In the UK, final salary pension schemes have historically formed the backbone of what has become an ...
In the UK, final salary pension schemes have historically 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 of choosing the most appropriate investment vehicle or investment manager.
Educating the member of the company pension scheme on the quality of benefits they are 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 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 that reflects scheme liabilities. First, the relative immaturity of schemes over the past 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 looked 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 returns expected by the scheme's actuary.
The bottom line is that taking investment risk has 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, 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 legislation on the minimum funding requirement (MFR), schemes have been 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 that 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, while 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 growing Government 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. It will depend on the size of their pot and the annuity rate at the time they retire. If a member is to maximise their potential pension, it is vital that they get the investment mix right. In order to maximise the 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 above, this is a concentration on equity investment for the early years and fixed interest investment as the member moves closer to retirement. By adopting this strategy, the member should maximise the size of the investment pot, while protecting themselves from movements in annuity rates as they approach retirement.
At each stage of life, therefore, the member needs to have the correct investment mix, as well as investing an adequate amount to meet 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. Usually this is 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 to maximise fund growth in the early years before switching to protect against annuity rate movements later. The usual strategy is to invest in a mixed or global equity fund until the member reaches 10 years before 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 understanding and encourage them to monitor the 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 adv
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