The reason that the term ‘retirement plan’ is often confused with that of ‘pension plan’ is that ultimately they are one and the same thing. There is no great distinction between the two other than that British people tend to refer to pension planning whereas US citizens prefer to use the terminology of retirement planning.
Pensions in the United Kingdom have a variety of structures. A retirement plan established by employers for the benefit of employees is commonly referred to as an occupational pension scheme. These schemes can take two distinctly different formats. The two types of pension schemes are known as Defined Benefit Plans and Defined Contribution Plans.
Defined Benefit (DB) Schemes
A defined benefit plan is a scheme wherein the retirement benefits are determined according to a set formula that can incorporate the employee’s pay, years of employment, age at retirement, etc.In the UK defined benefit schemes are generally indexed for inflation.
A defined benefit scheme can sometimes be referred to as a final salary scheme, wherein the pension paid is equal to the number of years worked, multiplied by the member’s salary at retirement, multiplied by a factor known as the accrual rate.
DB plans may be either funded or unfunded. The unfunded defined benefit pension scheme does not have assets set aside for the payment of benefits to its members on retirement. The pension benefit commitment is delivered by the employer or other pension sponsor, which in the case of the public sector, would be the government.
Contributions to a funded plan, are made by the employer and sometimes also by plan members. These contributions are invested in a fund which is managed with a view to meeting the retirement benefit requirements of the members. In the UK, the government has encouraged the funding of defined benefit plans through the provision of tax incentives to companies An actuary regularly reviews the funds assets and liabilities to ensure that the pension fund will meet future payment obligations.
Some DB schemes allow members to have a lump sum cash benefit upon termination of the plan; most members however receive benefits in the form of an annuity which provides a regular income in retirement.
Defined Contribution (DC) Schemes
Contributions made by employers and employees to a DC plans, are paid into an individual account for each member. The contributions are invested in the stock market, and the returns on the investment credited to the individual’s account. Employee can choose how much they would like to contribute, and have the ability to tailor the investment portfolio in accordance with their preferences. However, it should be noted that the investment risk and rewards In a DC plan are shouldered by the individual and not by the sponsor/employer.
In the UK members of a DC plan are obliged by law to purchase an annuity with the bulk of the fund.
Portability of DB and DC schemes
For those seeking to retire outside of Britain, DB and DC schemes are not very portable. Pension plans can be problematic for workers who change countries while employed, or for expats who want to retire outside of the UK and take their funds with them. Many expats have opted to transfer their UK pensions into a Qualifying Retirement Overseas Pension Scheme (QROPS) in part to avoid these complications.