Personal Finance

Pensions explained – find out all about pensions

A pension is a sum of money regularly paid to a person who has retired from work because of age or disability. Traditionally, pensions are those payments which are provided as a guaranteed annuity for a retired or disabled employee, or to a deceased worker’s spouse, his/her children or other beneficiary. There are various types of pensions available in the market, of which one or more type will be offered in any workspace. A ‘pension plan’ or ‘retirement plan’ can be described as an arrangement in which an employer (that is, a corporation, government agency, or labor union) offers a definite amount of money to its employees after retirement.

Let’s have a look in detail about the various pension schemes available in the market.

Occupational pensions

Occupational pensions, or company pensions, can be described as those pensions which are offered by the owner of a firm. In this pension scheme, the employees have to pay a proportion of their monthly income into the pension fund – that is a contributory pension. In these types of pensions, the employer of the firm is not compelled to make any contributions. That is, the employer may contribute or may not contribute into the pension fund. Occupational or company pensions schemes are broadly classified into two types:

  • Defined benefit scheme
  • Defined contribution scheme

Defined Benefit Scheme

As the name implies, the Definite Benefit scheme, defines a benefit for an employee upon his/her retirement. The definite benefit scheme can be referred as a final salary scheme, which assures the amount of pension an employee would get on his/her retirement. In this scheme, the employer has to contribute certain amount of money so that they can pay sufficient pensions. The definite benefit scheme protects the pensions from the variations of stock market value. The definite benefit plan also ensures a definite amount of pension that will be a percentage of the member’s final salary. The pension amount is calculated according to the number of years the employee worked for the organization.

Defined Contribution Scheme

Defined contribution schemes can also be mentioned as money purchase schemes. In this scheme the contribution is defined or specified, but one cannot think how much the benefit will be. In a typical defined contribution arrangement, the contributions are usually provided by the employee, the employer or sometimes both, into a pension fund which grows by means of investment. In most cases the employer does not bother how much amount an employee will actually receive as a pension. However, the employer makes some contribution to the pension fund – usually a certain percentage of the employee’s monthly salary. The employer invests the pension fund in the stock market and the actual pension amount an employee receives will be based on the performance of the investments. That is, in this scheme the risk has to be taken by the employee. And at the time of employee’s retirement, the amount of pension is taken to purchase an annuity – which is a type of investment used to provide adequate pension payments.

Stakeholder Pensions

Stakeholder pension is a pension scheme introduced by the government in 2001. According to this scheme, any organization which has more than five employees must provide a stakeholder pension, if they are not providing some other pension schemes. It is also possible for employees to take a stakeholder pension independently. Stakeholder pension can be considered as a kind of money purchase scheme. In stakeholder pensions, it is not necessary for the employer to provide any payments into the pension fund.

Personal Pensions or Private Pensions

Personal pensions or Private pensions are those pension schemes which are taken by individual from a financial service provider. In general, personal or private pensions are considered as money purchase schemes.

State pensions

State pension is considered as a crucial one. This is because only 50% of all employees working in any organization have ever had access to an occupational pension scheme. State pension can be classified into two types:

  • Basic state pension
  • Second state pension (S2P)

Basic state pension

Basic State Pension is a type of pension scheme which is usually paid to any person. The pension will be provided to any individual without considering his/her income, or whether he/she has made any national insurance contributions.

Second State Pension (S2P)

Second State Pension (S2P) can be described as a substitute of the previous State Earnings Related Pension Scheme (SERPS). Second State Pension offers a further income related aspect to the state pension. It is seen that there are several occupational pension schemes which are opted out or contracted out from second state pension. National Insurance (NI) contributions can be paid into the occupational scheme even though it is not essentially useful.

Now you get some idea about the various pension schemes available today. Starting a pension plan is one of the most significant investment decisions you will ever make. Security in your retirement is one of the major issues you must think about and plan for now so that you can maintain the lifestyle you enjoyed during your working life.