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What makes a good money purchase scheme?
'Money purchase' schemes are generally more straightforward than salary-related schemes, because each member is simply building up their own fund which they will use when they need to draw a pension income. The basic test therefore is how much your employer puts into your scheme, but there are still differences between schemes. They can be run in different ways, and can offer some benefits in addition to a straightforward pension.
There are two basic ways that money purchase schemes can be set up by your employer (or group of employers in some industries). These are:
- an occupational scheme where there are trustees managing the scheme (which can include multi-employer trusts or the government-backed NEST scheme); and
- individual pensions taken out with an insurance company to which you and your employer make contributions. These pensions may be stakeholder pensions , Group Personal Pensions (GPPs) or Group Self Invested Pension Plans (GSIPPs). Because the employer is arranging for a lot of pensions to be bought at the same time, there's a good chance that the charges for administering the scheme will be lower.
It's not possible to say that one of these is always better than the other, though it probably needs to be a large scheme to make an occupational money purchase scheme worthwhile because of the costs involved. In a company with high staff turnover or where there is a lack of long-term job security, stakeholder pensions and GPPs (Group Personal Pensions) have the advantage that a well-established insurance company will be looking after your money, and this may make it more straightforward when you change job.
What contributions does the employer make?
This is the most important factor when judging a money purchase scheme. Your pension will depend on how much you and your employer put into your own individual pension pot. The more you can save the better, but it's clearly better if the contributions come from your employer.
There is a minimum level of contributions for any money purchase scheme being used to meet an employer’s auto-enrolment duties. When the scheme was first introduced the minimum was 2% of pay, of which the employer had to pay at least 1%. From 6 April 2018 until 5 April 2019 it’s a minimum of 5%, of which the employer must pay at least 2%. From 6 April 2019 onwards it’s a minimum of 8% of which the employer must pay at least 3%. Those percentages may be calculated on all of your pay but they may only be calculated on part of your pay, above a certain level. You should try to find out which method your employer is using since it will affect the amount of money being saved into your pension pot. The Pension Regulator explains how minimum contributions work.
There is a very good case for a higher level of contributions than the minimum required for an auto-enrolment scheme. Most experts recommend that you should aim to save 15% of your pay (more if you don't start a pension until you are older) in order to retire at a reasonable age with a reasonable pension, and most people consider it fair if employers contribute at least twice as much as their employees. A good employer contribution would therefore be around 10%, leaving you to contribute 5%.
On top of this, the employer should pay the costs of other benefits in the scheme such as 'death in service' or disability benefits. Sometimes, how much the employer is prepared to put in will depend on how much you are willing to save, and may vary by age. For example, they may be prepared to match your contribution or make a minimum contribution, but pay more if you are prepared to pay above a particular threshold. You should make sure you understand the rules and aim to maximise what your employer pays if you can afford it.
What investment choices do I have?
As everyone has found in the last few years, investing in stocks and shares is no sure thing. The value of investments can go down as well as up. In a money purchase scheme, your pension will depend on how well your funds are invested. Over time, experts believe that money invested in stocks and shares will grow more than money invested in other ways. But the important phrase in the last sentence is 'over time'. If you are looking to retire in 30 years, then more risky or volatile investments make sense. If you are due to retire in a few years' time then you will want your money in safer investments that may not go up much, but won't fall in value. Good money purchase schemes should give you a choice of different funds in which to invest.
In a money purchase scheme being used for auto-enrolment there must always be a 'default fund' so that you don’t have to make a choice or take any other decisions when you are enrolled. However there should be a number of other options for you to choose from once you have joined a money purchase scheme.
Different people have different ideas about how much risk they want to take and which kinds of investments they prefer. Some schemes operate what is called 'lifestyling'. They automatically shift your fund into less volatile investments as you approach retirement, but you should check that this is in line with your plans. If you want to take early retirement, you may want to shift your investments earlier than a colleague who wants to retire later.
Are there other benefits?
With a money purchase scheme you are building up your own pension pot, which will be available as a source of income in your later years, including the option of a cash lump sum. There is little scope therefore for any extra benefits from a money purchase scheme. If you die, your pension pot will be available for your dependants, but nothing extra from the scheme. However, many employers will take out insurance policies to cover staff alongside their money purchase pension, and these may provide life assurance if you die, or an income if you become too ill to work.
Normally, the employer bears the cost of these, but you should still check the small print. Some will exclude some types of disability such as HIV- or AIDS-related illnesses, or sports injuries. A good scheme should pay up to two-thirds of your earnings if you become unable to work, and four times your salary as a death in service benefit.
What happens to early leavers?
Few people work all their lives for one employer, and it's common to retire after building up pensions with a range of employers. When you leave a money purchase scheme, it is normally 'paid up'. It will be left to grow (or shrink, if your investment choices do not do well) and each year the provider will deduct a charge from it. You can transfer the money to another pension provider but you may face charges for this that make it better to keep your pension paid up. If you want to start contributing to it again, you may face further charges.
The rules for stakeholder pensions are more favourable. Annual charges must not be more than 1.5% per year for the first ten years of scheme membership and then not more than 1% after that. You can transfer your fund without charge and you cannot be penalised for stopping, starting or varying your contributions. Some employers benchmark their schemes against the Pensions Quality Mark (PQM). The PQM sets standards for contributions, investment choice, communications, etc., but of course being accredited against the PQM doesn’t alter the fact that the amount of your pension from a defined contribution (DC) arrangement is not guaranteed.