Different types of pension schemes

This information is for financial advisers only. It mustn't be distributed to, or relied on by, customers. It is based on our understanding of legislation at the date of publication.

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Overview

The United Kingdom has a state pension system, which people can build up an entitlement to through paying National Insurance contributions. To supplement people’s State Pension entitlement, the UK has a well-developed and complex private pension system.

Private pension provision includes any pension benefit that is not provided by the state. If you work with pensions for any length of time, you will realise that there are many different types of private pension arrangement. This article aims to summarise the main types of pension arrangement that currently exist in the UK. Note – arrangement is a word given to describe a pension contract so can mean a scheme benefit, a policy or wrapper.

A scheme registered with HM Revenue & Customs as a registered pension scheme can benefit from certain tax reliefs and exemptions with the scheme aiming to provide benefits on retirement, ill-health and death. The theory is that this encourages employers and individuals to contribute to a pension scheme so that when people begin to move towards retirement they’ll have private pension income in addition to their State Pension and so will be less likely to rely on the State in old age.

The contributions paid into a pension arrangement are eligible for tax relief and most of the investment growth isn’t taxed but pension income paid out on taking benefits is taxable. This is referred to as EET (exempt-exempt-taxed) – contributions are exempt from tax on the way in, funds are exempt from tax while invested but pension income is taxed on the way out.

The term ‘registered pension scheme’ has a different meaning depending on the type of scheme, policy or wrapper held. For example:

  • An occupational pension scheme will be a registered pension scheme in its own right.
  • A personal pension policy, whether it is an individual policy or part of a group personal pension scheme, will be part of a pension provider’s registered pension scheme. Aegon currently has four separate personal pension schemes registered with HMRC and these are listed in the ‘Personal pensions’ section below.
  • Other policies, such as retirement annuities, individual buyouts and trustee proposed buyouts are registered pension schemes in their own right.

Each registered pension scheme must have a scheme administrator. For occupational schemes the scheme administrator is normally the trustee(s) whereas for personal pension schemes the scheme administrator is normally the pension provider. A scheme administrator’s duties include registering a scheme with HMRC, dealing with payment of tax to HMRC, reporting events and providing information to HMRC, operating tax relief (for pension arrangements operating relief at source) and providing information to scheme members (for example, regarding the lifetime allowance, benefits payable and pension input amounts).

Broadly, private pension arrangements in the UK can be grouped into the following five main categories:

  • Occupational pension schemes.
  • Buyout policies arising from occupational pension schemes (also known as s32 buyouts or trustee proposed buyouts).
  • Additional voluntary contribution pension schemes (which have a direct relationship with occupational pension schemes).
  • Retirement annuity contracts (also known as s226 policies).
  • Personal pensions.

There can also be variations in each category. For example, there are many different types of occupational pension scheme as they can offer different types of benefit or be aimed at different groups of employees. Before we go on to look at the five main types of pension arrangement in more detail, it’s worth looking at the difference between defined contribution and defined benefits pension arrangements.

Defined contribution pension arrangements can also be referred to as money purchase arrangements. A defined contribution pension arrangement is one where a set level of contributions are paid in with the aim of building up a fund to provide pension benefits on retirement. An employee with a defined contribution pension arrangement will not know in advance what the total value of their retirement fund will be. The value of the fund built up will generally depend on the amount of contributions paid in, the performance of the chosen investments and the charges applicable to the pension arrangement. With a defined contribution pension arrangement, the investment risk effectively falls on the member and they will dictate what investment choices are made.

Examples of defined contribution pension arrangements include money purchase occupational pension schemes, personal pensions (including self-invested personal pensions), stakeholder pensions and retirement annuity contracts. A defined contribution pension arrangement will always be in the form of a policy or wrapper in the name of the member. Where an employer is offering defined contribution pension arrangements (for example, as an occupational pension scheme or as a group personal pension) to its employees, the individual policies or wrappers will be grouped together under a scheme name and number to help with the administration of the scheme.

Defined benefits pension schemes are often referred to as final salary schemes. They aim to provide a guaranteed level of benefit with the funding position checked regularly to ensure that all benefit commitments can be met in respect of current members, deferred members (who have left employment), pensioners and dependents (receiving benefits in respect of members who have died). The benefits provided are generally calculated using a set formula that takes into account ‘final salary’, length of service and the scheme accrual rate. The accrual rate will typically be something like 1/60th or 1/80th of final salary per year of service.

