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Lecture 7

Pensions and Retirement

Dr Jacinta Nwachukwu

Principal Lecturer in Finance

School of Economics, Finance and Accounting

[email protected]

Pensions and Retirement

Lecture outline

Why you need to save for retirement

The support ratio (i.e., number of people of working age relative to people over the pension age)

Types of pension schemes in the UK

Buying an annuity at retirement

So why save for retirement?

Low basic state pension

The rising number of the ageing population

Declining birth rate

Decreasing number of people of working age relative to people over the pension age (i.e., the support ratio)

The rising State Pension age

https://www.gov.uk/state-pension-age

Something to think about

What does the information in Table 1 tell us about the differences in income distribution among pensioners according to the following characteristics?

Age

Gender

Marital status

Table 1: UK Average gross weekly income of different pensioners 2008/09

Type of Pensioner	Gross weekly income (£)	% of income from State pension and benefit	% of income from Other sources (%)
Pensioner couple both under age 75	£602	29	71
Pensioner couple where one or more is aged 75 or over	£469	49	51
Single male pensioner under 75	£308	53	47
Single male pensioner aged 75 or over	£301	54	46
Single female pensioner under 75	£280	55	45
Single female pensioner aged 75 or over	£250	67	33

UK government pension website

https://www.pensionwise.gov.uk/?gclid=Cj0KEQiAnIPDBRC7t5zJs4uQu5UBEiQA7u5Ne0u-Q5XfZRsah7i3lG7zYIDaXYYDHyAOWg6TE688axsaAre18P8HAQ

The support ratio

This is defined as the number of workers (i.e., people aged 15 and 64) divided by the number pensioners aged 65 and over

So a value of, say 2, means that there are 2 workers to support one pensioner

See Figure 1 for the support ratios of the world regions

Figure 1: The Support Ratios in major World Regions

2009

Europe North America Oce ania Latin American and the Caribbean Asia Africa 4 5 6 10 10 16 2050

Europe North America Oceania Latin American and the Caribbean Asia Africa 2 3 3 3 4 9

Types of pension Schemes in the UK

State pensions

Occupational pensions

Personal persons

Table 2: Main Types of UK Pension

Pension scheme	Organised by	Basis on which the pension is provided	How pensions are financed	Who pays?
State pension: basic	State	Defined benefit	Pay as you go	State provision
State pension: additional	State	Defined benefit	Pay as you go	State provision
Occupational scheme: final salary	Public sector employers	Defined benefit	Pay as you go	State provision + employee
Occupational scheme: final salary	Private and some public sector employers	Defined benefit	Funded scheme	Employer + employee
Occupational scheme and National Employment Savings Trust (NEST)	Private sector employers	Defined contribution	Funded scheme	Employer + employee
Personal pension	Individual	Defined contribution	Funded scheme	Individual, employer occasionally

State pensions and benefits

Basic State Pension

Additional State Pension

The Basic State Pensions (BSP)

The basic State Pension is paid at a flat rate unrelated to a person’s earnings

Entitlement depends on paying or being credited with National Insurance Contributions (NICs) during 40 years working life

NI Credits are awarded for certain periods of low pay under £151 threshold, out of work due to illness, unemployment and a host of other circumstances .

https://www.gov.uk/national-insurance-credits/eligibility

To get a full basic state pension, worth between £102.15 to £119.30 a week during the 2016 tax year, those reaching retirement age before 6th of April 2016 needed to have NICs covering nine-tenths of their working life.

Those reaching pension age after 6th of April 2010, the NICs needed for a full basic pension was lowered to 30 years. A shorter contribution record means a reduced pension.

When a person is out of work due to illness, unemployment and caring for children under the age of 12 years, they are awarded NI credits which count towards their state pension

Since April 2010, wives, husbands and registered civil partners can claim a basic pension of up to £61.20 a week based on their spouse’s or partner’s record if their own basic pension would come to less than this.

In addition, Pension credits are offered to those on low income and to people who have saved some money towards their retirement on or after 6th April 2016

The Additional State pension

Again like the State Pension this is available to people who reach retirement age on or after the 6th of April 2016

It is an earnings-related pension and restricted to employees with average working life earnings above a threshold of £14,100 per annum in 2010/11(i.e., £293.75 per week for a single person)

But, because many higher earners are increasingly “contracting out” of this additional state pension, this earning related pension is gradually being phased out and converted into a flat pension of £137.35 per week for a single person and £209.70 for a couple.

In an attempt to streamline the state pension, the government in 2011/2012 announced that any pensioner relying solely on the basic state pension is now entitled to claim a means-tested top-up

Means-tested benefits or “pension credit” has two elements

(i) The Guarantee income credit which raises the pensioners’ incomes to the minimum level of £137.35, rising to £155.60 for a single person and £237.55 for a couple in April 2016

(ii) The Savings credit guarantee which offers extra payment to people who save money towards their retirement. It pays £13.07 for a single person and £14.75 for a couple in April 2016.

https://www.gov.uk/pension-credit-calculator

The new state pension rules

https://www.gov.uk/new-state-pension

https://www.gov.uk/tax-on-pension

The occupational schemes

The Defined benefit scheme

2. The Defined contribution scheme

NEST PENSIONS

https://www.moneyadviceservice.org.uk/en/articles/nest-pensions

https://www.gov.uk/government/organisations/national-employment-savings-trust

The Defined benefit (DB)

This promises to pay a guaranteed pension at retirement.

