This chapter looks at private pensions in the UK. By contrast with state pensions (see Pension Trends Chapter 5) which comprise the basic and additional state pensions and related benefits such as Pension Credit, private pensions are provided by employers in the private and public sectors and by insurance companies.
In the UK, private pensions (all pensions other than state pensions), can be split into two main groups: occupational and personal. There are also differences between defined benefit (DB) and defined contribution (DC) schemes and funded and unfunded schemes (Figure 6.1).
In 2010 there were 8.3 million active members of occupational pension schemes, the lowest level since the 1950s.
The number of people contributing to personal pensions continued to fall, from 6.4 million in 2008/09 to 6.0 million in 2009/10 (Figure 6.4).
The latest estimates show 7.4 million active members of DB schemes and 6.9 million people contributing to DC (including personal) pensions (Figures 6.3 and 6.4).
In 2010, 54 per cent of active members of private sector DB schemes were in schemes that were closed to new members; in the public sector, over a third (36 per cent) of active members were in schemes that were closed to new members (Figure 6.5).
Overall, the proportion of employees who belonged to DB occupational pension schemes has fallen, from 46 per cent in 1997 to 30 per cent in 2011. The proportion of employees with DC workplace (occupational and group personal) pensions has risen from 10 per cent to 16 per cent over the same period (Figures 6.7 and 6.8).
Employer and pension scheme size are related to benefit structure (DB/DC). The public sector, made up of large employers, has schemes which are mainly DB, while the private sector, with a mixture of employer sizes, has a mixture of DB and DC schemes.
In funded DB schemes, the employer bears the investment risk and must pay out pensions at an agreed rate. By contrast, investment risk in DC schemes is assumed by individual members.
Workplace pension reforms will be implemented from October 2012. They are likely to represent the biggest change in the UK private pension system since the 1980s, although the staged approach to implementation means that any impact may not immediately feed through into estimates.
This chapter looks at private pensions in the UK. By contrast with state pensions (see Pension Trends Chapter 5) which comprise the basic and additional state pensions and related benefits such as Pension Credit, private pensions are provided by employers in the private and public sectors and by insurance companies.
The analysis presented here focuses on private pensions in the ‘accumulation’ stage, when people are building up their pensions. Receipt of state and private pensions is covered in Pension Trends Chapters 11 and 12.
The chapter provides an overview of the private pension system. It starts by comparing the UK system with that of other countries in the Organisation for Economic Co-operation and Development (OECD), and looks in some detail at the components of private pension provision.
It then considers some of the key issues such as differences between funded and unfunded pensions and between defined contribution and defined benefit pensions. It also presents evidence on how the characteristics of the system are changing over time, and indicates what this may mean for the future of the private pension system.
This chapter also looks at why comparison between the public and private sector is more complex than is apparent at first sight. The evidence suggests that the differences are associated with underlying factors, such as size of pension scheme (and employer) and approaches to management of risk.
Pension systems are designed to provide ‘replacement income’ for those who are no longer earning an income through employment. The replacement rate is a measure of how effectively pension systems are able to replace earnings in retirement. The gross replacement rate is defined as gross pension entitlement divided by gross pre-retirement earnings1.
Pension systems are normally made up of two distinct components: a mandatory state component and a private (non-state) component. The relative importance of each component to the level of replacement income provided to an individual on retirement varies from one country to another.
Some countries opt for pension systems designed to provide replacement income mainly through the state, while others place more emphasis on the private pension component. In some OECD countries such as Australia, Denmark, Iceland, Netherlands, Norway, Sweden and Switzerland, pension systems also include a mandatory private pension element.
In countries with relatively small mandatory pension components, individuals need to save on a voluntary basis to ensure that they have adequate incomes in retirement. In the 34 OECD countries, the average gross replacement rate provided by mandatory pension schemes for workers with average (mean) earnings is 57 per cent.
This figure is based on cross-country modelling carried out by the OECD which relies on a number of simplifying assumptions2. This and the other figures quoted in this section are not National Statistics.
The difference between the OECD average and mandatory replacement rates that fall below this average is referred to as the ‘pension gap’. According to the latest estimate available (compiled in 2009 and referenced in the 2011 edition of this chapter), the gross replacement rates of mandatory pension schemes for average earners range from highs of over 95 per cent in Iceland and Greece to lows of under 35 per cent for Ireland, Mexico, the UK and Japan. The UK, with a gross replacement rate of 32 per cent for average earners, has one of the largest pension gaps in the OECD, at 25 per cent.
