.

3. Basic State Pension and SERPS only.

4. Basic State Pension, SERPS and the S2P.

E2  Defined benefit (or final salary) schemes

Defined benefits schemes covered in detail in chapter 4

A defined benefit scheme provides benefits that are guaranteed to be a proportion of final salary at retirement, or on death (hence the other name of final salary schemes). They may be provided by both the private sector (i.e. schemes provided by private employers) and the public sector (e.g. the NHS scheme, the teachers’ scheme etc.). Defined benefit schemes tend to provide superior benefits to other types of pension scheme, in terms of both the level and range of benefits. The major advantage of this type of scheme for the employee is the guaranteed nature of the benefits.

The scheme sets a normal retirement age, which is usually the age up to which employer contributions will be paid, and this will be the age at which members will usually retire.

The benefits that a defined benefit scheme will provide will be based on the following three factors:

- pensionable service: this is usually the employee’s period of membership in the scheme;

- pensionable remuneration: this is the definition of salary that is used to calculate the member’s benefits; and

- the accrual rate: the rules of the scheme will determine the rate at which benefits accrue, e.g. 1/60th of pensionable remuneration for each year of pensionable service.

As well as a pension, a defined benefit scheme will also provide a tax-free cash lump sum, known as the pension commencement lump sum (PCLS) at retirement. The rules of the scheme will determine how much tax-free cash can be accrued for each year of service.

E3  Money purchase (or defined contribution) schemes

Money purchase schemes covered in detail in chapter 5

Unlike a defined benefit scheme, a money purchase scheme does not provide the member with guaranteed benefits. Instead, a fund builds up and the benefits that are ultimately provided depend on the size of the fund at that time. If the member chooses to purchase a lifetime annuity, the actual level of income will depend on the annuity rates when benefits are taken. Generally, part of the fund may be taken as a PCLS and the amount of PCLS is usually limited to 25% of the value of the fund. The value of the fund also determines the amount of death benefits paid to the member’s chosen beneficiaries on the member’s death. These schemes are often collectively called defined contribution schemes.

Be aware

The term ‘money purchase’ encompasses both defined contribution and cash balance schemes. A cash balance scheme is a type of money purchase scheme, but it provides a mix between defined benefit and money purchase, by promising a certain lump-sum payment at a specified age (which will usually be the scheme’s retirement age).

Within this study text we will use the term money purchase to describe these types of scheme.

A money purchase scheme may be an occupational scheme provided by an employer for the benefit of the employees, or it may be an individual arrangement funded by the member (and sometimes by the employer as well).

You may have come across various different ‘types’ of pension arrangement, e.g. personal pensions, stakeholder pensions, executive pensions, small self-administered schemes (SSASs), self-invested personal pensions (SIPPs) etc. These are all money purchase schemes.

Some money purchase schemes are ‘hybrid’ schemes, e.g. a targeted money purchase scheme. This type of scheme is funded to provide a specific amount of benefit at retirement, typically a proportion of final salary.

The Taxation of Pensions Act 2014 introduced legislation allowing an individual to take as much or as little as they like from their money purchase arrangements once they reach the normal minimum pension age, currently 55 (or earlier if the individual is in ill-health or has a protected pension age). This legislation took effect on 6 April 2015.

Question 1.3

Julia is about to retire and take benefits from her company’s group personal pension plan. Which of the following factors will be used to determine the level of pension she receives in retirement?

1. The size of her fund.

2. Her final pensionable remuneration.

3. Her pensionable service with the company.

4. The scheme’s accrual rate.

E3A  Key terminology in relation to money purchase schemes

A member of a money purchase scheme who takes benefits can usually take up to 25% of the fund as a pension commencement lump sum (PCLS) and use the balance to provide an income in the form of one of the following:

A lifetime annuity

The fund is used to purchase a contract from an insurance company and this will provide the member with an income for life. The amount of income provided depends on the size of the fund and the annuity rates available.

A flexible lifetime annuity is one where the annual rate of income can be reduced each year by any amount.

