Different types of pension scheme

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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The United Kingdom has a state pension system under which people can build up an entitlement by paying, or being credited with, 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. These FAQs summarise the main types of pension arrangement that currently exist in the UK. Note – in these FAQs, 'arrangement' is used in a broad sense and can mean any of the tax-advantaged registered pension schemes available in the UK.

A pension scheme registered with HM Revenue and Customs (HMRC) benefits from certain tax reliefs and exemptions. The theory is that this encourages employers and individuals to contribute to a registered 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’ covers occupational pension schemes set up by employers for their employees and personal pension schemes set up by providers.  It also includes individual policies, such as retirement annuity contracts and buyout policies (including trustee-proposed buyout policies) although these are not ‘schemes’ as most of us would think of them.

Each registered pension scheme must have a scheme administrator. For occupational pension 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 the scheme with HMRC, dealing with payment of tax to HMRC, reporting events and providing information to HMRC, claiming tax relief on behalf of members (for pension arrangements operating relief at source) and providing information to 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

Before we go on to look at the five main types of pension arrangement in more detail, it’s worth looking at how these arrangements are set up and the difference between defined contribution, defined benefit and hybrid arrangements.

Defined contribution pension arrangements are also known as money purchase arrangements. The contributions paid in build up a fund which will be used 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 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.

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. An employer may offer its employees membership of a ‘group personal pension’. This will not be a registered pension scheme in its own right. Instead, the pension provider will group the employees’ policies/wrappers together, usually under a unique number, for the purpose of administering them but they will form part of the provider’s wider registered pension scheme under which many other people have policies/ wrappers.

Defined benefits pension schemes (sometimes referred to as ‘final salary schemes’) 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 dependants (receiving benefits in respect of members who have died). The benefits provided are generally calculated using a set formula that takes into account ‘pensionable salary’, length of service and the scheme accrual rate. The accrual rate will typically be something like 1/60th or 1/80th of pensionable salary per year of service. Pensionable salary will be defined in the scheme rules and may be, for example, the final salary in the last year of service or the average salary over the last three years of service.

Example

For each year of pensionable service, a defined benefits scheme provides a pension benefit of 1/80th of final salary and a tax-free lump sum of 3/80ths of final salary. If a member takes their benefits after thirty years of pensionable service, and has a final salary of £50,000, the scheme will 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.

Less commonly, a pension scheme may offer 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. Cash balance arrangements may also be offered. 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

Generally, 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. Occupational pension schemes can operate on a defined benefits or defined contribution basis, or a mixture of both.

It’s important to understand the relationship between the various parties involved in an occupational pension scheme. Essentially, unless it's a master trust, the employer ‘owns’ the occupational pension 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. Policies taken out with a company which isn’t providing the main administration services to the scheme 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 pension 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

What’s described above is the traditional way of establishing and operating an occupational pension scheme but some employers may offer employees membership of a ‘master trust’. Essentially, a master trust is a defined contribution occupational pension scheme which is set up by a provider and made available to multiple employers. The participating employers do not need to be connected or associated with each other in any way. Contributions to the scheme are pooled and collectively managed by the provider.

Each employee will have funds ‘notionally earmarked’ for them within the pooled fund. The master trust 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 master trust is that many of the tasks associated with running an occupational pension 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 policy? Who can contribute? Benefit type
Former occupational pension scheme members or trustees of occupational pension schemes Established by the transfer of funds from an occupational pension scheme – generally don’t accept ongoing contributions The type of occupational pension scheme the transfer was made from will dictate the type of benefits held in the buyout policy

A section 32 buyout policy is also referred to as a deferred annuity contract and will always be set up by the payment of funds from an occupational pension scheme. It is applied for by an individual or by occupational pension scheme trustees. Each buyout policy will set out the applicable terms and conditions. For HMRC purposes, buyout policies are registered pension schemes but are not ‘schemes’ as we would think of them – they are one-person contracts.