It should be noted that in the OECD model, while the gross replacement rate for the UK mandatory (state) pension system incorporates the impact of state pension reforms under the Pensions Acts 1995 and 2007 (see Pension Trends Chapter 1), it does not take into account further changes which are currently being made under the Pensions Act 2011 (such as moving indexation of state pensions from the Retail Prices Index (RPI) to the Consumer Prices Index (CPI), the introduction of the ‘triple guarantee’ for the Basic State Pension or further increases to State Pension Age. The possible introduction of a single tier, flat-rate state pension, as proposed by the UK Government in the April 2011 Green Paper on state pension reform3 is also not taken into account.
Individual lifetime average (pre-tax) earnings for an average earner with a full career re-valued in line with economy-wide earnings growth.
For further details, see Antolín and Whitehouse (2009) and OECD (2011) under References. Please note the estimates presented in this section have not been updated by OECD since the release of the previous version of this chapter.
See Department for Work and Pensions (2011) under References.
People in the UK are encouraged to participate in private pension schemes in order to supplement the retirement income provided through the state pension system. Pension Trends Chapter 7 provides estimates of membership of private pension schemes in the UK during the ‘accumulation’ stage, while Pension Trends Chapter 12 covers private pension income received in retirement. In 2009/10, over two-thirds of pensioner units1 in Great Britain were in receipt of private pensions.
Voluntary private pension provision in the UK is encouraged by Government through the tax system2. Individuals’ contributions to private pensions qualify for tax relief, as do the investment income and capital gains of pension funds. Many people can also take part of their pension as a tax-free lump sum when they retire3. In addition, employers receive tax and National Insurance relief on the contributions that they make towards employees’ private pensions.
Estimate from the Department for Work and Pensions ‘Pensioners’ Income Series’
Pensioner units are defined as either:
Single pensioners: people over state pension age (65 for men or 60 for women in 2009/10).
Pensioner couples: married or cohabiting pensioners where one or more are over state pension age.
The tax structure of the UK pension system is known as ‘Exempt-Exempt-Taxed’ (EET) because contributions and earnings from investment are tax exempt, but pensions in payment are taxed.
People belonging to defined contribution pension schemes (see Glossary) can take up to 25 per cent of the accumulated pension pot as a tax-free lump sum. Those belonging to defined benefit schemes (see Glossary) can take part of their pension as a tax-free lump sum if scheme rules permit.
An occupational scheme is an arrangement (other than accident or permanent health insurance) organised by an employer (or on behalf of a group of employers) to provide benefits for employees on their retirement and for their dependants on their death. It is a form of workplace pension. In the private sector, occupational schemes have trustees and are governed by trust law.
Total membership comprises:
Active members: current employees who contribute (or have contributions made on their behalf) to the pension scheme.
Deferred members: former employees who have preserved their pension rights within a scheme but are not yet receiving pension payments; and widows, widowers, other dependents and pension credit1 members with some preserved pension.
Pensioner members: those receiving pension payments from the scheme; and their dependents and pension credit members.
An occupational pension scheme may be open, closed, frozen or winding up. An open scheme admits new members. A closed scheme does not admit new members but may continue to receive contributions from or on behalf of existing members who continue to accrue pension rights.
In a frozen or ‘paid up’ scheme, benefits continue to be payable to existing members but no new members are admitted, and no further benefits accrue to existing members. Members can make no more contributions but further employer contributions may be made, and may have to be made, for example to correct a deficit.
A scheme that is winding up is in the process of termination, either by buying annuities for the beneficiaries or by transferring assets and liabilities to another scheme or to the Pension Protection Fund2.
Personal pensions are available to any UK resident under 75 years of age. They are contract-based, not trust-based. The money from each member’s contributions is invested and a fund is built up. The amount of pension payable in retirement depends on the amount of money paid into the scheme, how well the investment performs and, if an annuity is taken, the 'annuity rate' (the factor used to convert the member’s fund into a pension) at or after retirement.
Stakeholder pensions are a type of personal pension designed to incorporate a minimum set of standards that were introduced in April 2001. They have capped management charges and there are no penalties for stopping contributions or transferring benefits to another scheme.
Self-invested personal pensions (SIPPs) are designed for people who want to manage their own fund. They have relatively high management charges and the more changes that are made to the investment plan, the higher the level of fees charged. They have grown strongly since 6 April 2006 (‘A-day’), when the rules were changed to encourage investment in SIPPs.
Group personal pensions (GPPs), group stakeholder pensions and group SIPPs are collective arrangements made for the employees of a particular employer to participate on a group basis. They are usually sponsored by employers and are, therefore, a form of workplace pension, but the legal contract is between the individual and the pension provider (an insurance company).
Defined benefit (DB) pension schemes are those in which the rules specify the rate of benefits to be paid. The most common DB scheme is one in which the benefits are based on the number of years of pensionable service, the accrual rate and final salary. However, Career Average Revalued Earnings (CARE) schemes are becoming more common. These base the pension on earnings over the whole career.
A defined contribution (DC) pension is one in which the benefits are determined by the contributions paid into the scheme, the investment return on those contributions (less charges), and any annuity that is purchased. DC pensions are also known as money purchase pensions. All personal pensions are DC pensions.