Example

A defined benefits scheme provides a pension benefit of 1/80th of final salary for each year of pensionable service and a tax-free lump sum of 3/80ths of final salary for each year of pensionable service. If a scheme member takes their benefits with thirty years of service and a final salary of £50,000. The scheme would therefore provide:

Pension = 30/80 x £50,000 = £18,750 per year.

Tax-free lump sum = (30 x 3)/80 x £50,000 = £56,250.

So, the scheme would provide the member with a tax-free lump sum of £56,250 and a pension of £18,750 gross per year.

Defined contribution and defined benefits aren’t the only two types of benefit that you could see when working with pensions. You may also see hybrid pension arrangements. These will typically be seen where an occupational pension scheme has both defined contribution and defined benefits sections (for example, a defined benefits main scheme with defined contribution AVC policies for voluntary employee contributions) or where the benefits provided are the better of the two options (defined benefits or defined contribution) at the time they are taken. You may also see cash balance arrangements. Although they are classed as money purchase, cash balance arrangements provide some sort of promise about the level of benefits that will be provided. For example, an arrangement may provide a set amount of fund per year of service, a set percentage of a member’s salary per year of service or it may guarantee a rate of investment return.

Who would typically join an occupational scheme? Who can contribute? Benefit type
Employees (including directors). Employers and employees. Usually either defined benefits or defined contribution.

Occupational pension schemes are established by an employer under trust with trustees appointed to run the scheme. The day-to-day administration is likely to be done by a pension provider with both the employer and trustees having legal obligations regarding the proper running of the scheme.

Employers are far more likely to put a group personal pension scheme in place for their employees these days. This is mainly to do with the additional administration and regulatory burdens that apply to occupational pension schemes in comparison to personal pension schemes.

It’s important to understand the relationship between the various parties involved in an occupational scheme. Essentially, the employer ‘owns’ the occupational scheme as they set it up by means of a trust deed, adopt the rules that set out how the scheme will operate and appoint the trustees who will run the scheme. The trustees’ powers are set out in the trust deed and rules and their role is a hugely important one as they are responsible for making sure the scheme is run properly and that the members’ interests are looked after.

The trustees are responsible for investing the money paid into the scheme, although scheme rules may allow members to make their own investment decisions and will typically set out where the money can be invested. Wholly-insured schemes will generally say that the money is to be invested ‘with an insurance company’ and some schemes will allow policies to be set-up with different providers. If that happens, you could see a member of an occupational scheme having a policy in the main scheme and one or more other policies with different providers (these are referred to as ‘investment only policies). A scheme’s rules may give the trustees the power to invest more widely than in insurance policies. For example, they could allow the trustees to invest directly in shares and commercial property. Schemes which give trustees wider investment powers are referred to as ‘self-administered’.

Providers generally offer a package of services that includes providing the establishing documents (trust deed and rules, employee communications, annual statements, etc). Employers and trustees can amend a provider’s standard documents to suit themselves but this is unlikely, and the provider could refuse to administer any changes made without their agreement. Although many of the legislative obligations relating to an occupational scheme lie with the trustees, providers historically did a lot of the work for them but this is less likely now. Since 6 April 2006, the ‘Scheme Administrator’ has been a legally defined role with specific duties, which many providers declined to take on for occupational pension schemes.

There is no direct relationship between occupational pension scheme members and the pension provider. The member’s relationship is with the employer and trustees, and members would look to the rules and any statements/scheme booklets sent to them by the trustees for information about the scheme.

The various relationships can be summarised very simplistically as follows:

Members <--> Scheme/Employer/Trustees <--> Pension provider (members deal with the scheme through the employer and trustees and they in turn deal with the pension provider).

Occupational schemes can be defined benefits, defined contribution or a mixture of both. Types of defined contribution occupational pension schemes can include Executive Pension Plans (which are typically set-up for directors and senior employees) and Contracted-in Money Purchase (CIMP) schemes (which typically allow all eligible employees to join).

