Pension scheme design, benefits and types of scheme
Pension scheme design determines the promise made to members, who bears the risk, and how cost is shared. SP4 tests whether you can describe DB, DC and hybrid structures, apply benefit formulae, and explain the consequences of a design choice for members, sponsors and the funding basis.
Benefit structures
- Defined benefit: pension linked to salary and service. Final salary uses pensionable salary at or near retirement; CARE uses salary each year, revalued to retirement.
- Defined contribution: a pot of contributions plus investment return; the member bears investment and longevity risk at decumulation.
- Hybrids: cash balance (a promised pot or lump sum, often with a guaranteed interest crediting rate), underpin arrangements, and collective DC where risk is pooled across members.
Statutory features
DB schemes must meet statutory revaluation and indexation minima (LPI-based), provide spouse and dependant benefits where contracted-out rights exist, and apply normal pension age rules. Early retirement usually reduces the pension; late retirement increases it, subject to scheme rules and tax limits.
Worked example
A CARE scheme accrues 1/60 of pensionable salary each year, revalued by CPI capped at 5%. A member earns £30,000 in year one, so the year-one pension is 30,000/60 = £500 a year. If CPI is 3% for the next 10 years, that slice grows to 500 × 1.03^10 = £671.96. The final CARE pension is the sum of every revalued slice, not 1/60 of final salary.
Traps
Confusing revaluation with indexation; applying final-salary logic to CARE; ignoring early-retirement reduction factors; treating the employer contribution rate as the cost of the promise; overlooking that DC transfers longevity risk to the member.