Pension credit in this case refers to instances where the spouse of a pension scheme member is given a credit in respect of any pension benefits arising on divorce.
The Pension Protection Fund was established in April 2005 to pay compensation to members of eligible defined benefit pension schemes, when there is a qualifying insolvency event in relation to the employer and where there are insufficient assets in the pension scheme to cover Pension Protection Fund levels of compensation.
In the UK, private pension schemes can be split into two main groups: occupational and personal (Figure 6.1).
Occupational pensions are provided by employers (see 4. Definitions). According to the Office for National Statistics Occupational Pension Schemes Survey (OPSS), there were 6.2 million active members of occupational pension schemes in 1953. The highest number of active members was recorded in 1967, when there were 12.2 million. In 2010 there were 8.3 million active members, the lowest level since the 1950s.
Personal pensions, including stakeholder pensions and self-invested personal pensions (SIPPs), are those where individuals enter into a contract with a pension provider, usually an insurance company. According to data from HM Revenue and Customs, the recent trend in the number of individuals contributing to personal pensions has been downwards, falling from 7.6 million in 2007/08 to 6.0 million in 2009/10.
Although group personal pensions (GPPs), group stakeholder pensions and group SIPPs may be sponsored by employers, with the employers facilitating payment of contributions for the members, the legal contract for all personal pensions is between the individual and the pension provider.
Workplace pensions comprise occupational pensions (provided by employers) and GPPs, group stakeholder and group SIPPs (facilitated by employers). It is not currently compulsory for UK employers to sponsor pension provision in the workplace or for employees to join pension schemes where they are offered. However, from October 2012 (in a phased implementation based on the employer size), employees will be automatically enrolled into workplace pension schemes (see 12. Workplace pension reform).
Figure 6.1 shows that occupational schemes can be divided into defined benefit (DB) and defined contribution (DC) schemes (see 4. Definitions). All personal pensions are DC. The private sector has a mixture of DB and DC pensions, while public sector schemes are mainly DB.
Figure 6.1 also shows that private pensions can be classified according to the funding approach taken: funded or unfunded (this is explained further in the Pension Trends Glossary). Funded consists of private sector occupational pension schemes, individual and employer-sponsored personal pensions and some occupational schemes in the public sector, the largest of which is the Local Government Pension Scheme (LGPS) for local authority employees.
Unfunded or ‘pay as you go’ pension schemes are found in the public sector. The main unfunded pension schemes are for the Civil Service, the Armed Forces, the National Health Service (NHS), teachers, police and firefighters. The benefits of unfunded public service schemes are financed from general taxation and employee contributions.
There are a number of options available to people with DC pensions (occupational and personal) at retirement. Most DC members opt to purchase annuities with their funds. Many also take part of their pension fund as a tax-free lump sum (up to 25 per cent of a DC pension fund can be taken in this way).
Annuities are a financial instrument provided by an insurance company that pays a guaranteed annual income to the holder for the rest of their life. Insurance companies are able to offer this by ‘pooling’ the mortality risks associated with individual annuity holders.
As some holders will die sooner than others, their funds will cover the payments for members whose life expectancy exceeds the average and whose pensions will need to be paid for a longer period. Insurance companies use annuity rates based on predicted estimates of a person’s mortality and the rate of return on long-dated Government bonds (Gilts) to decide the level of payments made to an individual.
The amount of the annuity offered at retirement will depend on a combination of the size of the individual’s fund, the annuity rate used and the type of annuity chosen. There are different types of annuity that can be purchased at retirement:
Level annuities provide the same level of payments for the whole of retirement. Their real value is eroded over time by inflation.
Index-linked annuities provide payments which rise over time in line with some measure of inflation. However, the initial payments will be lower than for a level annuity.
Escalating annuities with payments rising over time by a fixed amount every year; again, the starting point will be lower than for a level annuity.
Until 5 April 2011, people with DC pensions had to buy an annuity between the ages of 55 and 75. The alternative to buying an annuity before age 75 was an unsecured pension. In this case, the fund remained invested and may have continued to grow. Members could take an income from the fund either by using income withdrawal, or by using a 'short-term annuity'. However, unsecured pensions could not be continued beyond age 75, when the member had to secure an income by buying an annuity or an Alternatively Secured Pension (ASP).
ASPs were introduced in April 2006. They were a form of income drawdown for those aged over 75, suitable for individuals with a principled objection to pooling mortality risk which prevents them from purchasing a pension annuity.
From 6 April 2011, however, people with DC pensions are no longer required to buy an annuity by age 75. At any time from age 55 they can either buy an annuity or opt for ‘drawdown’. In either case, 25 per cent of the fund can be taken as a tax-free lump sum.
