What is a cash balance scheme? Active Members
There are many types of pension scheme.
This Factsheet looks at a cash balance scheme which is a form of money purchase scheme.
Introduction
There are many types of pension scheme offered by employers for their employees. This Factsheet looks at the cash balance type of money purchase scheme.
Money purchase schemes in one form or another are being introduced by more and more employers, and are now playing an increasingly important role in employees’ pension planning. This Factsheet is written for people who are active members of an employer sponsored cash balance scheme.
To understand what a money purchase scheme is, you ought to know the very basics about employers’ pension schemes. See our Factsheet What is a pension scheme?
What is a money purchase scheme?
A ‘money purchase scheme’ provides benefits based upon the amount of money that is in YOUR own personal pension ‘pot’ when benefits are due to be paid.
The amount that will be in your ‘pot’ when benefits arise will depend upon the payments made into your ‘pot’, the investment return achieved on each individual payment to the pot, and any costs which are charged against your growing ‘pot’. The benefits you or your dependents will get from a money purchase scheme will come entirely from your ‘pot’.
Employer-sponsored money purchase schemes include Contracted-Out Money Purchase Schemes (COMPS), Contracted-In Money Purchase Schemes (CIMPS), Executive Pension Plans (EPP) and Small Self Administered Schemes (SSAS).
Other types of money purchase schemes include Personal Pension Plans (PPP), Stakeholder Pensions (Stakeholder or SHP) and Group(ed) Personal Pension Plans (GPPP). These arrangements may be presented as employer schemes but in fact are personal arrangements rather than employer sponsored schemes (even though your employer may pay into them on your behalf).
What is a cash balance type of money purchase scheme?
A cash balance type of money purchase scheme will provide you with money purchase benefits at retirement – usually in the form of pension and tax free cash lump sum. However, until you begin to draw your pension benefits you will not know the actual amount of pension or lump sum that will be available.
With this sort of arrangement, you know what money goes into the ‘pot’ each year and you will also know the amount of ‘interest’ or ‘growth' that will be credited to those contributions. The amount of that ‘pot’ when benefits are payable, only depends upon what is paid into your pot and how long it remains in the pot.
The promised growth in the value of your ‘pot’ that will provide you with your pension benefits is ‘fixed’, but the ‘form’ and amount of your benefits available at retirement is not. You may for example, be able to choose how much lump sum you can take; any dependants’ benefits you may wish to attach; the level of pension increases you want during retirement; and any guarantee period you want (e.g. a lifetime pension but guaranteed for a minimum of 5 or 10 years).
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Cash Balance
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Other Money Purchase
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· Known growth in the pot up to retirement
· Unknown amount of pension benefit at retirement
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· Unknown investment growth in the pot up to retirement
· Unknown amount of pension benefit at retirement
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As a scheme member, you will be asked to pay a fixed amount into the pension scheme and your employer will also pay a fixed amount of the cost.
Example:
Employer ABC Widgets provides a cash balance scheme for employees’ retirement provision. Sam joins the pension scheme and is required to pay 4% p.a. of his pensionable pay monthly into the scheme in exchange for his employer crediting his ‘pot’ with an a further 16% of his salary for each year that Sam remains an active member of the scheme. His employer also promises an investment return on the overall pension contribution which matches inflation plus 2% p.a.
Assuming inflation was a steady 3% p.a., Sam’s pension ‘pot’ therefore grows at 5% per annum (i.e. 3% inflation plus 2%):
Pensionable Contribution Cash Balance
Salary (4%+16%) Pot at end of year
1st year £25,000 £5,000 £ 5,205 1
2nd year £25,000 £5,000 £10,762 2
3rd year £25,000 £5,000 £16,550 3
4th year £26,000 £5,200 £22,837 4
1(£5,000+5%)=£5,250
2(£5,250+5%)+(£5,000+5%)=£10,762
3(£10,762+5%)+(£5,000+5%)=£16,550
4(£16,550+5%)+(£5,200+5%)=£22,837
Notes: This is a very simplified example and assumes that the scheme grants a full 5% increase for each full year's contribution. Note also, that in Year 4, Sam's salary increased to £26,000 meaning an increase in his pension contribution.
Variations on a theme
Cash Balance schemes come in many variations with one of the main differences between schemes arising in what ‘interest’ (investment return) is given to members’ credited ‘pots’.
An employer may promise whatever rate it chooses; it could use a fixed rate e.g. 4% p.a.; a variable rate (such as linked to the growth in National Average Earnings).
All ‘credits’ to the members’ ‘pot’ are invested by the Trustees in various different investments selected to support the promised return. The amount of the promised investment return might change from time to time (but in all probability, any change may apply only to new members).
- If actual investments achieve a lower rate of return then the employer will have to make further contributions to make up the promised ‘pot’.
