Types of pension arrangements
A summary of the main types of pension arrangements, including money purchase (defined contribution), defined benefits and cash balance schemes.
- Money purchase schemes - a pension pot which is built up through contributions and investment returns. The level of retirement benefits will be dependent on the value of the pension pot when benefits are taken.
- Defined benefit schemes- this type of scheme pays a guaranteed income for life. The level of benefits payable are linked to pensionable earnings, duration of membership and other factors, rather than the level of contributions paid into the scheme.
- Cash balance – this type of scheme provides money purchase benefits. The difference between pure money purchase and cash balance schemes is that the size of the member's pension pot isn't only dependent on the contributions paid into the scheme.
Money purchase (also known as defined contribution)
A money purchase scheme is a scheme where the final value depends on:
- the amount of contributions made by the member and any other party (such as an employer and / or third party)
- the performance of the investments underlying the scheme
- the charges within the plan.
This means the benefits payable to or in respect of the member are calculated by reference to the capital value of the pension pot. As the contributions are normally invested in a range of funds or allowable investments, which can fluctuate in value, the value of benefits payable are not known in advance and the member bears the investment risk.
Money purchase schemes can be occupational or personal pension schemes. Personal pensions, SIPPs, SSASs and retirement annuity contracts are all types of money purchase schemes.
Definitions of a money purchase
The definition of a money purchase arrangement from the Finance Act 2004 is; 'an arrangement is a money purchase arrangement at any time if, at that time, all the benefits that may be provided to or in respect of the member under the arrangement are cash balance benefits or other money purchase benefits.'
The definition of money purchase benefits from the Pensions Act 2008 (as amended by the Pensions Act 2011) –
'means benefits the rate or amount of which is calculated by reference to a payment or payments made by the member or by any other person in respect of the member and which are not average salary benefits which fall within section 99A'.
‘A benefit other than a pension in payment falls within this section if its rate or amount is calculated solely by reference to assets which (because of the nature of the calculation) must necessarily suffice for the purposes of its provision to or in respect of the member.’
Pensions Act 2011Part 4, Section 29
Therefore, where the benefit from a scheme is not wholly calculated with reference to the assets it is not a money purchase arrangement.
Pension income from a money purchase scheme
The pension member can usually take up to 25% of their money purchase fund as a pension commencement lump sum (PCLS) (tax-free) and designate the balance of the funds to a product that can provide pension income (which will be taxed at the member’s marginal rate). Depending on the option selected, pension income may be in the form of a secure regular income or give the option to draw down income as required (the level of this drawdown may be limited, according to the option selected). The options available are as follows:
- Lifetime annuity – provides a secure level of taxable income.
- Scheme pension – provides a secure level of taxable income.
- Flexi-access drawdown – provides the flexibility to withdraw taxable lump sums and / or taxable income, with the income being drawn directly from the fund or by the purchase of short-term annuities. There’s no limitation to the level of withdrawals allowed.
- Capped drawdown (this is no longer available unless arranged before 6 April 2015) providing the flexibility to withdraw taxable lump sums and / or taxable income, with the income being drawn directly from the fund or by the purchase of short-term annuities. There are limitations to the level of withdrawals allowed within capped drawdown plans.
In addition to the above methods of providing a retirement income, following the introduction of flexible options, the pension holder may elect to take all or part of their uncrystallised pension fund as a lump sum. 25% of the lump sum will normally be paid tax-free, with the balance of the fund being taxed at the point the pension holder receives it. This method of extracting funds is called Uncrystallised funds pension lump sum (UFPLS)
However, the rules for each scheme will dictate what options are available for the member.
Defined benefit schemes provide retirement benefits that are calculated using a specific formula. Defined benefit schemes can provide a guaranteed lump sum and / or a guaranteed pension and generally provide benefits calculated using:
the scheme benefit level (referred to as accumulation or accrual rate / factor, for example, 1/60th, 1/80th, 1%), multiplied by
the number of years of scheme membership and
some definition of pensionable salary or final salary (usually a salary or earnings figure at the point of accumulation, or at / near retirement).
