3. Money Purchase Schemes (Defined Contribution Schemes)

How do they work?

In recent years many Companies have moved away from Final Salary Pension Schemes because they represent an open ended financial commitment. Costs to employers have increased as a result of additional regulations and there may be the need for them to pay substantial additional contributions to guarantee benefits during times when the funds have been adversely affected by poor investment returns. A large number of employers may now offer a Money Purchase Scheme rather than a Final Salary Scheme.

Companies can provide money purchase benefits either by setting up an occupational money purchase scheme or by paying into separate personal pensions for each individual under a ‘grouped’ arrangement. (Which are covered in Section 4).

A Money Purchase Pension Scheme is established under a ‘trust’ quite separate from the Company. It is looked after by trustees, whose job is to run the scheme as required by the trust deed and rules governing the scheme, taking advice where necessary. An insurance company is likely to provide the scheme administration and investment funds. Legislation has been introduced to prevent misuse of the pension funds by the Company. There is now the right for members to elect trustees and procedures have to be in place to settle disputes.

Under a Money Purchase Pension Scheme a level of contribution is set for the company and employee (this can vary between members) and these contributions are invested in the member’s account. The employee can obtain tax relief on contributions up to the full level of his earnings, but of course a much lower level of contribution is likely to be paid. There would be a tax charge if the combined employee and Company contribution exceeds the ‘Annual Allowance’ (see Section 1) but this will not be relevant in the vast majority of cases.

At retirement a tax free cash sum is usually taken up to 25% of the accumulated fund and the balance of the accumulated fund is used to purchase an annuity income for life. The scheme itself may also allow for a pension to be paid from the scheme rather than an annuity being purchased.

Under a Money Purchase Pension Scheme the member is taking the investment risk and the end result will depend on how well the investments have grown, the charges made for running the scheme and the price of buying the pension at retirement. There are no guarantees. Within the Scheme there is likely to be a range of investment choices. The correct investment for you will depend on the level of risk you are willing to take and this is an area where advice may be required.

At retirement the funds available under a Money Purchase Pension (after taking any tax free cash lump sum) are usually used to buy an annuity from an Insurance Company to provide a guaranteed income including inflation linking and spouses pension, as required. The more additional features that are chosen the lower the amount of pension that can be purchased with the funds.

Full details of the various ways of taking an income at retirement are given in the separate ‘Retirement Options’ factsheet.

Entitlements to benefits are given at a ‘normal retirement age’, most commonly age 65. Early retirement can be available from age 50, though early retirement will not generally be available until age 55 from the year 2010.

What happens if you die?

In the event of death prior to retirement the full fund can be paid to your dependants as a lump sum or alternatively all or part of the sum can be used to provide a dependants pension. The lump sum provided would be tax free, though there would be a tax charge if the lump sum exceeds the Lifetime Allowance (see Section 1).

The fund value will not always give adequate protection, particularly in the early years, and so the Company may establish insurance to provide additional cover. Alternatively this can be taken out by individuals, in many cases, with full tax relief on the contributions.

In the event of death following retirement, any benefits payable will be based on the type of annuity purchased. The payments may continue to a spouse or dependant if a spouses/dependants pension or guaranteed benefit has been selected. It is now possible for annuities to include an element of protection if the pension drawn falls short of the purchase price, and ‘unsecured income’ can be chosen whereby income is taken from investments without purchasing an annuity. Again, full details are given in the Retirement Options Factsheet

Contracting Out of the State Second Pension Scheme (S2P)

Contracted Out Money Purchase Plans (COMPS) exist where all members are contracted out of the State Second Pension (S2P). However this is based on the previous State Earning Related Pension Scheme (SERPS) and following the introduction of S2P the government will continue to pay a top up payment to eligible members at retirement.

The National Insurance rebates received from the government are paid into a separate protected rights fund. They cannot be accessed until age 50 (55 from 2010.) With effect from 6 April 2006 tax free cash of up to 25% can be taken. The remaining fund is converted into a pension which has to increase at a specified rate and the death benefits from the resulting fund are also subject to restrictions.

Where Money Purchase Schemes are not contracted out of S2P individual members may choose to do so by taking out a Personal Pension or Stakeholder Plan specifically for this purpose. The terms and benefit restrictions are similar to those listed above although as the member will be fully contracted out of S2P no government top up is payable at retirement.

Please note that, by contracting out of S2P, guaranteed benefits are given up and the end result will depend on how well the investments have grown, the charges made for running the scheme and the price of buying the annuity at retirement. The resulting pension could be more or less than would have been available from S2P.

Taxation Issues

• Employee contributions (if any) are entitled to tax relief at source. Contributions are normally deducted from the salary before tax is applied which means that basic or higher rate tax relief is given automatically.
• Employers are able to offset regular pension contributions against corporation tax as an expense of the business. Income (apart from UK Equity Dividends) and gains within the pension funds are exempt from tax.
• The lump sum available upon retirement is tax free and any pension payments will be subject to income tax at the member’s highest rate.
• The lump sum payable on death is normally not subject to Inheritance Tax.