- If the actual return is higher than needed to support the promised ‘pot’, the balance will generally be held back to ensure that promised ‘pots’ can be supported in the future for all scheme members, without extra employer contributions.
Who takes the risk?
In a cash balance type of money purchase scheme, the investment risk before benefits are claimed is borne by the employer. Any shortfall on promised ‘pots’ are made up the employer.
In some large schemes, the scheme may also promise the terms on which the ‘pot’ is converted into a pension. In this situation, the employer is taking on the investment risk after the pension starts and the risk that pensioners will live longer than the schemes advisers have assumed in setting these terms.
The fact that the growth of the pot is ‘promised’ means that the pot based upon that return must be made available to provide benefits irrespective of the value of the actual funds held by the scheme.
What actual benefits are provided by a cash balance scheme?
The benefits at retirement that your pension scheme provides can be designed in whatever way you wish, subject to HMRC rules and regulations. However, if the sponsoring employer is providing promises on the cost of the pensions, there may be some restrictions.
A cash balance type of money purchase scheme can provide an income (commonly referred to as a pension) or an income and a lump sum.
The ‘shape’ of that income depends upon whether YOU want a larger benefit payable immediately, or a smaller amount initially but which enjoys a measure of inflation protection (in the form of regular increases to your pension in payment – called ‘escalation’). The more inflation protection you have, the smaller your starting pension.
Example:
How much pension could a £100,000 pension ‘pot’ provide for a male aged 65?
Pension Increases to pension Dependant’s pension Pension after retirement on death
£6,752 p.a. Nil Nil
£6,152 p.a. Nil 50%
£4,880 p.a. 3% p.a. Nil
£4,316 p.a. 3% p.a. 50%
Based upon a £100,000 pension ‘pot’ for a male aged 65 at 22/09/2006 and no guarantee period. Figures are for illustrative purposes only; will vary from time to time and should not be relied upon.
If you choose to provide a pension for your partner to be paid on your death, the amount of initial pension payable to you will be lower than if you choose not to have dependant’s benefits. If you choose full inflation protection and a generous dependant’s pension, your starting pension will be lower still.
Most schemes also provide a lump sum death benefit should you die before your pension starts. This could be based solely on your ‘pot’ or perhaps a further amount based upon an insurance arrangement paid for by your employer.
Did I have to join my pension scheme?
You are not normally obliged to join, but your employer may automatically enrol you in the pension scheme. Alternatively, you may be required to work for your employer for a specified period, before you are eligible to join the pension scheme (e.g. 12 months). For more information see our Quicknote, Did I have to join my pension scheme?
What earnings are used in calculating my pension?
The calculations of pensionable salary (sometimes also called pensionable earnings) can be very complex and can involve factors such as maximum amounts to be taken into account, or exclusions of certain types of earnings (e.g. bonuses, overtime). This is important as your pension contributions will be based upon your pensionable salary. The less you contribute, the less there is invested towards your retirement ‘pot’. For more information see our Quicknotes, What earnings are used in calculating my pension?
When can I get my pension benefits?
Benefits will normally be payable to you when you reach your scheme’s normal pension age or Normal Retirement Date. This is important as it is the date at which you would normally be expected to start to draw your pension benefits without the consent of the employer or the Trustees.
Depending upon the rules of your scheme (not all schemes allow these alternatives), you may also be entitled to receive benefits at other dates such as:
- Early retirement
- Retirement due to ill health
- Terminal illness
- Late retirement (where you choose to work beyond normal pension age).
Can I calculate these benefits now?
If you are an active member your regular benefit statement should tell you what you might get at normal pension age based upon the contributions you have paid so far (whether these are actually paid or are notional, i.e. promised). Your benefit statement should also show what you might get for your expected future contributions, including an allowance for future investment growth.
These figures however, do not guarantee what benefits you will actually receive at normal pension age as circumstances can change in future, but they should help you plan for your retirement.
If you do not have a benefit statement or want to know how much your benefit would be at alternative dates, you should contact your scheme administrator.
The benefits will include a pension and also include the option of a lump sum payment at that date (usually in return for a reduction in the amount of pension you receive). Benefits illustrated may include a spouse’s or civil partner's pension, payable in the event of your death after retirement.
Some schemes provide a lump sum death benefit, part of which is sometimes paid from a separately insured life insurance arrangement.
Why are interest rates important to me?
The amount of your final pension will greatly depend upon long term interest rates at the time you draw your benefits. These interest rates, which determine the cost of borrowing large sums of money by the Government and companies over the next twenty or thirty years, drive the cost of buying pensions. The higher that long term interest rates are, the more pension you will usually expect to get for your ‘pot’, although other factors such as investment returns and annuity rates are equally important.