The employer underwrites the cost of providing benefits calculated using the benefit formula.
Defined benefit is sometimes referred to as final salary but not all defined benefit schemes are based on a member’s final salary. For example, career average revalued earnings (CARE) schemes are a form of defined benefit.
Defined benefit schemes are subject to stricter requirements than money purchase schemes. These requirements are intended to ensure there are sufficient funds to provide the pensions promised to members. The scheme must undergo regular valuations and make contributions to the Pension Protection Fund (PPF), which pays compensation to scheme members if the employer is declared insolvent and can no longer meet their pension commitments.
What is a defined benefit?
A defined benefits arrangement is defined in the Finance Act 2004 as;
‘an arrangement is a ‘defined benefit arrangement’ at any time if, at that time, all the benefits that may be provided to or in respect of the member under the arrangement are defined benefits.’
Defined benefits are:
'in relation to a member of a pension scheme, means benefits which are not money purchase benefits (but which are calculated by reference to earnings or service of the member or any other factor other than an amount available for their provision).'
Income from defined benefits
A defined benefits arrangement may only provide the member with a pension income as a scheme pension. Learn more about scheme pensions in our What is an annuity article
Finance Act 2004< s165(1) Pension Rule 3
A cash balance arrangement isn’t as common as defined benefits or pure money purchase arrangements. It’s a "type" of money purchase arrangement and has some similar characteristics. The benefits provided will be money purchase benefits, but the main difference is the benefits won’t rely solely on contributions made and investment performance. The benefit will be calculated by reference to an amount available for the provision of benefits to or in respect of the member ("the available amount") where there’s a promise about that amount. The promise includes, in particular, a promise about the change in the value of, or the return from, payments made by the member or any other person in respect of the member.
The agreement could be that a certain amount is added to the member’s pension each year or a specified percentage. There could also be no actual pension pot, instead a notional figure that is added to each year. When benefits ultimately become due the amount in the promised pot is funded and it is that amount that is used to provide benefits. There are certain differences between cash balance and money purchase arrangements – an example of this is calculating annual allowance. The method of valuing pension savings in a cash balance arrangement is similar to valuing defined benefit arrangements. You can read more about this in our Annual Allowance facts article.
Legal definition of a cash balance
The definition of a cash balance arrangement from the Finance Act 2004 is:
‘a money purchase arrangement is a cash balance arrangement at any time if, at that time, all the benefits that may be provided to or in respect of the member under the arrangement are cash balance benefits.’
‘cash balance benefits’ means benefits the rate or amount of which is calculated by reference to an amount available for the provision of benefits to or in respect of the member calculated otherwise than wholly by reference to payments made under the arrangement by the member or by any other person in respect of the member (or transfers or other credits).
Finance Act 2004< Part 4 s152(3) and (5)
How a cash balance provides income
The benefits provided under a cash balance arrangement are still money purchase benefits as they relate to the benefit pot rather than by reference to earnings or service. So the benefits are the same as with money purchase arrangements – the availability of a pension commencement lump sum and designation of the balance of the funds to provide the potential of further taxable withdrawals through the following options:
- a lifetime annuity – providing a secure level of taxable income
- a scheme pension – providing a secure level of taxable income
- flexi-access drawdown – providing the flexibility to withdraw taxable lump sums and / or taxable income, with the income being drawn directly from the fund or by the purchase of short-term annuities. There’s no limitation to the level of withdrawals allowed
- capped drawdown (this is no longer available unless arranged before 6 April 2015), providing the flexibility to withdraw taxable lump sums and / or taxable income, with the income being drawn directly from the fund or by the purchase of short-term annuities. There are limitations to the level of withdrawals allowed from a capped drawdown plan.
Uncrystallised funds pension lump sum is also available from uncrystallised cash balance arrangements.
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