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19th October 2018
:: Scheme Member | Types of Pension Scheme | What is a money purchase scheme? | Preserved members of a MP scheme

What is a money purchase pension scheme? - Preserved Members
 
This Factsheet looks at employer sponsored money purchase schemes, which have become the most common type of scheme for most new employees in the private sector.
 
It is written for people who are active, preserved and pensioner members of an employer sponsored money purchase scheme.
 
  
 
 
  
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Introduction
 
This Factsheet takes a detailed look at money purchase schemes – which are being introduced by more and more employers, and are now playing an increasingly important role in employees’ pension planning.
 
To understand what a money purchase scheme is, you ought to know the very basics about employers’ pension schemes. See our Factsheets What is a pension scheme? and Types of employer sponsored pension schemes.
 
 
What is a money purchase scheme?
 
A ‘money purchase scheme’ provides benefits based upon the amount of money that is in YOUR own 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 (GPP). 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).
 
Two of these arrangements – GPP and Stakeholder - operate in a different way to the others. They are ‘contract based’ rather than ‘trust based’.
 
Money purchase arrangements are an effective method of controlling the cost of running a pension scheme. However, this does provide less certainty for the scheme member as to how much they, or their dependents, are likely to receive.
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Contract based schemes
 
The employer selects a provider – an investment company – who will administer the arrangement and set up individual contracts with each member. The contract is a regulated product which requires the provider to set up the contract and disclose information about the arrangement directly to the member. In all other respects, they are identical to ‘trust based’ schemes.
 
Employer selects investment company (pension provider).
  • The pension provider has an individual contract with each employee.
  • The pension provider is responsible for payment of benefits to each employee.
  • The employer has no responsibility for providing employees with benefits.
Trust based schemes
 
Trust based schemes are where a Trust is set up by the employer to administer the scheme, and look after the investments and provide benefits for the members. The members’ contract is with the Trustees, who will be their first point of contact in relation to all issues related to the scheme. To confuse the issue a little, the Trustees themselves may take out a contract (or series of contracts) with an insurance company, investment manager or third party administrator to help them carry out their duties - but this does not affect who is responsible for the payment of benefits.
  • Employer sets up a Trust.
  • Trustees are appointed.
  • The Trustees select and manage the investments.
  • The Trustees are responsible for payment of benefits to members.
 
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Are there different types of employer sponsored money purchase schemes?
 
The vast majority of employer sponsored money purchase schemes provide benefits based upon the money held in individual ‘pots’ specifically on behalf of each member.
 
The amount in YOUR ‘pot’ at retirement will depend upon how much was put in by your employer and by YOU, and the investment returns achieved on those contributions.
 
The scheme administrator or Trustees invest these contributions on your behalf in a range of investments and investment funds, some of which may be chosen by you.
 
Any investment performance derived from each of these contributions becomes part of your ‘pot’.
 
Charges to pay for the scheme will be paid either by the employer or by making deductions from what is put in on your behalf, or from the growing ‘pot’ itself. Often, the charges are a combination of all of these so that the cost is borne partly by your employer, and partly by you.
 
Summary
 
In an employer sponsored money purchase scheme your ‘pot’ will usually consist of -
 
employer contributions
plus
YOUR contributions
plus
investment returns
 less
charges
 
What is in your ‘pot’ at retirement will be used to provide you with your pension benefits.
 
There is another form of a money purchase scheme which appears to be very similar to mainstream money purchase schemes, but which operates in a quite different way. This is called a cash balance arrangement.
 
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What sort of benefits are provided by a money purchase scheme?
 
The benefits that your pension scheme provides, depend largely on what you want, and your personal circumstances when you want to draw the benefit.
 
A 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 the 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
                            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, no guarantee period. Figures will vary from time to time and should not be relied upon.
 
Where you choose to provide a pension for your partner to be paid to them 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’. For active members, any lump sum death benefit may be based upon an insurance arrangement paid for by your employer, or by a deduction of a charge from your ‘pot’.
 
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Did I have to join my employer’s 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).
 
 
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’. 
 
 
When do I become entitled to 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 have been 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).
 
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Can I calculate these benefits now?
 
If you are an active member your regular benefit statement should indicate to you what you might get at normal pension age based upon the contributions you have paid so far, and expected future contributions, including an allowance for investment growth.
 
If you are a preserved member, your regular benefit statement will show the current value of your ‘pot’ and how it might grow in future.
 