The cost of buying a pension depends upon annuity rates. These rates are what an insurance company needs to cover the commitment to pay the pension for the remaining lifetime of the pensioner (and any dependant’s pension where this benefit is chosen). This is partly based upon the long term interest rates as most Government borrowing comes from long term investors like insurance companies.
Another important element is how long an insurer expects to have to pay the regular pension payments to a pensioner. As overall, we are living longer, so the less that insurers can afford to pay to those pensioners who use their ‘pot’ to buy a pension. Adding a provision to pay a dependant’s pension on death, adds to the amount of time a pension is potentially payable for.
Pensions being bought now are far lower than would have been bought by the same ‘pot’ 20 years ago.
Annuity rates vary from time to time and currently are almost as expensive as they have ever been. It should be noted that different insurance companies charge quite different amounts for each £1 of pension you buy with your ‘pot’. You can significantly increase your pension by shopping around for the best terms at the point you decide to take your pension. Your scheme may employ an adviser to do this for you, but if you are concerned, you should seek your own personal financial advice from an annuity specialist to get the best pension for you and your dependents.
A few very large employer-sponsored money purchase schemes do not use annuities to provide members’ pensions but the terms they use to convert the ‘pot’ into a pension will be very close to the market rates offered by insurance companies.
What are my benefits worth?
The value of your ‘pot’ can readily be given to you by the scheme administrator but its value may go up and down with time. The pension benefits which result from this fund cannot be determined in advance, as they will depend upon investment conditions at the date you retire.
If you want to investigate this further, you should consult an independent financial adviser if you are planning any changes in what you are trying to achieve.
Are my benefits secure?
Your pension benefits are as secure as the actual funds in which the contributions are invested.
The promise made by your employer will ensure that the employer requires the Trustees to invest in assets which closely match the promised pot. Benefits that carry a promise should be fairly secure. However, interest rates do rise and fall so it isn’t possible to estimate with any accuracy the amount of benefit you will receive, until quite close to your retirement.
After you retire, your benefits will usually be more secure.
‘Investment risk’, the risk of a ‘promise’ and ‘mortality risk’
In an employer sponsored cash balance type of money purchase scheme, you have no significant investment risk in relation to that part of the ‘pot’ which carries the promise, so long as the employer is capable of supporting the arrangement. If the employer becomes insolvent, the promise might cease but the Trustees must ensure that as far as possible that the promise will be honoured. This isn’t an absolute certainty so your Scheme Rules will say what will happen in this situation.
You will also be exposed to a degree of ‘mortality risk’. Mortality risk is the likelihood that you will die at any given time. Evidence reveals that people are living longer in retirement. The effect of people living longer and so drawing their pensions for longer than expected, means pensions are becoming more costly. The longer this trend continues the less your pension pot will produce in terms of actual pension income at retirement.
Can my benefits and contributions be changed?
Any changes in pensions legislation might mean that the scheme has to change.
Otherwise, there are legal requirements that certain changes can only be made after consulting some classes of members. Any improvements which don’t involve you in a higher cost would not require your consent. You would however be told of any change.
What rights do I have as a member to ensure the scheme is run properly?
Any member can seek election to become a Trustee. A Trustee is responsible for ensuring the scheme operates according to all the rules.
If you are unhappy about any aspect of the scheme, contact the scheme administrator or your employer. If they do not satisfy you, you can contact The Pensions Ombudsman or The Pensions Regulator depending on your problem (our Factsheets describe their responsibilities). Also, see our Factsheet Useful Contacts to find who to contact.
Summary & Key Points
When making enquiries about your pension benefit it is very important that you make it clear that you are an active member rather than a preserved or pensioner member. Active, preserved and pensioner are different classes of membership of a pension scheme and any definitions and paragraphs contained within your Scheme Rules or scheme literature relating to any benefit may differ considerably between these categories.
For each pension benefit you need to consider the following items:
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Is your pension scheme a cash balance scheme?
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How much of your earnings, including any bonuses, overtime, allowances and benefits in kind, go towards your pension earnings? Will your earning reduce the closer you get to retirement?
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What is the formula used in calculating your pension benefit? Do you understand it?
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Is there any reduction to the amount of earnings that go to calculating your pension benefits?
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What pension benefits are provided by your pension scheme? Pension, lump sum, death benefits, ill-health benefits, early payment, pension increases?
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Keep informed. Your scheme may modify benefits and Rules. Legislation may change. Your circumstances may alter.
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Rules differ from scheme to scheme and are wide and varied in content. Don’t assume that what applies to one of your pension schemes will necessarily apply to others that you may have.
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HMRC impose rules which registered pension schemes must conform to.
People seldom have identical pensions and you should avoid drawing comparisons with colleagues whose circumstances may at first appear the same but could emerge as having significant differences.
This is not an authoritative document. Seek professional advice from an appropriately experienced and qualified adviser.
What is a cash balance scheme? v2.3 Active
Last updated 12/01/2007