What’s been described above is the traditional way of establishing and operating an occupational pension scheme but you may also see the term ‘mastertrust’ mentioned in connection with occupational schemes. Joining a mastertrust can be seen as option for an employer as an alternative to setting up a single employer occupational scheme. Essentially, a mastertrust is a multi-employer occupational scheme offered by a provider and employers who join a mastertrust scheme will do so with the aim of providing workplace pensions for their employees. The participating employers don’t need to be connected or associated with each other. A mastertrust scheme will typically provide money purchase benefits with the contributions paid in being pooled together.

Each employee will have funds ‘notionally earmarked’ for them within the pooled fund. The mastertrust will be established by a declaration of trust and will have a trustee board to govern the scheme. The benefit of an employer joining a mastertrust is that many of the tasks associated with running an occupational scheme are taken on by the trustees and the provider administering the scheme (eg, scheme registration, governance, regulatory and legislative compliance, HMRC reporting, managing investments, etc). Contribution levels and benefit options will normally be decided by each participating employer.

Who can apply for a S32? Who can contribute? Benefit type
Former occupational pension scheme members or trustees of occupational pension schemes. Set up to accept a transfer from an occupational pension scheme.

The type of occupational pension scheme the transfer was made from will dictate the type of benefits held in the buyout. You could see:

Non-reserved units – these originate from employer and employee contributions paid into a defined benefits occupational scheme.

Reserved units (GMP) – these originate from an employee being contracted-out before 6 April 1997 on a guaranteed minimum pension (GMP) basis in a defined benefits occupational scheme.

Reference scheme test benefit (RST) – these originate from an employee being contracted-out from 6 April 1997 onwards in a defined benefits occupational scheme.

Non-protected rights (NPR) – these originate from employer and employee contributions in a defined contribution occupational scheme.

Former protected rights (PRP) – these originate from an employee being contracted-out in a defined contribution occupational scheme. Contracting-out was abolished on a defined contribution basis from 6 April 2012, so former protected rights funds are now treated the same as non-protected rights.

A section 32 buyout is also referred to as a deferred annuity contract and will always be set-up to accept a transfer from an occupational pension scheme. It is applied for by an individual or by occupational scheme trustees. Each buyout policy will have a policy conditions booklet and this will cover the terms and conditions applying to the policy. For HMRC purposes, buyout policies are registered pension schemes but are not ‘schemes’ as we would think of them. A buyout policy will usually be set up in one of the following circumstances:

  • An occupational scheme member leaves employment and wants to transfer the fund they’re entitled to so that it’s under their control. One option offered could be a transfer to a buyout policy (although Aegon no longer set-up buyout policies in this situation). The member could alternatively opt to transfer to a new employer’s pension scheme or to a personal pension.
  • When occupational scheme members leave employment they will usually have a paid-up benefit in the scheme.  Trustees continue to have obligations in relation to paid-up members and might decide to have a ‘tidy up’ by transferring the funds to individual buy-out policies in the members’ own names.
  • If an occupational scheme winds up, each member’s benefits have to be secured outside the scheme. Members will usually be given the option to choose where their own funds are transferred to and one of the options could be a transfer to an individual buyout policy. If they don’t make a choice or if the trustees have been unable to contact a member, the trustees can arrange for a buyout policy to be issued in the member’s name. These are usually referred to as trustee-proposed buyout policies (TPS32) or group buyouts as they are set-up without the consent of the member.

Before 6 April 2006, a buyout policy couldn’t accept any contributions as it was set-up solely to accept a transfer payment from an occupational scheme and wasn’t allowed to take in any further funds. Since 6 April 2006, as buyout policies are technically registered pension schemes, they could accept additional funds. However, most providers didn’t amend their contracts to allow this. Occasionally, you could see a buyout policy that has an additional amount applied to it after the original transfer – this may be because additional funds were identified by the transferring scheme after the original transfer was made or if a compensation (redress) payment has been added to the buyout policy (eg, as a result of mis-selling, administration or advice issues).

For information, the term S32 refers to section 32 of the Finance Act 1981, but the concept of buying out benefits existed well before this. All section 32 of the Finance Act 1981 did was allow members to choose the provider that secured their benefits, if allowed to do so by the occupational scheme rules. The relevant legislation for buyout policies is now in the Finance Act 2004.