A scheme pension

The scheme administrator uses the balance of the fund to secure an income for life for the member. For a money purchase scheme this is similar to a lifetime annuity in that the amount of income provided depends upon the size of the fund and scheme pension rates available.

A drawdown pension

An income is drawn directly from a money purchase fund. There are two different forms of drawdown:

Capped drawdown

The amount of income that can be drawn each year is subject to limits set by the Government Actuary’s Department (GAD).

Note: it is no longer possible to set up a new capped drawdown plan, though individuals who have already designated funds into one can continue in it. They have the option of changing to flexi-access drawdown.

Flexi-access drawdown

There are no restrictions on the amount of income that can be drawn each year.

An uncrystallised funds pension lump sum (UFPLS)

A lump sum taken from a money purchase fund from which benefits are yet to be taken (known as an uncrystallised fund).

The member can take as much or as little as they like from the fund as an UFPLS.

Death benefits looked at in chapter 6 and their taxation in chapter 2, section E

Death benefits may be paid to a dependant of the member, to a nominee or to a successor.

Dependant

Defined by HMRC as someone who meets one of the following:

- the member’s widow(er)/civil partner at the time of the member’s death; or

- a child of the member who is under the age of 23 at the date of the member’s death; or

- a child of the member who, in the opinion of the scheme administrator, was dependent on the member due to mental or physical impairment at the date of the member’s death; or

- a person who was not married to/in a civil partnership with the member at the date of the member’s death, but who, in the opinion of the scheme administrator, was;

- financially dependent on the member, or

- in a financial relationship of mutual dependence with the member, or

- dependent on the member because of their physical or mental impairment.

Nominee

A nominee is any individual, other than a dependant, nominated by the member to receive the benefits from a pension plan upon the member’s death. If the member does not make a nomination prior to their death (either to an individual or a charity), and there are no dependants, a scheme administrator can make the nomination on behalf of the scheme member.

Successor

A successor is an individual nominated by a dependant or a nominee to continue to receive the dependant’s or nominee’s flexi-access drawdown (which will then become a successor’s flexi-access drawdown).

A successor can also be someone nominated to continue to receive the income from a previous successor’s flexi-access drawdown.

If a nominee or successor fails to nominate someone to continue to receive the income from their flexi-access drawdown, then the scheme administrator can do so on their behalf.

Learning point

In this study text we are going to use the following abbreviations to describe a number of well-used terms.

Basic State Pension

BSP

benefit crystallisation event

BCE

Consumer Prices Index

CPI

money purchase annual allowance

MPAA

National Insurance contributions

NICs

pay as you earn

PAYE

pension commencement lump sum

PCLS

per annum

p.a.

Retail Prices Index

RPI

State Pension age

SPA

uncrystallised funds pension lump sum

UFPLS

Key points

The main ideas covered by this chapter can be summarised as follows:

Role of Government

- The Government has been involved in shaping pension provision in the UK for many years and there have been many changes to the rules and legislation applicable to pensions.

- Some of these changes include greater protection for members of occupational pension schemes, support for the poorest pensioners, changes to State Pensions and State Pension age, encouraging private pension provision, the introduction of a single pensions tax regime and pension flexibilities.

- Some people are not saving enough towards their retirement, although the introduction of automatic enrolment means that the proportion of people saving ‘adequately’ for retirement has reached its highest ever level.

- Many companies are closing their defined benefit schemes and replacing them with money purchase alternatives.

- There have been a number of scandals over recent years that have damaged the reputation of the UK pensions industry.

- Falling stock markets and falling gilt yields have decimated annuity rates and thus pension income over the past few years.

- The Government wants to ensure that pensioners in the UK enjoy an adequate standard of living. A system of auto-enrolment, whereby all employers have to automatically enrol all eligible workers into a qualifying pension scheme was introduced from October 2012 to address this issue.

Demographic trends

- The UK has an ageing population; the proportion of people who have retired is growing whilst the working population is reducing.

