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It has been described by Sullivan (2004, p. 5) and Buckle (2004, p.126) that a pension is an income received by a retired person in place of earnings from employment. The need for pension arises because the people's ability to earn an income from employment falls in later life. In traditional societies and developing countries, families provide economic support for elderly. However the extended family structures found in traditional societies are less common in industrialized world. Thus pensions are necessary for economic support for the families in the developed countries (see appendix 1 for graphs).It has been argued (Booth et al . 2008. P. 55-61) that government concern themselves with pension provision because there is real risk in market provision of income security and some individuals may make wrong choices in managing their wealth due to lack of skills. Secondly the individuals do not have the ability to take the correct steps to secure their pension because of lack of knowledge of markets. Also some government provides employment to old people, which is important for those who do not have sufficient savings.
Howells and Bain( 2004, p.115) state that pension provision in United Kingdom comes from three basic sources: the state scheme (basic state pension), an occupational scheme and personal pension. Basic state pension is paid by state to everyone above a certain age. It operates on a pay as you go basis (PAYG) basis and is paid for out of general taxation. The pay as you go scheme is financed directly from contributions. Each generation of workers is in effect paying for its predecessors' pensions, in the confident hope that the next generation will pay theirs. A person nowadays need 30 qualifying years for full basic state pension before they start receiving any payments.(http://www.bbc.co.uk/news/business-11619379)
Amy is working in Cardiff and Wales NHS trust which is a government payed job and they offer a pay as you go pension scheme. Most of the UK public sector schemes are financed on a Pay as you go(PAYG) basis. Sullivan (2004, p. 32) explains that pay as you go scheme has its certain advantages as well as disadvantages. The main advantages of PAYG scheme are that contributions are lower, total benefits are higher, retirement occurs at an earlier stage and scheme security is higher. It usually provides retiring workers with tax free lump sums equal to 3/80th of their salary for each year of service. Public sector employees do make contributions but the contribution rate is slightly lower than those in private pension scheme. The average age of retirement in public sector scheme is 60 or younger as compared to 65 in private sector scheme. Nurses are able to retire from NHS at the age of 55. Because they pay benefits for longer due to their lower retirement age, Amy would receive more valuable pension than to those in private sector scheme. Also Amy's PAYG scheme is adjusted for inflation while the scheme in private sector only provides inflation- proofing up to 5%. PAYG scheme is unaffected by the change in asset market conditions and also free from the risk of pension losses arising from the bankruptcy of the employer. This is because government is more stable than private sector scheme in time of economic crisis. However some disadvantages are that PAYG scheme in UK provides only a minimum level of retirement income. So that is why people decide to make additional provision and for many this is provided by Defined benefit scheme. However not all employers operate such scheme so for that reason government introduced state earnings related pension scheme (SERPS). This was too funded out of general taxation on a PAYG basis. In 1988, there were fears that taxation was unlikely to be sufficient to pay for these pensions. The reason was that average life expectancy was increasing and the birth rate was declining. Also PAYG is scheme is too rigid and if an employee has to switch job from public to private sector it would have to terminate his existing scheme and begin another with new employer. PAYG scheme is provided by public sector and public sector jobs are usually low paid than private sector. So by accepting a job in public sector workers trade lower current incomes for higher future incomes. However this must be true in previous years but in January 2010 a report came which said that a public sector workers now on average receive 2000 more than private sector.(http://www.telegraph.co.uk/finance/economics/7036131/Record-gap-between-public-and-private-sector-pay.html)
Occupational pensions are provided by employers in both public and private sector. Blake (2000,p F55-F56) says that there are two basic types of occupational pension schemes: the unfunded and the funded scheme. Many of the public sector schemes are unfunded schemes. In such schemes there is no build up of an investment fund and they have little impact on the capital market. The funded scheme is further divided in two categories, defined benefit and defined contribution. Defined benefit (DB) determines employee's benefit as a function of both years of service and wage history. In DB fund contributions are set at such a level that they will build up a savings fund over the years which will be enough to provide the defined benefits for the pensioner. Heather is also working in the private company and has taken defined benefit scheme. This scheme offers a confirmed income replacement ratio in retirement. The people can expect to enjoy the same standard of living as they were enjoying before the retirement. But this is the case for those employees who keep the same job throughout their career and on average only 5% of people in UK do this. Defined benefits scheme are provided by certain employer and when one changes job he will have to move to the new employer's scheme which will result in portability loss with respect to pension benefits. He can then either take the transfer value equal to the cash equivalent of his accrued pension benefits or leave a deferred pension in the scheme he is leaving. Also one of the problems of the scheme is that the growth rate of fund does not only depend upon the level of contributions but also on what happens to the value of assets in which the funds invests. Peter and Bain(2004, p.117) explains that until 1930s mostly pension funds were invested largely in fixed interest government bonds which provided nominal rate of 3-4% per annum and with low inflation in those year a real return of 2-3%. However after second world war, inflation raised up to higher levels and pension fund managers switched to holding company shares. Finally when markets collapsed in year 2000 and continued to fall in 2001 and 2002, the value of invested funds fell rapidly and it became clear that some funds would not be able to meet defined benefits unless the employer was ready to meet the shortfall. This shows that under db scheme the risk attached to making future pension payments rests with employers.
