How Different UK Pensions Work

Undefined Benefit: Fixing the UK Pensions System Bruno Bonizzi, Jennifer Churchill and Sahil Dutta August 2023

State Pension

A worker (and their employers) will make at least ten years of National Insurance (NI) contributions. Alternatively, they’ll receive NI credits if unemployed or not in work for caring responsibilities.
Upon retirement at 66 (the legal minimum age for application to the state pension), people receive a guaranteed payment by the state, up to a maximum of £203.85 a week if they have made thirty-five years of contributions.

Risk borne by: The state. The pension is not “funded” by an investment portfolio, working instead as a PAYGO system, financed by NI contributions, and backed by the state.

Redistributive Impact: The state pension is the most redistributive pension mechanism, with higher-paid workers supporting pensions of lower paid workers. Regardless of the amount they contribute, citizens who have the same number of years of contribution will receive an equal pension.

Occupational Defined Contribution

A worker and their employer pay money into a pension scheme, arranged either directly by the worker with a pension provider, or typically by the employer in an occupational pension scheme.
This scheme invests the pool of money into financial markets, either directly or, more often, by contracting this role out to one or more asset managers.
The investments are meant to generate returns, for example via dividend payments, interest paid on sovereign bonds, or through rising financial asset prices.
Upon retirement, members should have a fund that they can gradually draw down through old age or use to purchase an annuity from an insurance fund, which provides a guaranteed annual sum throughout retired life. They can also take a lump sum in cash.

Risk borne by: Individuals. The employers’ contribution is defined, but the pensioners’ benefit is uncertain. The level of retirement income depends on the contributions made and the performance of the investment fund. If returns are lower than expected, the individual worker themselves bears the cost and employers are protected.

Redistributive Impact: None/ Regressive.

Occupational DC pensions directly reproduce distributions and inequalities of income, with both employee and employer contributions scaled as a percentage of a worker’s salary. This gap can be exacerbated if, for instance, under the strain of a cost-of-living crisis, someone on a lower income becomes unable to afford their contributions and either pauses them or lowers their rate, which is then matched by a lower contribution rate or pause on the part of employers. Moreover, contributions are tax-deductible, meaning that higher earners take greater government subsidies than lower earners. Pensions tax relief cost £43 billion in 2020/21.

Occupational (Funded) Defined Benefit

An employer has a workplace pension scheme into which they and individual workers make regular, tax-deductible contributions.
This scheme invests the pool of money into financial markets, either directly or, more often, by contracting this role out to one or more asset managers.
The investment fund generates returns, while also receiving new money contributed by current workers and employers.
Upon retirement, members will have a guaranteed annual sum provided throughout retired life, usually calculated from their average career salary.

Risk borne by: Employers. The benefit is defined, but the cost of paying for that promise is uncertain. If returns are lower than expected, the employers make up the shortfall (alongside existing workers). According to the Pensions Protection Fund, in 2020 defined benefit schemes would have needed a combined £668 billion in additional funds before they could all afford to insure all their benefits.

Redistributive Impact: Limited.

Occupational Defined Benefits schemes reproduce existing labour market inequalities, albeit to a lesser extent than DC schemes. This is because while final pension benefits are based on earnings, these are not linked to contribution rates, which in some cases (e.g., Local Government Pension Schemes) are progressively linked to members’ incomes. In this way, those on higher incomes pay proportionately more than those on lower incomes but accrue the same pension entitlements.

Public Sector (Unfunded) Defined Benefit Pension

An employer (the NHS, Schools, Civil Service) maintains a workplace pension scheme into which they and employees pay.
Retired workers are paid a guaranteed annual income based on their career contributions, paid for by the contributions of current workers and employers.

Risk borne by: The state. Any shortfall will be covered by the Exchequer, as retirement income is guaranteed. The pension is not “funded” by an investment portfolio, but rather relies on a PAYG system.

Redistributive Impact: Limited.

Like funded Defined Benefits schemes, these funds reproduce existing labour market inequalities, albeit to a lesser extent than DC schemes. Contribution rates in schemes such as Teachers’ or NHS pension scheme are linked to members’ earnings. In this way, those on higher incomes pay proportionately more than those on lower incomes but accrue the same pension entitlements.

Personal Pension

An individual who wants to put money aside for a pension makes contributions into a pension scheme provided by a financial institution. These contributions can also be tax-free, up to a limit.
The institution will invest on behalf of the individual, either directly or by contracting out to asset manager(s), into a variety of financial assets.
The investments are intended to generate returns, growing the value of the contributions made by the individual over time.
Upon retirement, members will have a fund that they can either cash out in one go, draw down from through old age, or use to purchase an annuity from an insurance fund, which provides a guaranteed annual sum throughout retired life.

Risk borne by: Individuals. The individual’s contributions are defined, but their benefit is uncertain. The level of retirement income depends on the contributions made and the performance of the investment fund. If returns are lower than expected, then the individual themselves bears the cost. This type of pension is effectively a form of tax-incentivised savings account.

Redistributive Impact: None/Negative.

Similar to funded Occupational DC schemes, there are no redistributive mechanisms at work here. Personal pensions effectively work as a tax-deductible saving mechanism.