- The fastest population increase has been in the number of people aged 85 and over.

- Life expectancy at birth is currently 79.1 years for a boy and 82.8 years for a girl.

- Annuity rates for a male aged 65 looking to buy a single life annuity have reduced from over 15% at the beginning of the 1990s to around 5% by 2016.

- Increased life expectancy has caused significant reductions in annuity rates over recent years.

Corporate environmental factors

- A new system of auto-enrolment came into force in October 2012.

- All employers have to comply with requirements to auto-enrol all eligible workers (or ‘jobholders’) into a qualifying pension scheme.

- The main challenge facing the Government in recent years has been to find a way of increasing pension saving in the UK.

- Membership of defined benefit schemes is declining, due largely to increasing costs.

- Changing employment trends and increased job mobility have further reduced the amount of pension provision in the UK.

Incentives, disincentives and attitudes to saving

- Various tax related incentives are offered to try to encourage people to save for their retirement, e.g. tax relief on contributions and tax-free fund growth.

- Some of the restrictions relating to pensions act as a disincentive towards pension saving, e.g. the limit to the amount that can be taken as a tax-free cash lump sum and lack of access to pension funds until age 55.

- Other factors such as costs, adviser charges and the complexity of pensions are also disincentives.

- Attitudes towards saving can also lead to a lack of pension provision; this may be due to affordability, the feeling that the ‘State will provide’ or pension saving being a low priority because retirement is many years away.

Main pension scheme types

- Those reaching their State Pension age before 6 April 2016 may be eligible to receive one or more of the Basic State Pension, the State Graduated Pension Scheme, the State Earnings Related Pension Scheme (SERPS) and the State Second Pension (S2P). Those reaching their State Pension age on or after 6 April 2016 may be eligible to receive the single-tier State Pension.

- A defined benefit (or final salary scheme) provides benefits that are guaranteed as a proportion of final salary at retirement (or on death).

- Defined benefit schemes tend to provide superior benefits to other types of pension scheme, in terms of both the level and range of benefits.

- The major advantage of a defined benefit scheme for the employee is the guaranteed nature of the benefits.

- A money purchase (or defined contribution) scheme provides benefits based on the size of the fund and, if applicable, annuity rates when benefits are taken.

- There are no guarantees of the level of benefits provided by a money purchase scheme; the member bears the investment risk and, if applicable, the annuity rate risk.

Question answers

1.1

‘Pay as you go’ means that the National Insurance contributions of the current working population pay for today’s pensioners’ State Pensions.

1.2

b. Since Paul has always been self-employed, he has only built up an entitlement to the Basic State Pension.

1.3

a. A group personal pension plan is a money purchase arrangement and the size of her fund will determine (to some extent) the amount of income she receives in retirement. If she chooses to purchase a lifetime annuity then current annuity rates will also have an impact.

Self-test questions

1.

As well as life expectancy, annuity rates are based on expected returns from which type of underlying investment?

2.

In recent years, the fastest population increase has been in the number of people aged:

1. under 16.

2. under 35.

3. 65 to 75.

4. 85 and over.

3.

Outline four taxation incentives associated with a pension scheme.

4.

Albert, who reached State Pension age in November 2015, was employed for his entire working life since the age of 16. He was never a member of a contracted out pension scheme. Which State Pensions are being paid to Albert?

1. Basic State Pension only.

2. SERPS and S2P only.

3. Basic State Pension, SERPS and S2P only.

4. Basic State Pension, graduated pension scheme, SERPS and S2P.

You will find the answers at the back of the book

Table of Contents

Title Page

Pensions and retirement planning

Using this study text

Examination syllabus

General study techniques

Use the calendar

Use the clock

Use the study materials

Wider reading

Use any support available

Revision

1 Context of pensions planning

Introduction

A Role of Government

B Demographic trends

C Corporate environmental factors

D Incentives, disincentives and attitudes to saving

E Main pension scheme types

Key points

Question answers

Self-test questions