Historically, UK final salary pension schemes have formed the backbone of what has become an extreme...
Historically, UK final salary pension schemes have formed the backbone of what has become an extremely healthy pensions industry. They are arguably the best option for members as they provide certainty of pension benefit without the responsibility for choosing the most appropriate investment vehicle or investment manager.
Educating the member on the company pension scheme and the quality of benefits he or she is to receive is certainly beneficial as it promotes increased awareness and encourages voluntary contributions. However, as the benefit is guaranteed, this is not as critical as in the case of money purchase schemes.
Final salary schemes have been characterised by sponsoring employers and a trustee board responsible for the investment strategy and choice of the investment manager.
These bodies have access to actuarial and investment advice on which to base their decisions. The key point is that the scheme, and therefore the sponsoring employer carries the investment risk, while the member enjoys the benefits.
The health of final salary schemes has been built up over the years by an increasing exposure to equities.
These have clearly been the best performing asset class compared with inflation in earnings growth. It is the growth in earnings that is reflected in the rise of liabilities in pension funds.
First, the relative immaturity of schemes over the last 20 years has allowed them to concentrate their investment exposure on equities and reap the benefits of the extra performance.
Secondly, as schemes' investment managers have sought to outperform each other, they have also gradually increased their exposure to better performing equities at the expense of other asset classes.
This combination has had a positive effect on scheme valuations, leaving pension schemes in a healthy state, with many, until a few years ago, on contribution holidays - as actual investment returns outstripped the returns expected by the scheme's actuary.
Investment risk has undoubtedly been good for the pension fund industry. Without it, the costs of funding schemes could have been a lot higher or the benefits to members lower. As long as the investment risks undertaken are consistent with the objectives of the scheme and closely monitored and understood by trustees, they should be beneficial.
The irony is that this is in the process of changing. As a result of the government's legislation on the minimum funding requirement, schemes are required to reconsider their long term investment strategy, particularly if they have too high an exposure to equities relative to their mix of active to pensioner liabilities.
If schemes are mismatched in terms of their investment strategy and performance suffers, then the sponsoring employer runs the risk of having to inject funds into the scheme to meet the solvency requirement.
This reduction in equities leads to a reduction in risk, which could potentially affect the long-term health of the final salary industry.
Over the last few years there has been a marked growth in money purchase schemes. In many cases this has seen companies setting up money purchase schemes for new members only, whilst retaining the final salary scheme for existing members.
One of the many reasons for this change to money purchase has been companies' discomfort with the ever-increasing regulatory costs of final salary schemes. The Government's removal of the ACT credit, for many smaller schemes, was the final straw.
Faced with more and more legislation, companies have been able to reduce or at least control the costs of their schemes by changing to money purchase.
The primary effect of this has been to switch the investment risk from the scheme and sponsoring employer to the member. In future a member's pension benefits will not be guaranteed and will depend on the size of his or her pot, and the annuity rate at the time he or she retires.
If a member is to maximise their potential pension, it is vital that he or she gets the investment mix absolutely right.
In order to maximise their pension, the member of a money purchase scheme needs to follow a similar investment strategy to the one successfully adopted by final salary schemes. As discussed earlier, this is a concentration on equity investment for the early years and fixed interest investment as he or she moves closer to retirement. By adopting this strategy the member should maximise the size of their investment pot, whilst protecting themselves from movements in annuity rates as they approach retirement.
At each life stage, therefore, they need to have the correct investment mix as well as ensuring that they are investing an adequate amount to meet their expectations.
In the case of occupational money purchase schemes, as noted above, the trustee board is responsible for deciding the investment choice for members and appointing the investment manager.
This is usually after taking professional advice from a firm of actuarial and investment consultants on the most appropriate structure for the scheme, taking into account the nature of the company's business and its employees.
The key advantage to members in this approach is that the investment strategy suggested by the trustees should be the most appropriate in order to maximise the growth of their fund in the early years before switching in later years to protect against annuity rate movements. The usual strategy is to invest in a mixed or global equity fund up to 10 years before the member's retirement, and then to switch progressively into long-dated gilts and cash until retirement.
The member should also benefit from ongoing education and advice about the scheme. That will help improve their understanding and encourage them to monitor their expected pension.
However in the case of group personal pensions, members are often given a wide range of investments from which to choose. Without adequate advice
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