The drawdown option allows people with a lifetime pension income of £20,000 or more to take unlimited amounts out of their pension fund at any time (‘flexible drawdown’), while people with less than £20,000 can take up to an amount equivalent to what they would receive from an annuity in any one year (‘capped drawdown’).
The fund remains in existence until it is exhausted, and on death any unused funds can be passed on to heirs (subject to taxation). The drawdown system replaces the unsecured pension and ASP.
Unit Linked Guarantees (ULGs) are relatively new to the UK and offer an alternative to the traditional annuity or drawdown options. They use a combination of investment growth and risk hedging to guarantee increasing payments during retirement.
From the 1950s to the 1980s, most occupational pension schemes were DB schemes, and employers had the option to make membership of such schemes compulsory. However, the Social Security Act 1986 made membership of occupational schemes voluntary and introduced changes designed to promote DC occupational pension schemes and personal pensions.
The rapid growth of financial markets from the 1980s also made saving in DC pension schemes more of an option than it had been before. The growth of DC occupational pension scheme membership in the private sector dates from this period.
Figure 6.2 shows active membership of private sector DB and DC occupational schemes by their scheme foundation dates. Most (92 per cent of) active members of open DC schemes in the 2010 Occupational Pension Schemes Survey (OPSS) were in schemes founded in 1980 or later and 45 per cent were in schemes founded in 2000 or later. By contrast, 52 per cent of active members of open DB schemes in the 2010 OPSS were in schemes founded before 1980.
Around 35 per cent of active members of open DB schemes were in schemes that were founded in 2000 and after. However, some of these schemes recorded in OPSS as ‘new’ may actually have been replacements for existing schemes, for example Career Average Revalued Earnings (CARE) arrangements as an alternative for a ‘final salary’ schemes.
Figure 6.3 shows the proportion of active members of occupational pension schemes in the UK (employees currently contributing) by sector (public or private), funding approach (funded or unfunded) and benefit structure (DB or DC).
It should be noted that most of the data presented in this chapter is for active (employee) membership of pension schemes, or, in the case of personal pensions, individuals currently contributing. This is because, while looking at income from private pensions (Pension Trends Chapter 12) tells us about the outcome of the private pension system that existed in previous decades, our main focus here is the structure of the current pension system and its implications for the current generation of working age people when they retire.
In 2010, according to the Occupational Pension Schemes Survey, there were 8.3 million active members of occupational pension schemes. 89 per cent of active members (7.4 million) belonged to DB schemes, 11 per cent (1.0 million) to DC schemes (Figure 6.3).
In 2010, just under two-thirds of membership (63 per cent or 5.3 million) was in the public sector and just over one-third (37 per cent or 3.0 million) was in the private sector. This is in contrast to 1953 (when the survey was first run) when active membership of occupational schemes was divided equally between the private and public sectors, each with around 3.1 million members.
Figure 6.3 also shows that in 2010, 60 per cent of active members of occupational pension schemes belonged to funded schemes. Funded private sector schemes accounted for 37 per cent of active membership, while funded public sector schemes accounted for 23 per cent of active membership and 36 per cent of active membership in the public sector2.
Unfunded public sector schemes accounted for two-fifths (40 per cent) of all active membership in 2010, and 64 per cent of active membership in the public sector.
According to figures published by HM Revenue and Customs (HMRC), there were 6.0 million individuals contributing to personal pensions in 2009/10 (Figure 6.4). Between 2007/08 and 2008/09, the figures showed a sharp fall in the number of individuals contributing to personal pensions, from 7.6 million to 6.4 million.
This was because many people who had made small contributions to personal pensions in 2007/08 stopped contributing, probably due to increased financial pressures during the recession.
The proportion of active members of private sector occupational DC schemes has been gradually increasing in recent years, reaching 31 per cent in 2010. However, the actual number of active members, while fluctuating slightly, has remained around 1.0 million.
If we add this to the HMRC estimate of the number of individuals contributing to personal pensions (6.0 million), the total active membership of DC pensions (including personal pensions) can be estimated at 6.9 million.
Given the number of active members in DC occupational pension schemes has remained broadly flat (OPSS) but the number of individuals contributing to personal pensions has been dropping (HMRC), the trend in overall DC membership is also falling.
Figure 6.4 shows information from HM Revenue and Customs (HMRC) on the numbers of individuals contributing to personal pensions, including stakeholder pensions. The majority (88 per cent) of those contributing to personal pensions were employees. There were 0.7 million ‘self-employed and other’ individuals contributing to a personal pension in 2009/10, the majority (92 per cent) of which were self-employed. (Pension Trends Chapter 7: Private pension scheme membership includes a section on the self-employed).
