There are two different types of pensions in the UK – defined benefit pensions and money purchase pensions. The first of these is salary-related, so it only available to employees and the most common defined benefit pension is the final salary pension.
On the other hand, a money purchase type of pension is used by the employed and the self-employed. Money purchase pension are the most common type of pension in the UK and include occupations defined contribution schemes, personal pensions and even Section 32 buyouts.
How money purchase schemes work
With this type of pension scheme the money saved is invested and the proceeds are used to buy an annuity to provide regular income in retirement (an annuity).
You can make regular contributions to a money purchase schemes, as is the case with defined contribution schemes or use a lump sum, as with Section 32 buyouts. Some defined contribution pension schemes will let you make additional lumps sum payments, as well as regular contributions, so money purchase scheme can be very flexible with regards to pension contributions.
These contributions will also be enhanced by tax relief, providing they are less than the annual allowance limit of £255,000. The amount of tax relief you will receive will depend on your tax rate. Those paying the basic rate of tax and the new additional rate of tax (due to be introduced in 2011) will receive 20% tax relief on their contributions. Higher rate taxpayers can get 40% tax relief.
In most cases, members of a money purchase scheme will use their accumulated pension fund to buy an annuity on retirement. The amount you’ll receive as pension income will depend on the amount saved, the returns generated and the annuity rate used to convert the pension pot into regular income in retirement.
Types of Money Purchase Schemes
Personal pensions and self-invested personal pensions (SIPPs): These can be an ideal way for the self-employed and those without an occupational pension scheme to save for retirement.
Occupational defined contribution (DC) schemes: These include the standard company DC schemes, stakeholder pensions and group personal pensions and Even the Government’s soon to be launch low-cost occupational scheme NEST is a DC pension scheme.
Section 32 Buyout transfers: Unlike the other money purchase scheme this policy is set up using a lump sum, often a transferred pension fund from an ex-employer’s pensions scheme.
There are two important variables that can affect money purchase schemes – volatility in the investment markets and fluctuations in annuity rates.
The returns achieved with a money purchase scheme will be affected by the ups and owns of the investment markets. So, if returns are low, you may have to increase the amount you save to stay on course for a comfortable retirement. With these types of schemes it is important to review your pension planning regularly to make sure that things are going to plan and to take action if they are not.
Annuity rates on the other hand, depend on many variables, including the type of annuity you want to buy, your age and health as well as inflation and the yield on Government bonds or ‘gilts’. Insurance companies buy gilts to match the expected payout of the annuity, but these can fluctuate just like any investment market. The result is that if rates are low when you buy your annuity, you may get pension income which is less than expected.