The top three pension myths
After hundreds of consultations over the past 12 months we compiled a list of the three most frequent pension misconceptions.
Guaranteed final salary schemes
The most common myth about UK private pensions is that final salary (defined benefit) schemes are guaranteed.
The second most commonly held incorrect assumption was that final salary schemes always increase in value each year; and the third that final salary schemes automatically provide for spouses and dependants when the member dies.
It has become clear that there is a lot of misinformation and, in some cases, downright lies in the public domain about UK private pensions.
This must be addressed urgently as it could seriously compromise people's long-term financial planning strategies. The myths need to be busted.
The belief that final salary, or defined benefit, pensions are guaranteed is simply not true in the vast majority of cases.
Defined benefit (DB) schemes are, by their very nature, reliant on the financial stability of the members' firm. The question someone, especially a younger worker, should ask themselves is ‘will my company still exist and be financially sound in three or four decades' time when I come to draw my pension?'
Also, it should be remembered that pension formulas can, and often do, change over time and such modifications can significantly alter how much a member accumulates in their pension fund.
Next there is the idea that DB pensions always annually increase in value. While the value on paper may indeed increase, what members need to bear in mind is the real return that is being achieved after inflation has been taken into account. The majority of pension schemes are now applying increases in line with CPI (consumer prices index) rather than RPI (retail prices index) and the government forecasts that CPI will be 1.2% less per annum than RPI over the long term.
Final salary pension
Finally, we have the belief that spouses and children will receive a member's final salary pension should that member die. In many cases a spouse will receive 50% of the income the pension member was receiving on death – but again, this is not guaranteed. Due to the increasing liabilities that pension schemes are facing, many are now changing the terms in which spousal benefits are paid.
Such changes include amending the amount of annual increases the spouse will receive annually on the pension, pension reductions for considerably younger spouses (more than 10 years), and declining spousal pensions if the spouse is a non-UK domicile and the marriage was not registered in the UK.
Nigel Green is founder and chief executive at deVere Group
This feature was written for our sister website Money Observer
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
Final salary pension
A defined benefit pension scheme is one where the payout is based on contributions made and the length of service of the employee. A typical scheme would offer to pay one-60th (0.0168%) of final salary (the one you’re earning when you finally retire) for each year of contributions to the scheme (even though these years were probably paid at a lower salary). Someone retiring on a final salary of £30,000 who had been a member of the scheme for 25 years would receive a pension of 42% of their final salary (£12,300 a year before tax). Sadly, many companies are winding up their final salary schemes or closing them altogether, meaning pension benefits accrued after a certain date (or those available to new employees) may be on a less generous money purchase basis.