Figure 6.5 focuses on open schemes, which new members can join. A comparison of the results with those shown in Figure 6.3 (which includes active members of closed schemes) shows that for the younger generation the option of joining a DB scheme is much reduced: in 2010, there were only 1.0 million active members of open DB schemes in the private sector, compared with 2.1 million active members of private sector DB schemes as a whole; over half (54 per cent) of active members of private sector DB schemes were in schemes that were closed to new members. In the public sector, in 2010, over a third (36 per cent) of active members were in schemes that were closed to new members.
Figure 6.5: Active members of open occupational pension schemes: by sector, funding approach and benefit structure, 2010
It should be noted that there is likely to be a small element of double-counting here, as some people with occupational pensions may also contribute to personal pensions. According to estimates from the Family Resources Survey, less than 3 per cent of individuals in the UK who had a pension had both an occupational (or other employer-sponsored pension) and a personal pension in 2009/10.
It should be noted that there is no public/private sector split available for personal pensions. While the majority of individuals with personal pensions are likely to be employed in the private sector, public sector employees may also have personal pensions (for example, the Civil Service offers a group stakeholder arrangement called Partnership).
The Local Government Pension Scheme for local authority employees is the only major public sector scheme that is funded.
One of the most important factors explaining the structure of the private pension system in the UK is size of pension schemes, which is usually associated with size of employer. DB schemes are traditionally associated with large employers (although they also work for small employers), while DC schemes are frequently favoured by smaller employers. Thus, it is not surprising that the public sector, made up of large employers, has schemes which are mainly DB, while the private sector, with a mixture of employer sizes, has a mixture of DB and DC schemes.
Within the private sector, there are a small number of large schemes and a much larger number of small schemes. However, the majority of active members belong to large schemes. This pattern is likely to be reinforced as automatic enrolment polices are implemented and employers enrol their employees into the National Employment Savings Trust (NEST), a large occupational pension scheme (see 12. Workplace pension reform).
However, given the expectation that NEST will generally be used by the smaller employers (and their implementation dates are not until 2017 to 2018), the impact may not be seen immediately.
Figure 6.6 shows the distribution of active membership of open and closed private sector occupational pension schemes by scheme size (based on total membership) and benefit structure in 2010. DB schemes with 2 to11 members made up less than 1 per cent of active DB membership and DC schemes with 2 to 11 members accounted for 6 per cent of active DC membership. Membership was concentrated in the larger schemes, with 86 per cent of active members of DC schemes belonging to schemes with 1,000 or more members and 44 per cent to schemes with 10,000 or more members.
The equivalent figures for DB schemes show that 92 per cent of active members were in schemes with 1,000 or more members and 69 per cent were in schemes with 10,000 or more members. DB schemes with 10,000 or more members accounted for nearly half (48 per cent) of active membership of private sector occupational pension schemes in 2010.
Figures 6.7 and 6.8 use data from the Annual Survey of Hours and Earnings (ASHE) to examine trends in DB and DC workplace pension provision over time by size of employer.
Figure 6.7 shows, for a given employer size, the proportion of employees who belonged to DB occupational pension schemes between 1997 and 2011. Overall, this proportion has fallen, from 46 per cent in 1997 to 30 per cent in 2011. Larger employers have a higher proportion of employees as members of DB schemes than smaller employers.
However, for employers with 1,000 or more employees, the proportion of employees who were members of DB occupational pension schemes has fallen by 14 percentage points to 46 per cent in 2011. For employers with 500 to 999 employees, the proportion has fallen by 22 percentage points to 26 per cent in 2011, while for employers with 100 to 499 employees, the proportion has fallen by 23 percentage points to 15 per cent in 2011.
At the same time, there has been an increase in DC pension provision in the workplace (DC occupational pension schemes, GPPs and group stakeholder pensions). Figure 6.8 shows, for a given employer size, the proportion of employees with DC workplace pensions between 1997 and 2011. Overall, the proportion of employees with such pensions has risen from 10 per cent to 16 per cent over this period.
Most of the increase has taken place in medium-sized workplaces. For employers with 100 to 499 employees, the proportion of employees with DC pensions increased from 12 per cent in 1997 to 27 per cent in 2011. For employers with 500 to 999 employees, the proportion increased from 11 to 25 per cent.
The proportion of employees with DC pensions working for employers with 1,000 or more employees rose less rapidly, from 8 to 13 per cent. Meanwhile, for employees working for small firms (with 1 to 12 employees and 13 to 99 employees), membership of DC pensions increased in the first part of this period, from 1997 to 2002 and 2003, before falling off in the second half.