Additional Contributions

The basic benefits from a Company pension scheme may be insufficient to meet the member’s retirement objectives. It is possible to make additional pension contributions to increase the pension on retirement (rather than some other means of saving), or to retire early by:

• Making additional contributions to the Company Scheme, or
• Setting up a separate individual pension scheme to take the additional contributions.

Which option is best will depend on the circumstances. A separate personal scheme will give you greater individual control, but there may be features of the Company scheme which outweigh this, e.g. lower charges and/or advantageous terms for converting funds to income at retirement.

In most cases advice should be sought regarding the options for paying additional pension contributions including how these compare with non-pensions savings plans.

Maximum Benefits

Prior to 6th April 2006, various Inland Revenue approval ‘regimes’ imposed maximum benefits on occupational money purchase schemes, but these no longer apply. The limitations are now only in respect of the level of contributions which can be paid on which tax relief is given, the maximum amount of tax free cash, and the maximum fund which can be accumulated without a tax charge as described above.

Members of occupational schemes before April 2006 may be able to protect advantageous provisions from the previous approval regimes, as described in Section 1.

Leaving Service

Few people remain with the same employer throughout their working lives and on leaving service a decision needs to be made regarding any entitlements accrued under a Company pension scheme. It should also be borne in mind that valuable insurances (particularly on death or disability) may be provided as part of or in conjunction with the Company scheme, and these insurances will probably cease on leaving service. A review of additional insurance provisions may also be necessary.

Where an employee leaves an employer’s Money Purchase Pension Scheme before normal retirement age, he or she may be able to choose from the following six options:

1. Leave the preserved funds in the Company scheme where they will stay invested until retirement.
2. Transfer to a new employer’s occupational pension scheme where the individual has started work with an employer who offers such a scheme.
3. Transfer to a Personal Pension or Stakeholder Plan.
4. Transfer to a Section 32 policy which broadly provides the same money purchase benefits as a personal pension, but may occasionally be preferable based on individual circumstances.
5. Take early retirement benefits, normally only where the member is aged at least 50 years (changing to age 55 from 2010).
6. Where the employee has less than two years qualifying service they can take a refund of personal contributions that had been paid into the scheme, subject to certain deductions. Entitlement to a transfer of both employee and Company contributions arises after 3 months.

As you will appreciate, the decision on which option to take, and whether to transfer is not straightforward and the correct course of action will depend upon your attitude to risk. Advice should be taken in all cases.

Care needs to be taken when transferring from an occupational pension scheme to ensure that no valuable benefits are being lost, e.g. tax free cash above 25% of fund from pre April 2006 service.

Executive Pension Plans (EPP’s)

This is the name given to a Money Purchase Company Scheme set up for a single employee or small number of employees. This type of plan is normally used by a company to pay high levels of employer contributions for senior managers and directors. The contributions are invested in an insured contract with a product provider. The Company normally pay the contributions although the member is able to contribute to the Plan. The provisions of the scheme are generally the same as Money Purchase Schemes. These schemes are likely to become less common after April 2006, as they now provide equal benefits to personal pensions, which are simpler to administer.

Small-Self Administered Schemes (SSAS’s)

A SSAS is a Money Purchase Company Scheme set up for a small group of employees (normally directors), up to a maximum of 11. These schemes give the widest investment possibilities including individual shares rather than insured/collective investments. Investment options include:

• Making a loan to the employer or an associated company.
• Buying or selling land or property.
• Borrowing.
• Buying or selling an unlisted company’s shares.
• Buying or selling shares in the employer or a company associated with the employer (subject to limits).
• Buying, selling or leasing other assets from or to the company or an associated company.

Changes from April 2006 mean that it is now possible to buy sell or lease most kinds of asset directly to or from scheme members or other ‘connected’ parties. A SSAS is therefore useful in providing pensions for employees whilst at the same time using pension assets to assist the operation of the Company. From the member’s point of view there is a risk that if the business itself fails this could have adverse consequences for the pension, as well as loss of employment. It is for this reason and the fact that large employer contributions can be made that SSAS’s are usually restricted to company directors.

There are various regulations regarding the operation of a SSAS, particularly in respect of the investments allowed, but otherwise it operates in a similar way to the other Money Purchase Company Schemes as above. The trustees of the scheme are usually the directors themselves.

Similar provisions can be made under a SIPP (self- invested personal pension) and these are likely to be considered as an alternative to a SSAS. There are differences between the two which will influence the decision, e.g. it is possible to make loans to the Company under a SSAS but not under a SIPP.

Section 32 Policies

Section 32 policies were introduced by the Finance Act 1981 and are an alternative to personal pensions as individual arrangements to receive transfer payments from occupational pension schemes.

All the benefits under a Section 32 policy are on a Money Purchase basis, apart from any Guaranteed Minimum Pension (GMP) arising from Government rebates that would usually make up S2P benefits (see above). Since April 2006 the benefits from a Sections 32 are subject to the same general rules as personal pensions but there are situations where they may be advantageous, e.g., receiving transfers on wind up where tax free cash is greater than 25%, or minimising the amount of ‘protected rights’ for final salary transfers. If you are looking to transfer benefits from a Company Scheme it is important to seek guidance from your Financial Adviser.

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