Who can join? Who can contribute? Benefit type
Any member of an occupational pension scheme. Employees (not the self-employed). AVCs and FSAVCs are generally defined contribution pension arrangements.

AVCs (additional voluntary contributions) and FSAVCs (free-standing additional voluntary contributions) have been available since 1987. AVCs allowed employed people who only had one source of income to save more than their employer required them to pay into the occupational pension scheme they were a member of. AVC policies were typically offered as defined contribution arrangements and would be subject to occupational pension scheme rules. The AVC provider can be the same one that manages the ‘main scheme’ or the members paying AVCs could be given a choice of providers. You generally don’t get ‘stand-alone’ AVC schemes other than perhaps for public sector employees.

FSAVCs allowed employees to build up a pension fund independently from an employer’s occupational pension scheme. An employer may not have known that an employee was funding an FSAVC and perhaps planning an early retirement escape! FSAVC’s looked like personal pensions in a way as they were taken out by someone entering into a contract with the provider and the employer was not involved. The individual was responsible for choosing how their contributions were invested. It’s uncommon to see an FSAVC policy nowadays. The administration requirements for FSAVCs set by HMRC were relatively complicated and required a lot of work on the part of the provider due to the interaction between occupational scheme and FSAVC benefits. These administration requirements fell away on 6 April 2006 so, to make life simpler, many providers switched their FSAVC policies to personal pensions at that time.   

Who could have applied for a S226? Who can contribute? Benefit type
Self-employed people or employed people not in an occupational pension scheme. The policyholder.

No new retirement annuity contracts could be sold after 30 June 1988 – they were replaced by personal pensions from 1 July 1988. Existing retirement annuity policies could continue as they were.

You could see different types of benefit when dealing with retirement annuity policies. Older retirement annuity contracts (eg set-up prior to the early 1980s) generally offered a set amount of benefit for each contribution paid. Newer retirement annuity contracts (eg, set-up from the early 1980s up to 30 June 1988) were generally unit-linked or with-profit defined contribution arrangements.

Some retirement annuity contracts have guaranteed annuity rates (GAOs), which guarantee a set amount of annuity when benefits are taken based on the size of the fund and a person’s age. There may be restrictions on the terms of the annuity that can be bought using a GAO and if different terms are requested by a policyholder, then current annuity rates would be used instead.

Retirement annuity contracts were available between 1956 and 1988. During these times, they were the only approved pension contract available to the self-employed and those who didn’t have access to, or who didn’t want to join, their employer’s occupational pension scheme. No new retirement annuity contracts could be sold from 1 July 1988 but contracts in place before that date could continue.

Before 6 April 2006, it was only possible for retirement annuity contracts to accept personal contributions from the policyholder. It wasn’t possible for employer contributions to be paid to a retirement annuity contract. It has, in theory, been possible for employer contributions to be paid to a retirement annuity since 6 April 2006, but many providers did not update their contracts and systems to allow this.

Personal contributions to retirement annuity contracts are typically paid gross with the policyholder claiming back any tax relief due direct from HMRC. It has been possible since 6 April 2006 for personal contributions to be paid net of basic rate tax relief to retirement annuity contracts, but many providers did not update their contracts and systems to allow this.

Retirement annuity contracts are treated as registered pension schemes even though they are individual contracts. They could, in theory, offer anything that pensions legislation allows - for example, access to drawdown or payment of an uncrystallised funds pension lump sum (UFPLS). However, pension providers generally haven’t amended the existing contract terms to allow access to drawdown.

Reference to S226 is a hangover from days long gone – it refers to section 226 of the Income and Corporation Taxes Act 1970 which became section 620 of the Income and Corporation Taxes Act 1988.  The relevant legislation is now in the Finance Act 2004.

Who can apply for a personal pension? Who can contribute? Benefit type
Anyone, whether they are self-employed, employed, retired or not working. Individuals, employers and third parties. Personal pensions are defined contribution pension arrangements. They can be sold as individual policies or wrappers or as part of a group personal pension scheme. In each case, the individual applies for the contract with the pension provider.