It is sometimes suggested that public sector schemes provide better pensions than private sector schemes. It is difficult to compare benefits in the two sectors because of their different structures (the public sector is predominantly DB while there is a mixture of DB and DC provision in the private sector). However, one method of comparing benefits is to look at the ‘accrual rate’ for current employees in DB schemes in the two sectors. The accrual rate is the fraction of salary accrued by the employee for each year of service that will form the basis of the annual pension at retirement1. Table 6.9 compares the accrual rates of DB schemes in the public and private sectors.
|Private sector||Public sector|
|50th or better||5||2|
|Between 50th and 60th||6||..|
|60th plus an additional lump sum||4||11|
|80th plus 3/80th lump sum||17||46|
|Between 60th and 80th||12||4|
|Less generous than 80th||2||0|
In 2010, 80 per cent of public sector and 64 per cent of private sector scheme members were accruing benefits at 60ths or at 80ths plus an additional 3/80th lump sum (which is seen as comparable with 60ths in terms of benefits). Similar proportions were accruing benefits at more generous rates than this; 14 per cent of those in the private sector compared with 13 per cent of public sector scheme members. 22 per cent of private sector scheme members were accruing benefits at less generous rates than this, compared with 7 per cent of public sector scheme members.
Public sector schemes have traditionally had earlier normal pension ages2 than private sector schemes (age 60 or lower). Since the 1970s, the OPSS results have shown that between three-fifths and three-quarters of private sector scheme members belong to schemes with a normal pension age of 65; in 2010, the figure was 73 per cent. In the public sector, 57 per cent of active members in 2010 were still accruing pension rights under rules which allowed them to retire at age 60 or before.
However, most public sector schemes have increased normal pension age to 65 in recent years, either for new entrants or for all members, so there are increasing numbers of public sector employees to whom a normal pension age of 65 applies.
As a result of recommendations outlined in the 2011 report of the Independent Public Service Pensions Commission chaired by Lord Hutton of Furness3, most of those still accumulating rights under rules which allow them to draw a pension in normal circumstances at age 60 are likely to be moved into schemes with a normal pension age of 65 which would increase in future in line with proposed increases in State Pension Age.
At the time of publication, discussions are still ongoing between the Government, the schemes and the trade unions over the implementation of these recommendations for each of the schemes affected4.
For example, a ‘final salary’ defined benefit scheme might provide a pension based on an annual accrual rate of 1/80th: a person retiring after 40 years’ service would accrue 40 times 1/80th or 40/80ths and, therefore, receive half of their final salary as a pension. It is a legal requirement that the accrual rate is constant over the entire period of service in a given part of the scheme.
Normal pension age is defined as the age at which active members and deferred pensioners become entitled to receive their benefits.
The final report of Lord Hutton's review of public service pensions was published in March 2011.
The Local Government Pension Scheme, the main funded public sector scheme, has been exempted from the reforms.
Another important factor which helps to explain the structure of the private pension system, in particular the shift from DB to DC schemes in the private sector, is the approach to risk.
In DB schemes, the scheme rules specify or ‘define’ the rates of benefit to be paid. In funded DB schemes, the employer bears the investment risk and must pay out pensions at the agreed rate, regardless of the returns made on the invested contributions. Costs may be passed on to the next generation of employees in terms of reduced benefits, but current scheme members have a good idea of the pension that they will receive on retirement.
This contrasts with the position of DC pensions, where current members’ future pension benefits are not ‘defined’ and may be eroded by a fall in the value of pension fund investments. The stock market decline of 2008 was a forceful reminder for many people with DC pensions that investment risk in such pensions is assumed by individual members rather than by their employers.
In addition to investment risk, employers providing DB pensions must account for longevity risk – the risk that the actual life expectancy of scheme members after retirement is different from that anticipated (see Pension Trends Chapter 3) – and also the cost of compulsory indexation to compensate for inflation for deferred and pensioner members.
For DC pensions, these and other risks, in particular those associated with purchasing an annuity, are borne by individual members rather than by employers. In recent years, people with DC pensions have faced declining annuity rates, which mean that their accumulated pension savings buy less pension income than previously.
DB schemes have to take account of risk in their funding strategies, and this has traditionally meant higher contributions from employers in order to be certain that the schemes can meet their projected pension liabilities. Employers with DC pensions do not have to pay such risk premia because members are not guaranteed any particular level of pension.
Figure 6.10 shows the contribution rates of private sector occupational pension schemes. Employers with DB schemes paid 15.8 per cent on average in 2010, compared with 6.2 per cent for employers with DC schemes. Employees also contributed more into DB schemes on average than they did into DC schemes (5.1 per cent and 2.7 per cent respectively).
The system of contracting out (see Glossary) accounts for some of the difference in contribution rates (see Pension Trends Chapter 8), but most of the difference can be attributed to different approaches to risk management of DB and DC schemes.
Figure 6.10: Weighted average contribution rates to private sector occupational pension schemes: by benefit structure and contributor, 2010
In 2010, the OPSS questionnaire was redeveloped to ensure that if there were different contribution rates for different groups of members, these were recorded. The scheme was asked to give the different rates and the corresponding proportion of active members to whom that rate applied.
