AMOUNT
OF BENEFIT
There are two distinct methods of ascertaining
how much any given benefit should be. These are described as being
defined benefits or money purchase benefits. Some schemes may
provide a mixture of the two types of benefit but it is convenient
to consider them separately. Both methods entail the involvement
of actuaries.
1. Defined Benefits
Here the benefits are fixed or more usually
ascertainable. The calculations of benefits is usually by reference
to salary to which a fraction (for example 1/100, 1/80, 1/60)
for each year is applied. Usually it is applied to the final salary
although some schemes apply to an average of career earnings.
Somehow these benefits have to be funded. So
long as the scheme is continuing, effectively the employer is
bearing the cost and investment risk. What is required to fund
the benefits is worked out by an actuary. He will work out the
likelihood of how many people will leave service or die before
retirement date and how much the benefits for them will cost and
the likely time when those benefits will come into payment.
Since the benefits are based on length of service
and salary the actuary will have to make assumptions as to what
those are likely to be. For example he will take current salaries
and make assumptions about salary inflation. He will also have
to allow for people being promoted to better paid positions but
over the average of any reasonably sized scheme the seniority
distribution of people is likely to remain about the same. He
also has to make assumptions about when these benefits will come
into payment and that involves assumptions about how long people
will serve. Finally, he needs to make assumptions about what annuity
rates will be available to purchase pension at the time. These
are all based on complex formulae which are largely related to
yields on long-term gilts.
That enables the actuary to work out what is
likely to need to be invested and when. He then has to work back
to determine what has to be put in now and over the period in
order to achieve that sum and to spread that evenly over a period
of years. In doing that of course the funds are invested and therefore
he has to make assumptions about investment yields on that money
between being put in and being eventually needed. Indeed he has
to make assumptions about the return on the initial investment
and also what is known as the re-investment rate for the re-investment
of the income on the original investment. The Pensions Act 1995
requires trustees of a pension scheme to meet the minimum funding
requirement and to have schedules of contributions for that purpose.
This helps to reduce over-creative use of assumptions.
Having worked out what the necessary contributions
are these are then expressed as a percentage of salaries and that
percentage rate is known as the funding rate. At any given time
that funding rate may produce a surplus or a deficit. No-one can
know exactly, and the surplus or deficit may vary depending upon
what assumptions are used. Assumptions are therefore very critical.
If the assumptions are wrong, the whole thing is wrong. Assumptions
are vitally important, particularly in final salary schemes. By
seemingly minor adjustments of a fraction of a percent, millions
of pounds can appear or disappear. With assumptions to be made
about salary inflation, general inflation, investment rates, re-investment
rates etc., scope for statistical prestidigitation is very wide
indeed. When you receive an actuarial report almost certainly
the assumptions will be the vital part. Over the life of a scheme
variations and or errors in assumptions can be evened out. When
pension rights are to be valued, future income is being capitalised
now and the assumptions must be right.
They can also be paid to a separate individual
arrangement known as a free standing additional voluntary contribution
scheme, which is a bit like a personal pension.
2. Money purchase
In a pure money purchase scheme there is no
promise as to the amount of the benefits which will be received.
Usually there is a fixed rate of contributions from employer and
employee and whatever these build up will be the amount to be
applied to the benefits at the end of the day. Some of the contributions
may be applied to life assurance benefits. The investment risk
is with the members, not the employer who is not underwriting
a global fund.
Some money purchase schemes do not even have
a prescribed contribution rate. They are purely discretionary.
They are sometimes known as "top-hat" schemes.
Eventually an actuary works out what benefits
the accumulated sum will buy.
For a variety of reasons (including perceived
cost control, escaping the full rigours of the Pensions Act) these
have increased greatly recently and you will encounter them more.
3. Additional Voluntary Contributions
Under the Pension Schemes Act 1993 a member
has a statutory right to pay additional voluntary contributions.
They usually provide money purchase benefits, going into a separate
fund. The separate fund can mean they are forgotten about when
benefits are being quoted.
