Defined benefit pensions
Defined benefit pensions are increasingly uncommon but you may have one if you work for a large company or in the public sector.
If you are fortunate enough to have a defined benefit pension what does this mean for you and your retirement?
What is a defined benefit pension?
All defined benefit pensions (sometimes called final salary pension or career average pension) share one common and highly valuable characteristic - at retirement they promise to pay you a secure income for life.
They offer certainty in retirement as the final ‘benefit’ is known. What exactly the benefit is will depend upon the employer’s scheme as they are all different.
Generally, the more you earn, the higher the position you hold and if you have been at the company for a long time, the more generous the pension you are likely to receive.
It is your employer’s responsibility for ensuring there is enough money in the pot to pay the promised pension when you reach retirement. This is a valuable benefit as all investment risk lies solely with the employer not you.
- Provides a guaranteed known income when you retire
- Your employer bears all investment risk
- Typically provides a good income in relation to what you put in
- Limited flexibility in terms of income and death benefits
- May offer poor value if unmarried or in ill health
What is the difference between a defined benefit and defined contribution pension?
A defined benefit pension (or final salary pension) provides a guaranteed income when you retire, and your employer bears all the investment risk and ongoing charges.
Whereas, a defined contribution pension (also known as a money purchase scheme) can be a private or workplace pension, whereby you and/or your employer contributes towards your retirement fund.
The amount you receive from your pension depends on the amount of money there is saved in your pension pot when you retire. The responsibility is placed on you and you personally bear the investment risk and ongoing charges, not your employer.
Most modern workplace and personal pensions, including SIPPs, available today are defined contribution pensions. These pensions work a little differently.
In this type of pension, the amount contributed is known however, unlike a defined benefit pension, the outcome at retirement is not.
Your contributions will be invested in a mixture of investments chosen by you.
The value of the benefits you will receive on retirement is then determined by the total value of the investments purchased by the contributions. Simply put the more you pay in and the better the investments perform, the more you could get back when you retire.
- You personally bear the risks and charges – not your employer
- The value of your pension and the income it produces can fall as well as rise so you may get back less than you invested
- Following the introduction of pension freedoms, defined contribution pensions are far more flexible in terms of how much and when you can take an income and offers more flexible death benefits
When can I take my pension?
Each defined benefit scheme has a scheme specific normal retirement age (NRA) which determines when you can access your benefits. You may have the option to take your benefits earlier, but you should be aware of any early reduction factors that may apply.
Most defined benefit pensions have a normal retirement age of 65.
It may also be possible to take your pension without retiring although this may not be particularly tax efficient depending on your other sources of income.
Finally, you might be able to defer taking your pension, which may mean you get a higher income when you do take it.
How much will I receive from my defined benefit pension?
Whilst all schemes are different, the income you will receive at retirement is typically based on 3 common factors:
- Your salary (pensionable earnings) while working: based on either your final salary, or sometimes an average of your salary over your career (also known as Career Average Relevant Earnings)
- The number of years you’ve worked for the employer when you retire or at the time you left the scheme (pensionable service); and,
- The proportion of your salary you’ll get as an annual retirement income (known as the accrual rate) typically stated as a percentage say 1/80th
How much is a defined benefit pension worth?
As an example: if you retire on a final salary of £40,000, have worked for the company for 40 years and the proportion of your salary used is 1/80th, your benefit would be:
£40,000 x (40 x 1/80) = £20,000 per annum
Once your pension starts to be paid, it will increase each year by a set amount for life to take into account the rising cost of living.
Don’t forget that your actual pension income will be taxable.
Are defined benefit plans taxable?
If you choose to take a pension commencement lump sum (PCLS) when you take your benefits this will be tax free. The pension income you receive from the scheme will be taxed at your marginal rate of income tax.
However, its important to note the calculations for a lump sum can be complicated.
It may be built up as a separate pot to the guaranteed income or alternatively you may have the option to convert (or commute) some of your pension income into a lump sum.
If it’s built up as a separate pot the calculation is similar to how your income is calculated. It is usually based on a higher proportion of your salary (accrual rate) say 3/80 rather than 1/80. For instance, in the example earlier the lump sum would equate to:
£40,000 x (40 x 3/80) = £60,000 one-off tax free lump sum
If you have to convert a proportion of your income, the lump sum you will be entitled to is based on what’s known as a 'commutation factor'.
Basically, if the commutation factor is 12, you get £12 of lump sum for every £1 of guaranteed income you give up.
The maximum tax free lump sum is the lower of 25% of the pension value or £268,275 in most cases although, if you opt to take this by converting income, you often lose more than 25% of your annual pension income.
Therefore, depending on your personal circumstances, it may not always be in your best interests to opt for any lump sum.
What happens if I die?
Ensuing your family are looked after in the event of your death is often a key priority.
Usually your spouse, civil partner or dependants will continue to receive a pension when you are no longer here.
This is usually a fixed percentage of your pension (such as 50%) at the date of your death.
If you have converted some of your income into a lump sum at outset, the death benefits are often based on the income you were entitled to prior to conversion.
Any dependant’s pension will end on their death and it is not possible for future generations to benefit.
If you die before drawing your benefits, the scheme may also pay a lump sum in addition and/or return the contributions you have made.
What happens to my pension if my company goes bust?
A number of people are rightly concerned about what will happen to their pension if the company promising to pay your pension income fails or cannot afford to meet its obligations.
Importantly, if this does happen, the Pension Protection Fund (PPF) may compensate you up to certain limits.
If your pension scheme qualifies for the maximum level of protection, what you will receive will depend on several factors including:
- whether you had passed the scheme normal retirement age when your employer became insolvent,
- your membership status (are you the scheme member or a widow/er/child of a scheme member receiving a dependants pension), and
- your length of service with the employer.
Generally speaking, if you have not already drawn benefits from the scheme when it enters the PPF you will be entitled to receive a pension equal to 90% of the pension you built up during your working life. Historically there was an upper cap, but this has since been removed.
Any compensation paid will be increased annually in line with inflation - capped at 2.5% - and not with the former scheme rules.
Can employers change the terms of a defined benefit plan?
It’s possible for an employer or trustee to make changes to a defined benefit pension scheme, however the ability to make changes should be set out in your scheme’s rules.
It’s important the rules are followed, and you must be consulted. Section 67 of the Pensions Act 1995 applies to all occupational pension schemes with more than one member.
Should I transfer my defined benefit pension?
If you’re in an ‘unfunded’ public sector pension (e.g. NHS, civil service of teacher pension), these don’t allow transfers. Private sector (and some other public sector pensions) are funded which means you can transfer a cash value to a defined contribution pension.
Anyone wishing to transfer a fund value of £30,000 or more will need to take financial advice to ensure they fully understand both the benefits and risks of transferring their pension.
Opting to transfer a defined benefit pension to a defined contribution pension is unlikely to be in most people’s best interests and it is not a decision to be taken lightly.
Any potential advantages are often outweighed by the highly valuable benefits you’re giving up.
You might find yourself worse off, even if your employer offers you incentives to transfer out.
How we can help
This is a complex area of financial planning and our suitably qualified, unbiased and regulated financial advisers can provide clarity and help answer some of the following questions:
- Can my defined benefit pension meet my income needs in retirement?
- Can I afford to retire early?
- Should I take the tax-free lump sum or a higher guaranteed income?
- What should I do with the tax-free lump sum?
- How will my family be looked after when I am no longer here?
- Would the flexibilities offered by a defined contribution pension better meet my own unique needs and requirements?
If you are unsure of the answer to any of the above questions please why not arrange a free initial consultation with a Financial Adviser today?