Pension schemes are of various types, as outlined below. There are strict legal controls on who can give financial advice, and employers should therefore ensure that they do not advise employees on the best pension option for them. Employees cannot be required by their employer to join a particular scheme, or indeed any scheme. The Inland Revenue has produced a free leaflet giving information on pension options for employees and sources of further guidance and help ( Pensions links ).
There are two main types of company pension scheme: those that provide defined benefits and those that are based on defined contributions.
Defined benefit schemes provide pensions that are defined by reference to generally, the employee's salary at or near retirement and how long the employee has been a member of the scheme. Commonly, employees accrue the right to a pension of one eightieth or one sixtieth of their salary at or near retirement for each year they are in the scheme. Therefore an employee with 40 years' service in a defined benefit scheme with an accrual rate of one eightieth will retire on half his or her salary, at or near retirement.
These schemes may require employees to make a contribution ('contributory schemes') or may, less frequently, be entirely funded by the employer ('non-contributory schemes'). The employer must make whatever contributions are necessary to fund the scheme adequately, based on actuarial advice. If the pension fund is in surplus, the scheme rules may allow the employer to reduce its contributions or pay no contributions for a period (sometimes referred to as taking a 'contributions holiday').
Some pension schemes are funded by specified contributions from the employer, and sometimes also from the employee, defined as a percentage of the employee's wages or salary. While the employer's liability to pay contributions is fixed, the size of the pension is not. It depends not only on the size of the contributions that have been paid into the fund by the employer and the employee, but also on how well those contributions have been invested, and what annuity rates are available when the employee reaches pension age.
Employees who want to enhance their pension benefits are currently entitled to make additional voluntary contributions (or AVCs). There are rules that apply to both occupational and personal pension schemes for people who want to pay more into their pension scheme.
Employees cannot be forced to join an employer's pension scheme. They may prefer to take out a personal pension. Personal pensions are also an option for employees whose employer does not offer an occupational pension.
Personal pensions are operated by financial services companies, independently of employers. Employers can, however, arrange for personal pensions to be offered on a group basis (known as a 'group personal pension scheme'), so giving employees the benefit of the lower administrative charges that come with economies of scale.
Some employers choose to contribute to employees' personal pensions, as an alternative to providing a pension scheme themselves.
Stakeholder pension schemes are operated by financial services companies rather than by employers. But certain employers must facilitate employees' access to a stakeholder pension, by choosing a scheme (after consulting with employees), providing employees with information on the scheme and deducting employees' contributions to the scheme from their pay if they choose to join. Stakeholder pensions are discussed in more detail later in this section (stakeholder pensions).
Occupational and personal pensions operate against the backdrop of the state retirement pension. Employees are eligible for the basic flat-rate state pension if they have paid, or been credited with, sufficient National Insurance contributions. Men need to have contributions for 44 years, women for 39, to qualify for the full pension. (Women will also need 44 years' contributions when the state pension age is equalised for men and women.) Those without full National Insurance contributions records may still be entitled to a reduced basic state pension.
The age at which the state pension becomes payable is currently 65 for men and 60 for women. A common retirement age of 65 is to be phased in over a 10-year period, beginning in April 2010. Women born before 6 April 1950 will continue to be able to claim their state pension at 60, but women born on or after 6 April 1955 will not be able to claim their pension until they reach 65. Women born between 6 April 1950 and 5 April 1955 will receive their pension at some age between 60 and 65, depending on their date of birth.
Those who do not qualify for a full basic state pension may qualify for a non-contributory pension once they reach the age of 80.
Between 1978 and 2002, the state administered a State Earnings-Related Pension Scheme (SERPS), which provided additional benefits based on earnings between the lower and upper National Insurance earnings limits. In April 2002, the State Second Pension was introduced. This provides a more generous additional state pension for low and moderate earners and certain carers and people with a long-term illness or disability ( Pensions links ).
If an employer's pension scheme meets certain conditions, it is entitled to 'contract out' of the State Second Pension by applying for a contracting-out certificate under the Pension Schemes Act 1993. Both employer and employee then make reduced National Insurance contributions, and the employee is no longer entitled to a State Second Pension in respect of the period that they are contracted out.
An employee with a contracted-in employer pension scheme, personal pension or stakeholder pension can also contract out of the State Second Pension, meeting the requirements laid down by the Department of Work and Pensions. Both employer and employee continue to pay National Insurance contributions at the usual rate, but the Inland Revenue makes a lump sum payment into the individual's pension account at the end of each year of an amount broadly equivalent to what would have been paid towards the State Second Pension. This rebate is applied on a sliding scale depending on the age of the member.