Personal pensions replaced retirement annuity contracts from 1 July 1988. A fundamental difference between retirement annuity contracts and personal pensions is that personal pensions are set up under a scheme established by a pension provider. So, they sort of look like occupational pension schemes, with an establishing deed and rules, but with the pension provider taking on the responsibilities that the employer and trustees would under an occupational scheme (there’s more to it than that but that’s the broad principle). The personal pension scheme ‘belongs’ to the provider, whereas an occupational scheme ‘belongs’ to the employer.

Individuals applying to join a personal pension scheme will think of it as ‘their’ plan,  possibly without realising that they are one member, alongside thousands of others, of a much bigger scheme. As stated in the ‘Overview’ section above, Aegon has four different ‘personal pension schemes’ registered with HMRC. These are:

  • Scottish Equitable Personal Pension Scheme – this includes insured personal pension policies whether they are individual policies or part of a group personal pension scheme. The scheme can also include phased retirement personal pensions and capped drawdown policies that offer investment in insured funds only.
  • Scottish Equitable Self-Administered Personal Pension Scheme – this includes personal pension policies, whether they are individual policies or part of a group personal pension scheme, which have self-administered investment options. The scheme also includes phased retirement personal pensions and capped drawdown policies that offer self-administered investment options.
  • Scottish Equitable Stakeholder Pension Scheme – this includes stakeholder pension policies whether they are individual policies or part of a group stakeholder pension scheme.
  • Aegon Self-Invested Personal Pension Scheme – this includes self-invested personal pension wrappers sold on Aegon’s platform under Aegon Retirement Choices, One Retirement and Retiready. It includes individual wrappers plus those set-up as part of a workplace pension scheme. The scheme contains both uncrystallised SIPPs and crystallised drawdown wrappers.

The change from retirement annuity contracts to personal pension schemes allowed the development of ‘group personal pension schemes’. Technically, there’s no such thing as a group personal pension – it’s simply a collection of individual personal pensions administered together whose members happen to work for the same employer. The concept of a group personal pension allows employers to offer its employees a personal pension as an alternative to an occupational pension scheme. If an employee leaves the service of an employer offering a group personal pension scheme, they’ll still have a personal pension in their own name. In practice, the pension provider will probably remove the former employee from the group personal pension ‘umbrella’ by removing the scheme name and number. In that respect, personal pensions are more flexible than occupational pension scheme policies.

Contributions can be made to a personal pension by the individual who applied for the contract, their employer or by a third party on the individual’s behalf. Any third party contributions are treated as if they were paid by the individual themselves. Examples of ‘third parties’ include other individuals (for example, a spouse, parent or grandparent) or a corporate body or other legal entity (for example, an adviser paying compensation into an individual’s policy as a result of poor advice, mis-selling or poor administration).

Stakeholder policies were introduced from 6 April 2001 as an attempt to encourage employers to set-up pension policies for their employees. They were intended to promote more long-term saving in pensions and were especially aimed at low and moderate earners. Stakeholder policies are required to meet a number of conditions such as a cap on policy charges, minimum contribution levels, a default fund choice and flexibility in starting and stopping contributions. Essentially, employers with five or more employees were required to provide access to a stakeholder scheme unless they offered a suitable alternative.

There wasn’t a huge take-up in stakeholder policies and one of the main issues was that contributing to stakeholder policies wasn’t made compulsory so many schemes were set-up as ‘shell’ schemes with no contributions being made into them. Stakeholder policies are very similar to personal pensions in terms of the contributions that can be paid in and the benefits that can be paid out.

Since the automatic enrolment legislation was introduced on 1 October 2012, employers are no longer required to provide access to a stakeholder pension scheme. Instead, they are now required to enrol staff in a pension scheme that is suitable for automatic enrolment from the ‘staging date’ that applies to them. Existing stakeholder policies and schemes can remain in place and it may be possible to use a stakeholder scheme for automatic enrolment purposes if it meets the required criteria.

Automatic enrolment is part of the pension reform changes that the government introduced to make it easier for people to save for their retirement. Under the reforms, all employers have to automatically enrol workers who meet certain conditions, and who aren’t already in a pension scheme that meets minimum requirements, into an auto enrolment pension scheme. They need to do this from their ‘staging date’. They’ll also have to allow other workers to join such a scheme. An auto enrolment scheme can be a defined contribution scheme with a minimum contribution level or a defined benefit or hybrid scheme providing a minimum benefit level. In both cases, other conditions have to be met.