A buyout policy will usually be set up in one of the following circumstances:

  • An occupational pension 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. The member could alternatively opt to transfer to a new employer’s pension scheme or to a personal pension.
  • When occupational pension 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 buyout policies in the members’ own names.
  • If an occupational pension 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 pension 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, a buyout policy may have 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).

Section 32 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 pension 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

Additional voluntary contributions (AVCs) are contributions a member chooses to make to their employer’s occupational pension scheme over and above any which they are required to make as a condition of membership. Depending on the scheme rules, a member making AVCs could have a choice of providers with which to invest their contributions.

Free-standing additional voluntary contributions (FSAVCs) were introduced in 1987 and allowed employees to build up a pension fund independently from an employer’s occupational pension scheme. An employer need not have known that an employee was funding an FSAVC policy and perhaps planning an early retirement escape! FSAVC policies 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. HMRC’s administration requirements for FSAVCs were complicated and required a lot of work on the part of the provider due to the interaction between occupational pension 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

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 (GAR), 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 GAR and, if different terms are requested by a policyholder, current annuity rates would be used instead.

Retirement annuity contracts were available between 1956 and 1988. During this time, 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. They were replaced by personal pensions.

Retirement annuity contracts are one-person, stand-alone contracts which were aimed primarily at the self-employed.  Before 6 April 2006, retirement annuity contracts could only accept personal contributions from the policyholder; if the policyholder was employed, their employer could not contribute. Since then, it has, in theory, been possible for an employer to contribute but many providers did not update their contracts or systems to allow this. Personal contributions are typically paid gross with the policyholder claiming any tax relief directly from HMRC. 

Since 6 April 2006, each retirement annuity contract is, technically, a registered pension scheme even though they are individual contracts. Although all retirement annuity contracts will have been taken out over thirty years ago, they could, in theory, offer anything that the current pensions legislation allows – for example, access to income drawdown or uncrystallised funds pension lump sums. If a contract does not offer the type of benefit the policyholder wants, they could transfer to a scheme which does.

Reference to S226 is a hangover from days long gone – it refers to section 226 of the Income and Corporation Taxes Act 1970. 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 pension scheme (there’s more to it than that but that’s the broad principle).

A personal pension scheme ‘belongs’ to the provider, whereas an occupational pension scheme ‘belongs’ to the employer (unless it's a master trust).

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.

The change from retirement annuity contracts to personal pension schemes allowed the development of ‘group personal pension schemes’. The concept of a group personal pension scheme allows an employer to offer its employees a personal pension as an alternative to an occupational pension scheme. Technically, there’s no such thing as a group personal pension scheme – it’s simply a collection of individual personal pensions which the provider administers together because those individuals work for the same employer. There can be many ‘group personal pension schemes’ for many different employers all sitting under the umbrella of a provider’s personal pension scheme.

An employee who leaves service having been a member of their employer’s ‘group personal pension scheme’ will retain their membership of the provider’s scheme. The provider will, most likely, simply amend their records to disassociate the individual’s policy from the former employer. In that respect, personal pension policies 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 schemes were introduced from 6 April 2001 in 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 schemes were 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 of stakeholder policies and one of the main issues was that contributing wasn’t made compulsory so many schemes were set up as ‘shell’ schemes with no contributions being made into them. Stakeholder schemes 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 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’ll also have to allow other workers to join such a scheme if they ask to join. 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. 

You can read more about automatic enrolment in our FAQs. Full details can be found on The Pensions Regulator’s website.

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 include schemes for NHS staff, civil servants, the Armed Forces, teachers, emergency services employees and local government employees.

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 introduced 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 over their lifetime without incurring a tax charge (known as the lifetime allowance). 

As 6 April 2006 approached, scheme trustees and 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 was introduced on 6 April 2006, subsequent governments have continued to tinker with and tweak the pension rules and requirements. For example, we’ve seen the annual allowance reduced, the introduction of ‘carry forward’ of unused annual 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 don’t have to offer all of the benefit options the legislation allows; if they don’t, a member will generally have the option to transfer their pension fund to a scheme which does.

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