Prior to 2010 only the contribution rate that applied to the majority of members was recorded. This means that caution should be exercised when comparing the figures for 2010 with earlier estimates. In general, the average contribution rates have shown a small increase over the last ten years for both members and employers in DB and DC schemes.
Private sector employers with no Government guarantee who provide DB pensions must also pay an annual levy to the Pension Protection Fund (PPF) to protect members’ pensions should they become insolvent. The PPF was set up under the Pensions Act 2004 to provide compensation to members of such pension schemes in cases when employers are declared insolvent and there are insufficient assets in the pension scheme to cover its liabilities.
Given the rising costs of providing DB pensions, due to DB schemes’ approach to dealing with risk, a growing number of private sector employers have sought to ‘de-risk’ pension provision by closing DB schemes and replacing them with DC schemes. This explains the shift in membership from DB to DC pensions in recent years. Also, some schemes have negotiated for existing DB liabilities to be permanently bought out by insurance companies and specialist buy-out firms (see Pension Trends Glossary).
In addition, a variety of alternative retirement saving vehicles have emerged that attempt to offer a way of sharing the risks associated with employer-sponsored provision so that the risks for employers are smaller than in final salary DB schemes but do not fall entirely on the employee, as in DC pensions. CARE schemes (see 4. Definitions), such as the Nuvos scheme for the Civil Service introduced in 2007, are an example of risk sharing.
The Independent Public Service Pensions Commission chaired by Lord Hutton proposed that all public sector schemes move to a CARE model. At the time of publication, discussions are still ongoing between the Government, the schemes and the trade unions over the implementation of these recommendations for each of the schemes affected. The 2010 annual report of the Occupational Pension Schemes Survey showed estimates, for the first time, for weighted average contribution rates to existing career average schemes (revalued in line with prices).
Average member contribution rates to CARE schemes, at 5.4 per cent, were higher than both rates for defined benefit schemes as a whole (5.1) and defined contribution schemes (2.7 per cent). Average employer contribution rates, at 11.8 per cent, were lower than for defined benefit schemes as a whole (15.8 per cent) and higher than defined contribution rates (6.2 per cent).
Another risk sharing option involves providing a larger proportion of the final salary pension as a lump sum, or even providing the whole amount as a lump sum which the member has to annuitise or draw down. Here, the employer still bears the investment risk but avoids part or all of the post-retirement indexation and longevity risk. Hybrid pension schemes, which combine both DB and DC elements, are another way of sharing risk.
Although the UK has a well-established private pension system, there are concerns about the cost of providing state retirement benefits for an ageing population (see Pension Trends Chapter 2). The Pensions Act 2008 put in place a framework for workplace pension reform designed to increase saving for retirement. This framework was amended slightly by the Pensions Act 2011 but broadly the reforms make the following changes:
All eligible employees are to be automatically enrolled into a qualifying workplace pension scheme; and
The launch of a new trust-based DC pension scheme known as the National Employment Savings Trust (NEST), to assist employers with provision. NEST became open to membership at the end of 2011.
Starting in October 2012, with gradual roll-out to all employers by 2018, employers will have a duty to automatically enrol all eligible employees into a qualifying pension scheme and to make contributions on their behalf. Workers will be able to opt out of their employer’s scheme if they choose not to participate, but they will be re-enrolled after a set period (automatic re-enrolment will not happen more frequently than once every two years and nine months).
In order to qualify, DC schemes will have to make minimum contributions of 8 per cent on a band of earnings, of which at least 3 per cent must come from the employer. However, there will be a phasing in period, when lower contributions will be allowed (see Pension Trends Chapter 8). DB schemes that are contracted out of the State Second Pension will need to hold a contracting out certificate.
The Pensions Act 2011 also introduced an annual review of the auto-enrolment earnings trigger, the upper or lower limits of the qualifying earnings band, and an optional waiting period of up to three months before an employee needs to be automatically enrolled into a workplace pension1.
NEST meets the qualifying scheme standards and provides another option (in addition to the existing ones) for employers who do not have a scheme. It will offer a choice of investment funds in addition to its default Retirement Date Funds for those members who do not make an investment choice2. Employees who join the scheme will be able to retain membership of NEST when they move jobs.
The 2012 reforms are likely to be the biggest change in the UK private pension system since the 1980s, as they should extend coverage to millions of employees who currently lack a private pension, in particular those in the target market of moderate to low earners. It is significant that NEST, the option which is likely to be taken up by many employers who do not have a private pension scheme at present, is being set up on a DC basis.
This is expected to increase the number of people contributing to DC pensions, as discussed in section 13. The future of private pensions. The primary users of NEST are expected to be the smaller employers.
The 2012 workplace pension reforms are designed to increase coverage of private pensions, particularly for private sector employees who are not making adequate provision for old age. Assuming, as appears likely, that most of the expansion in coverage will take place through NEST and other DC pensions, the reforms could significantly increase the membership of DC pensions.