These figures however, do not guarantee what benefits you will actually receive at normal pension age as circumstances in the future will differ from those assumed in the statement, but the figures 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 will 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 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 can be paid from a separately insured life insurance arrangement.
 
 
Are the assumptions used in projecting my pension benefits at retirement realistic?
 
Your benefit statements, which aim to show what your pension benefits will be worth when you draw them, are based upon a set of assumptions which are determined by the Government or by Regulators and therefore only provide an indication of what might emerge for you. The amount in your ‘pot’ at that time will depend upon the actual investment returns on your monies paid into your ‘pot’ by you, and your employer.
 
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How does my ‘pot’ grow?
 
The contributions which you make, and which your employer makes, are invested in a range of investments or investments funds. Those funds may be selected by the employer, or YOU, or where the scheme is administered by Trustees, they may design the fund selection with the help of investment specialists. You may have the option to switch between different types of investments or investment funds.
 
In many schemes, contributions into your ‘pot’ may be held in a ‘default’ fund if no specific investment fund is chosen by YOU.
 
Some pension schemes have an automatic switching arrangement which operates as scheme members approach Normal Retirement Age. This is commonly known as ‘lifestyling’, with the main purpose being to reduce volatility and investment risk as you get closer to your retirement.
 
Your fund in your ‘pot’ will rise (or fall) in line with the return on each of the individual investment funds where your contributions are invested. When you draw your benefits, the scheme administrator will work out how much pension the money in your ‘pot’ can purchase.
 
Depending upon how your pension scheme operates, you will be given a menu from which you can select benefits to suit your personal circumstances, such as a spouse’s or civil partner’s pension, a tax free lump sum, pension increases during retirement, for example.
 
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Why are interest rates important to me?
 
The amount of your 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 is usually said to depend 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 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 - instead choosing to pay pensions directly from the funds held on account - but the terms they use to convert the ‘pot’ into a pension will be very close to the market rates offered by insurance companies.
 
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What are my benefits worth?
 
The value of your ‘pot’ can readily be given to you by the scheme administrator but its value will go up (but may also go down) with time.
 
Your pension benefits at retirement which result from your ‘pot’ cannot be precisely determined in advance as they depend upon investment conditions up to 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 investments of the investment funds in which the contributions are invested.
 
The larger the investment fund and the more reputable the investment manager, the less likely the funds are to lose all their value.
 
The wider the range of investments which the fund holds, the less they will move up and down.
 
Some funds like commodity funds, hedge funds or emerging markets can be highly speculative so values can rise and fall sharply.
 
Investment markets will 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.
 
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What is meant by ‘investment risk’ and ‘mortality risk’?
 
In an employer sponsored money purchase scheme, the fact that your future pension benefits will depend upon the value in your ‘pot’ at retirement, means that you may be exposed to ‘investment risk’ through weak investment performance.
 
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.
 
See what your Life Expectancy is.
 
 
Can my benefits and contributions be changed?
 
Any changes in pensions legislation might mean that the scheme has to change.
 
Sometimes a scheme will change to another form of scheme, or perhaps the investment options will be reviewed. In this situation, you should be given full details of all intended changes.
 
 
What rights do I have as a member to ensure the scheme is run properly?
 
If the scheme operates with Trustees, any member can seek election to become a Trustee. A Trustee is responsible for ensuring the scheme operates within the pensions law.
 
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 list of Useful Contacts.
 
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Summary & Key Points
 
When making enquiries about your pension benefit it is very important that you make it clear that you are an active, preserved or pensioner member of the scheme. 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:
  • Is your pension scheme a money purchase scheme?
  • How much of your earnings, including any bonuses, overtime, allowances and benefits in kind, go towards your pensionable earnings? Will your earning reduce the closer you get to retirement?
  • What pension benefits are provided by your pension scheme? Pension, lump sum, death benefits, ill-health benefits, early payment, pension increases, dependants’ benefits?
  • Keep informed. Your scheme may modify benefits and Rules. Legislation may change. Your circumstances may alter.
  • 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.
  • 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 Factsheet forms part of our Module Types of Pension Scheme and should be read alongside the other Factsheets and Quicknotes in the series.
 
This is not an authoritative document. Seek professional advice from an appropriately experienced and qualified adviser.
 
 
What is a money purchase scheme? Generic v3.2
Last updated 22/12/2006
Last reviewed 15/06/2007
 
 
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What is a money purchase pension scheme? - Preserved MembersMP
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