Understanding unfunded pensions

PEOPLE are asking me more questions about unfunded pensions.

In an earlier article, I said there was ‘no pot of gold’ in such schemes.

However, as P Trippett wrote to the Olive Press to say, Local Government Schemes are in fact funded and I had erroneously included them in my list of unfunded schemes.

However, there are many other pensions which are unfunded including, for example, the UK State Pension Scheme.
I have been asked to expand on this and to explain what it means.

Pensions broadly fall under three categories; they are either defined contribution (DC), defined benefit (DB) or State pensions.

DC schemes are set up as a long-term plan and the level of pension benefits available in retirement will be determined by how much money is in the pension pot at that time. This in turn relies on contribution levels and investment growth.

DB schemes have benefits that are defined at the outset and often referred to as a final salary schemes. The level of benefits payable will be determined by the number of years of service and the final pensionable salary at retirement age. There is no investment risk for the members, providing their employer can honour the benefits that have been promised.

In the private sector, DB schemes will mainly have a large pension pot set aside to meet the liabilities arising when people retire and want their pensions paid to them. Some such schemes are fully-funded but many are underfunded, which could have a negative impact for people requesting a transfer value, for example.

In the public sector, however, and with State pensions, these are largely on a ‘pay as you go’ basis. This means that the pensions being paid this year have to come from the current year’s budget, rather than reserves. This is why such a large proportion of the budget for some organisations is set aside each year to pay the pensioners, before they even start to fund the operation for the current year.

The impact of changing demographics is visible in the State Pension Scheme that is on a ‘pay as you go’ basis, with pensions each year being funded from National Insurance contributions being paid by people who are working that year. Hence ‘pay as you go’.

This system works well when you have an increasing working population when compared to the number of pensioners. While employment in the UK is at an all-time high, so is the number of people beyond retirement age. In fact, this population is growing faster than the increase in the rate of employment, as people are living longer and the ‘baby boomers’ move into retirement.

This is why the State pension age has been increased – and will continue to be increased in the future – to help soften the impact.