Another type of occupational pension scheme is defined contribution scheme. in (Blake, 2000 and Feldstein, 2000) it is described that in defined contribution employer and in some cases employees make regular contributions into employer's retirement account. Contributions from both parties are tax deductible and investment income accrues tax free. Also the government has decided to reduce the tax relief by April 2012 which will further reduce the pension funds.( http://www.bbc.co.uk/news/business-11539238) Contribution may be invested in securities, bonds, stock and money market funds. The employee bears all the risk of investment and at retirement he either receives a lump sum or an annuity depending upon the size of value of funds in the retirement account. After the problems cause by the defined benefit scheme (as described above) most of the firms changed from db to dc schemes. One of the advantages of DC schemes is that one can switch jobs without any portability loss. Also the operating costs of DC schemes are much less than the DB schemes. An individual who joins the DC scheme at an early age and maintain his contributions for a long investment period can earn a decent pension. UK stats show that a 25 year old can male can have a pension of two-thirds of his final salary. However total contributions of dc scheme are 9% as compared to 15-18%of db schemes. Like db schemes, DC also bears the risk of assets but there are also other risks such as ill health, disability and death. In DB schemes such risks are carried out by the scheme sponsor while in DC they have to be purchased by member as additional insurance policies and insurance companies add more costs of about 10-12%of the purchase price. There is also an inflation risk which causes the value of pension to fall if there is unanticipated high inflation.
Last type of pension is personal pension plans also known as individual dc schemes. This type of scheme allows worker to save independently for their retirement. These are provided by life insurance companies and other financial service providers. This scheme is very similar to the defined contribution scheme and has the same advantages and disadvantages. Like there is no portability loss when switching employers but there is the risk of fall in value of assets and annuity rates which cause the terminal value of funds to reduce.
In (Booth et al, 2008, p. 41-43 and Disney R,2000) the main problems of PAYG scheme described making it difficult for government to cope are early retirements and population ageing. As in PAYG scheme the workers are paying for their predecessor's pension and currently the birth rate has declined resulting in lesser workforce and more old people who are taking retirements at early age (further detail on problems is given in appendix2). This has put a great burden on government to pay pensions. That is why government has started emphasizing to take on personal pension plans. The main solution for this as stated by the World Bank, that government should develop a three pillar pension systems. Those are public scheme, mandatory saving scheme by private sector and private pension. There are four strategies to correct the public pension: Parametric Reform, Actuarially Fair, Clean break Privatization and Partial Privatization. (For detail see appendix 3)
In my opinion Amy should go for a PAYG scheme the one she is offered. This is because there is very less risk of failure by the government to pay pension. However in private and personal schemes there is always a risk of employer to default payments like in Maxwell and Enron's case( see appendix 3for detail on cases). Other risks such as fall in value of assets and in annuities, ill health, disability, unemployment and death are excluded from PAYG scheme. All of the risk is on government unlike in private pension and dc scheme risk is on employees. Amy can retire early and get an acceptable secure pension throughout her life.
Blake, D. 2000. Does it matter what type of pension scheme you have. The Economic Journal, 110(461), pp F55-F56.
Blake, D. 2003. Pension schemes and Pension funds in United Kingdom. New York : Oxford University press. Available at: http://books.google.com/books?hl=en&lr=&id=fPcEfxQvpD4C&oi=fnd&pg=PA55&dq=pension+funds&ots=cPi3ywbrmW&sig=Ut6VqPpCENmmapSouB-AAA1vgOQ#v=onepage&q&f=false
Booth, P. et al. 2008. Problems of PAYGO pension systems. Pension Provision: Government failure around the world. pp 41-43
BBC News.2010. Tax relief on pension is reduced. Available at : http://www.bbc.co.uk/news/business-11539238 [ Accessed : 30th November 2010]
Budd, A. and Campbell,N.2000. The roles of private sector and public sector in the UK pension system. In: Feldstein, M. ed. Privatizing Social Security. University of Chicago Press. pp112-115. Available at : http://books.google.com/books?hl=en&lr=&id=voDcj1rWxTMC&oi=fnd&pg=PA99&dq=uk+pensions&ots=EDhMpVty-Y&sig=LpOBkfJ8jot5zPM2hvdvJHeElVU#v=onepage&q=uk%20pensions&f=false
Buckle, M and Thompson, J.2004. The UK financial system: Pension fund liabilities. Manchester University Press.
Disney R.2000. Crises in Public Pension Programmes in OECD: What are the Reform Options?. The Economic Journal, 110(461), pp F13-F20.
Howells, P. and Bain, K. 2004. Financial Markets and Institutions. Pearson Education Limited.
Peachey, K.2010. State Pension: The overhaul and you.[Online]. BBC News. Available at: http://www.bbc.co.uk/news/business-11619379 [Accessed: 30th November 2010]
Sullivan, M.2004. Understanding Pension[Online]. London. Available at: Net library [ Accessed: 1st October 2010].
Wallop, H. 2010. Record gap between public and private sector pay[Online]. The Telegraph. Available at: http://www.telegraph.co.uk/finance/economics/7036131/Record-gap-between-public-and-private-sector-pay.html [Accessed: 30th November 2010].