The likely result is that by the end of this decade the majority of active members of private pension schemes in the UK may be in DC pensions, by contrast with the current situation where there are more active members of DB than of DC pensions (see 7. The changing landscape). This raises the question of whether DC pensions will be capable of providing sufficient pension income for future generations of pensioners.
Figure 6.11 builds on the idea of the ‘pension gap’ (see 2. Replacement income) to explore the contribution rates required in voluntary pension systems to achieve the average gross replacement rate of OECD mandatory pension systems (57 per cent). For simplicity and comparability, the OECD calculations assume that people with voluntary pensions have a private DC pension plan.
The analysis also assumes full work histories: people enter the labour market in 2006 at age 20 and work continuously until State Pension Age (SPA), which differs from country to country. As the model assumes unbroken work histories, it does not take into account the variations which exist between countries in average length of work histories. Readers should note that the source information from OECD in this section has not been updated since the 2011 edition of this chapter. The estimates in this section are not National Statistics.
Figure 6.11: Contribution rate required to bridge the pension gap in selected OECD countries
In the OECD pension model, the UK has one of the largest pension gaps of OECD countries, at 25 per cent. This means that it needs relatively high private pension contribution rates to close the gap. Assuming a real rate of investment return of 3.5 per cent net of administrative charges, the contribution rate required for average earners in the UK with a full work history (assumed to be 45 years) is 5.9 per cent (Figure 6.11), below those of Japan and Ireland but higher than the contribution rates which would be needed in most other OECD countries.
Figure 6.12 shows the effect of reducing the number of years for which contributions are made. Assuming a real investment return of 3.5 per cent (net), an average earner in the UK with ten missing years of contributions would need to pay 8.3 per cent of earnings into a DC pension scheme in order to bridge the pension gap. With 20 missing years, contributions would need to be made at 12.5 per cent of earnings.
Figure 6.13 shows how different investment returns can affect the level of contributions that average earners with full work histories need to make to DC schemes to bridge the pension gap. The lower the rate of investment return, the higher the contribution rate required to bridge the gap.
With a real rate of investment return at 2 per cent, an average UK earner with a full work history would need to contribute 7.3 cent of earnings throughout their career to achieve the OECD average gross replacement rate from mandatory pension schemes. With a real rate of return of 7 per cent, the level of contributions needed falls to 1.7 per cent of earnings.
The OECD analysis is based on models of possible outcomes, using different assumptions to illustrate scenarios. It is not possible to establish with any certainty what the results will be in specific cases, or whether individual DC members will do better or worse ‘on average’ than DB members in terms of pension outcomes. This is because DC outcomes depend on a number of different factors, and vary between individuals.
This variability of DC pensions may be an issue for the future of the private pension system. In DC pension schemes, risk is assumed by individual scheme members (see above: 10. Approaches to risk). Some individuals may do better than expected, while others may do worse, particularly if the performance of the funds in which their pensions are invested is poor.
Therefore, average DC pension outcomes are not sufficient as a measure of whether DC pensions are delivering the benefits expected by pension savers. Even if people with DC pensions do well ‘on average’, the system as a whole would fail to meet people’s expectations if significant numbers of individuals were to receive below-average pensions from DC pension schemes. It is worth noting that replacement rates differ depending on the level of earnings.
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Antolín P, and Whitehouse, E.R. (2009) ‘Filling the Pension Gap: Coverage and Value of Voluntary Retirement Savings’, OECD Social Employment and Migration Working Papers, No.69, OECD Publishing. Filling the Pension Gap: Coverage and Value of Voluntary Retirement Savings
Department for Work and Pensions (2008): Risk sharing - public consultation.
Department for Work and Pensions (2011) A state pension for the 21st century, April 2011 (Green Paper on state pension reform).
HM Revenue and Customs pension statistics website.
Martin, J. P. & Whitehouse, E.R. (2008) ‘Reforming Retirement-Income Systems: Lessons from the Recent Experiences of OECD Countries’, OECD Social, Employment and Migration Working Paper No. 66.
National Employment Savings Trust website.
OECD (2011), Pensions at a Glance 2011: Retirement-Income Systems in OECD and G20 countries, OECD Publishing.
OECD (2009), Pensions at a Glance: Retirement-Income Systems in OECD Countries, Paris.
OECD (2008), OECD Private Pensions Outlook, OECD, Paris.
Office for National Statistics, Occupational Pension Schemes Annual Report.
Office for National Statistics, Annual Survey of Hours and Earnings Pension Tables.
Office for National Statistics, Glossary - Pension Trends (198.9 Kb Pdf) .
Pensions Commission (2004) Pensions: Challenges and Choices, The First Report of the Pensions Commission. The Stationery Office: London.