A pension pot that may all depend on definitions

MENTION THE word "pension" and most people envisage a reassuringly secure income in retirement. Even the concept of "pension planning" is inclined to make one believe that you can plan for a certain level of income.

Unfortunately, that very much depends on the type of pension you have. The picture outlined above is very much a product of DEFINED BENEFIT pension schemes.

Defined Benefit (or DB) schemes are pensions where the amount payable in retirement is determined by the number of years served with a company.

In general, both the employer and employee will pay a certain percentage of the employee's gross salary into the scheme. The key point is that, regardless of the investment performance of that money, the fund undertakes to pay a predetermined proportion of the employee's income in retirement.

If the performance of the fund falls short or annuity rates drop, the employer has to pick up the slack.

Before the Celtic Tiger, this was indeed the standard form of occupational pension in the Irish market. Now, increasingly, DB schemes are seen as "gold-plated" and tend to be the preserve of the public service.

All new pension schemes and a significant proportion of older ones have switched to the DEFINED CONTRIBUTION model.

Defined Contribution (or DC) may sound very similar to DB, but it is anything but. The most significant difference is that the risk in relation to the eventual pension one receives transfers from the employer to the employee. Rather than employers having to provide an open chequebook, their contribution is fixed at a certain level.

No longer can you gauge accurately what your income will be in retirement. It depends. On what?:

On how much money you and your employer pay in;

On how investment markets perform;

On how actuarial assumptions about the age to which you are likely to live change;

On how the bond markets - markets for government and high grade corporate debt - perform.

That is a significant number of variables for an individual trying to gauge how much they need to invest in their pension on an annual basis.

One of the drivers of the change has been a tightening of the "funding standard" applied to pension funds by the regulator, the Pensions Board.

Concerned that some companies might have been failing to adequately fund their pension schemes, the board altered the accounting rules for pension assets. Companies now have to account for the state of their pension fund on the balance sheet with their annual accounts.

In times of volatility, such as the past year where stock markets have fallen dramatically and average pension funds have taken a 26 per cent hit, the impact on company balance sheets can be severe.

As Ireland Inc is currently discovering, increased balance sheet debt can lead to higher borrowing charges. Companies are also obliged by the Pensions Board to put in place proposals to address any pension scheme shortfall within a defined period.

The problem, according to pension industry sources, is that many people continue to believe that the amount they would have contributed under a DB scheme will be sufficient to fund an adequate pension.

Research conducted by the UCD Michael Smurfit Graduate Business School and published earlier this year indicated that the average employee contribution to DC schemes was 6 per cent, a figure that was broadly matched by employers.

That means DC schemes are operating on the basis of a combined 12 per cent of gross salary. Rachael Ingle, of benefits consultants Hewitt Associates, said this was considerably below the figure required.

"A 35-year-old starting a pension today would need contributions of 25 per cent to ensure an income of 50 per cent of salary at age 65, in addition to the State pension," she said.

And that was before the market's recent collapse that saw 8 per cent wiped off the value of pension funds last month alone.

A separate problem for occupation pension holders is the obligation to draw down their retirement income by way of an annuity fixed at the time they retire. Annuity rates vary depending on the yield of government or AAA-rated corporate bonds.

If you are unlucky enough to retire at the wrong time in the cycle, you can find income for the rest of your life adversely affected.

Pressure is growing to increase flexibility for defined contribution pension fund members by allowing them to switch their pension funds into an Approved Retirement Fund (ARF), subject to certain minimum requirements.

These allow people to keep funds invested even in retirement, drawing down only the amount they need at any given time.