Demystifying final salary payments
I've been having some interesting conversations lately about what happens when members of final salary company pension schemes reach retirement. The reason I'm mentioning it is it seems to me hardly anyone appreciates how occupational pension schemes provide pensions.
Once you have completed your time with your employer and reached retirement age, the company pension scheme pays out a pension for the rest of your life. But it seems to me that everyone I speak to thinks company pension schemes do this by taking a big pile of money out of the pension fund on the day people retire and using it to buy a secured annuity for the retiree. Schemes can do this, and some final salary schemes do, but many schemes don't.
It is common for final salary company pension schemes, particularly the larger ones, to simply pay the pension income to pensioners out of the pension fund - much in the same way an individual with a money purchase pension pot might do these days, through an income drawdown product.
For that reason, the continued income to the pensioner throughout retirement is completely dependent on the pension fund being able to continue to make the pension payments. That's why pensioners are more secure these days, following the recent introduction of the Pension Protection Fund (PPF). The PPF doesn't just protect the pension benefits of those still working and those with deferred pension entitlements, it also protects the pension benefits of many people whose company pensions are already in payment.
There is also a bit of a myth about the fact that people are required to purchase an annuity at the age of 75, too. It's true that some people must do this, but only those with personal pensions or with income drawdown arrangements. For people receiving final salary pensions paid out of company pension funds, there is no such requirement. The scheme will sometimes opt for an annuity bought from an insurance company, but the fact remains that it is possible for a money purchase scheme (particularly for a large money purchase occupational scheme) to provide pensions directly out of the pension fund in the same way as final salary schemes do.
There are plenty of pensioners in their late 70s and 80s today whose pensions have never been secured by the purchase of annuities, and never will be.
The comparison between what happens with pension payments from final salary schemes and what happens with money purchase income drawdown plans is, I think, a good one. In both cases, the pension fund continues to be invested for growth, and the income is drawn from it. The main difference is that individual income drawdown accounts are tailored to the needs of the individuals involved, whereas the mass income drawdown approach (if I can call it that) of company schemes is tailored to the needs and requirements of all parties involved in the company pension fund; those who are retired, those who are still working, those with deferred pension entitlements and, of course, the sponsoring employer. The other difference is that individual income drawdown must cease by age 75 with the purchase of an annuity. It seems to me the time has come for a rethink of this rule that requires some people to purchase an insurance product in the form of an annuity just because they reach an arbitrary age, whereas other pension savers in effectively the same position have no such requirement laid on them.
First published in Pensions Week, 10 September 2007