Typically, this specified amount is linked to the employee’s number of years in services and their salary at the time of retirement rather than the performance of the markets in which the contributions are invested.

The most common type of DB schemes in the UK guarantees to provide a pension that builds up (accrues) at the rate of one-sixtieth of the member’s final salary for each year of service up to an Inland Revenue maximum of forty-sixtieths of final salary at retirement, up to a maximum of £105,600 in 2005-2006

That is: Yearly pension = accrual rate*number of years in scheme* salary

Options which could be used to reduce the cost of DB schemes and yet retain the salary link may include:

(i) Reduce the accrual rate to one-eightieth

(ii) Use a career average salary rather than final salary, after adjusting for inflation between the time it was earned and the person retiring

Defined contribution (DC) schemes

A defined contribution scheme, also known as money purchase scheme, depends on:

(1) The amount paid in by employers and employees rather than salary

(2) How the invested money grows. This depends on the performance of the asset market in which the fund is invested.

(3) The amount of pension annuity that can be purchased from an insurance company at retirement.

(5) The level of charges deducted by the pension providers

Most employers prefer a DC scheme because it only pays specified contributions to the scheme. Besides, it is not obligatory that employers contribute to DC scheme.

Overall, a good DC scheme or plan should:

(i) Invest minimum employer and employee total contributions of between 10-20% of annual salary

(ii) Delegate the investment management to an institutional fund manager that has a proven track record

(iii) Incur competitive administration and investment charges

(iv) Impose no financial penalties for those who leave the scheme, reduce contribution or retire early

Personal Pensions

Anyone can have a personal pension and anyone can pay into a personal pension for someone else.

Personal pensions have similar characteristics to the DC occupational schemes mentioned earlier.

However, personal schemes do not offer the benefits which are provided by occupational pension schemes. It is therefore up to the employee to purchase extra benefits

Other disadvantages of personal pension schemes may include:

(i) Return from the assets in which the funds are invested is impossible to know in advance. If they perform badly, the pensioner will have too little in the fund. They will need to top up their contribution when markets are doing badly. But this limits their current spending and standard of living.

(ii). Inflation which reduces the purchasing power of money. So to protect against this, the person planning for retirement would need to forecast the rate of inflation and contribute the necessary extra money to maintain the real value of their pension fund.

(iii) Longevity: The longer the person lives, the more months of pension that have to be paid out, and the greater the total cost of the pension.

Buying an annuity at retirement

An annuity is an investment where the investor swaps a lump sum for a regular income.

A pension annuity is paid out for the rest of the policyholder’s life, regardless of how long they live.

See Table 3 for the different types of income provided by annuities.

Table 3: Annuity Rates Compared

Type of annuity	Average annuity rate per £10,000 for a single woman aged 65	Pension income assuming an initial investment of £10,000
		At the start of retirement	After 10 years of retirement	After 20 years of retirement
Conventional annuities	£576	£576	£576	£576
Inflation-linked annuity	£348	£348	£445	£570
Annuity escalating at 3 percent a year	£396	£396	£532	£715

Note that:

End of lecture

Take home assignment 1

In recent years, the income from traditional annuities have fallen sharply which has led investors to believe that these products offer poor value for money.

Question: How can pensioners boost the future income from their DC pension funds in order to compensate for the low interest rates and increase in longevity which are responsible for the fall in conventional annuity income?

Take home assignment 2

Assume you earn £150,000 per annum and have been in a Defined Benefit pension scheme for 20 years

Question: Outline your options on how to use your contributions to the occupational pension scheme to save on the tax payable

Take home assignment 3

You have been asked to help Fred, who is 40 and earns £55,000 per annum, to select a pension plan. His wife, Jane, earns £70,000 and is in the Civil Service pension scheme, which is a defined benefit arrangement.

What factors would lead you to recommend to Fred, in turn, an occupational Defined contribution scheme, ISAs or a self-invested personal pension (SIPP)?

What investment options would you recommend for a SIPP pension fund for Fred?

Something to think about

Explain how the eligibility for the basic and additional state pension is built up

What is the qualifying year and how many working years do you need for the basic state pension?

What are the deferment rules for those who wish to delay drawing down their state pension?

Something to Think about

The UK Life expectancy at age 65

Someone reaching age 65 in the year…….	…..could expect on average to live for this many more years
	Men	Women
1981	14.0	18.0
1991	16.0	19.4
2001	19.5	22.3
2011	21.4	24.0
2021	22.5	25.1
2031	23.4	26.0
2041	24.4	26.8
2051	25.3	27.7