Public sector pension schemes can be established by or under an Act of Parliament, specified in an order made by the Treasury or approved by a Minister of the Crown or an appropriate UK, Scotland, Wales or Northern Ireland government body or department. Examples of public service pension schemes include pension schemes for the NHS, civil servants, the armed forces, emergency services, teachers and local government employees.

The government have historically allowed people to contract out of the additional pension that they could accrue on top of the basic state pension. This additional pension is typically accrued based on the level of a person’s earnings and there have been various different versions over the years. For example, you may see reference to the State Earnings Related Pension Scheme (SERPS) or the State Second Pension (S2P). If someone was contracted out, this meant the government would make payments into a private pension arrangement in place of the benefits that would have built up in SERPS or S2P. Contracted out benefits typically had set conditions that had to be followed when they came into payment meaning that contracted out benefits had to be kept separate from other funds in a private pension arrangement. Contracting out worked differently depending on the type of scheme that benefits were being built up in:

  • Defined benefits - if someone was contracted out for service up to 5/4/97 then they accrued a guaranteed minimum pension (GMP). If they were contracted out from 6/4/97, then they accrued a ‘reference scheme test’ benefit (RST). Contracting out on a defined benefits basis ceased from 6 April 2016 following the introduction of the single tier state pension. However, you will still see GMP and RST funds when dealing with defined benefits schemes and some buyout policies.
  • Defined contribution - if someone contracted out of a defined contribution scheme (whether it was an occupational pension scheme or personal pension), they built up a ‘protected rights’ fund from the money that would otherwise have gone to the government in National Insurance contributions. Contracting out on a defined contribution basis ceased from 6 April 2012 and since then protected rights funds can be treated the same as ‘ordinary’ non-protected rights funds. They are often referred to now as ‘former protected rights funds’ and you may still see reference to them when dealing with defined contribution pension arrangements.

The date of 6 April 2006 is significant in pensions as it was the date that the current legislation and guidance relating to private pension arrangements was introduced. You may see this referred to as ‘A-day’ or ‘pensions simplification’. By the mid-2000s the government recognised that the pensions landscape was far too complicated so their solution was to sweep away most of the old rules and introduce a single set of new rules which would apply to all types of previously-approved pension schemes and arrangements. From 6 April 2006, all ‘approved’ schemes and contracts became ‘registered pension schemes’ unless they opted out.

Instead of different types of pension arrangement having different contribution and benefit limits (as was the case before 6 April 2006), the government tried to bring in one set of rules to apply to all private pension arrangements. For example, they set an annual limit on the amount contributions that could made to registered pension schemes without incurring a tax charge (known as the annual allowance). They also set a limit on the value of the benefits someone could draw from registered pension schemes without incurring a tax charge (known as the lifetime allowance). 

Scheme trustees and providers can be selective in what they offer under their scheme rules and contracts. At 6 April 2006, providers had to decide how they were going to apply the new rules to existing schemes and contracts. Some of the new rules were not optional (for example, the annual and lifetime allowances). Others were, and still are. For example, since 6 April 2006, it has been possible for buyouts and retirement annuity contracts to offer drawdown but many providers decided against updating their older contracts in this way because they couldn’t easily administer such a significant change to the way they operated.

Even though a whole set of new rules were introduced on 6 April 2006, subsequent governments have continued to tinker and tweak pension rules and requirements. For example, in recent times we’ve seen the annual allowance reduced, the introduction of ‘carry forward’ of unused allowances, the lifetime allowance reduced resulting in various fund protection options (fixed protection 2012, 2014 and 2016 plus individual protection 2014 and 2016) and the implementation of pension flexibility on 6 April 2015. The pension flexibility rules introduced more options for taking benefits from defined contribution pension arrangements. When taking benefits, the majority of people still take a tax-free lump sum and the three main ways to use the remaining benefits are to buy an annuity, go into drawdown or take a taxable lump sum. Scheme trustees and providers of defined contribution pension arrangements don’t have to offer all these options in practice and some may choose not to - although it may be possible for an individual to transfer their pension savings to a product or pension provider that offers the option that an individual wants to use.

Pensions Technical Services