Defined Benefit pensions are now most commonly seen in larger employers and public-sector organisations. The number of businesses offering this type of pension is decreasing. However, millions of people are still members of this type of scheme and if you have one, then understanding how it works will give you a great foundation on which to base your decisions as you prepare for retirement.
This guide will help you to understand the options facing you and the benefits and disadvantages they present.
Of course, the only sure-fire way to know whether an option is right for you, is to seek professional advice and guidance before making any concrete decisions.
Defined Benefit pensions may also be referred to as ‘Final Salary’ pension or schemes. But for the sake of simplicity and comprehension, we will refer to them as ‘Defined Benefit’ throughout this guide.
A Defined Benefit pension provides a guaranteed income throughout your retirement. The amount you receive each year typically rises in line with the Consumer Price Index (CPI), to maintain the true value of the income. This is known as indexation.
The income you receive when you retire is calculated using three factors:
- How long you have been in the scheme (in years)
- The accrual rate for your scheme (for example, you may receive 1/60th or 1/80th of your pensionable earnings for each year you are a member of the scheme)
- Your pensionable earnings
This means that the amount guaranteed to members of Defined Benefit schemes will vary from one person to the next. It is worth remembering that your pension income will be lower if you decide to take a lump sum, known as Pension Commencement Lump Sum (PCLS) when you retire.
You can find out the benefits you have accrued in your Defined Benefit pension, and what you might get in retirement, by looking at your latest annual statement. You can request this from your scheme administrator if you don’t have an up to date one.
Defined Benefit pensions offer three key advantages:
- The income you receive during retirement is guaranteed for the rest of your life
- The income is typically protected against inflation through indexation
- The scheme will provide a pension for your spouse, and possibly your civil partner or other financial dependents, should you die before they do
Although it is the responsibility of your employer to ensure that the scheme can meet its obligations to members, there are times when that is not possible. For example, if an employer goes out of business.
In such a case, the Pension Protection Fund (PPF) will step in to compensate and cover some or all the pension income you would have been entitled to.
The amount paid out by the PPF will depend on your age and level of benefit entitlement at the time your employer becomes insolvent.
If you have already retired:
- Your pension will continue, if you were past the normal retirement age
If you retired early and had not reached the normal retirement age when the business failed:
- You will be paid a percentage of your previous income, dependent on your age
- The percentage will be lower, the further you are from the normal retirement age
- The cap is increased by 3% for every year you paid into the scheme after 20 years
If you have not retired when the business declares insolvency:
- You will receive 90% of your entitled income when you reach the normal pension age
- From the date the PPF take over your pension, until you reach normal retirement age, your pension ill rise in line with inflation, subject to a 2.5% cap
- Your annual income will rise if you defer your retirement age
In all above cases:
- Income earned through service after 5th April 1995 will rise in line with inflation – this is capped at 2.5%
- Income earned before this date will not rise annually.
If you die, the PPF will distribute your compensation to:
- Your spouse or civil partner
- Children under the age of 18
- Children under the age of 23 who are disabled or in full-time education
You can find out whether your scheme has been transferred to the PPF, by clicking here.
When the time comes to retire, you will be faced with four options:
- Use the scheme as intended, accepting that there will be penalties imposed if you decide to retire before the normal age (this is usually 65, although not always)
- Take a Pension Commencement Lump Sum (PCLS), also known as a tax-free lump sum. This will result in a lower income thereafter
- Transfer your fund to another arrangement such as Flexi-Access Drawdown. This option requires careful consideration and independent financial advice if your fund is worth more than £30,000
- Apply for a partial transfer, moving some of the fund into another arrangement and leaving the rest behind. This will lower your income from the Defined Benefit scheme, but allows you to put part of the fund into a plan of your choosing. Very few Defined Benefit schemes offer this option, but it’s always worth checking to see if it is available, and of course, the right thing for you to do
In most circumstances, the most appropriate course of action is to remain a member of a Defined Benefit scheme. This is due to the guaranteed income it provides throughout retirement.
The CETV is the amount you can transfer to an alternative arrangement should it prove to be the right thing to do. It is calculated using several factors, including:
- How long you have been a member of the scheme
- The scheme’s accrual rate
- The pensionable earnings you received during your membership
- Assumptions about future inflation rates
- Annuity rates
- The performance of the fund at the time you apply for the CETV
Usually, providers allow one free CETV application per year, but you or your financial adviser may be able to apply for further calculations for a fee.
Transferring away from a Defined Benefit scheme, whether you are still working, or you plan to retire, is usually the wrong thing to do.
However, there are occasions when a transfer is the right option.
Often, those who choose to move away from their Defined Benefit scheme, when they retire, will instead access their fund through Flexi-Access Drawdown. This allows you to take a flexible income, as and when you need it.
Defined Benefit pensions and Flexi-Access Drawdown both have advantages and disadvantages. These should be compared fully, alongside advice from a professional adviser, to determine which is better suited to your needs and circumstances:
With a Defined Benefit scheme, the income you receive during retirement is guaranteed. It is the responsibility of your employer to make sure that they can pay the amount due to you.
The income you receive is not flexible and will only change to match the effects of inflation. Protection is in place via the Pension Protection Fund (PPF), should your employer be unable to uphold their responsibility.
With Flexi-Access Drawdown, your income is not guaranteed.
The funds transferred in are invested to reflect your attitude to risk. The amount you withdraw is flexible and set by you. This means that you are in control of your income and can alter it to meet your needs as they change. However, it is vital that you plan carefully to ensure that you don’t run out of money; stock market volatility or taking out an unsustainable level of income could cause you financial hardship in the future.
A Defined Benefit pension is guaranteed to provide an income from the day you retire to the day you die. It will then continue to provide an income for your spouse, and possibly your civil partner or other financial dependents, should you die before they do. However. this is generally at a lower level.
Flexi-Access Drawdown is not certain to provide an income for the rest of your life. Without careful financial planning, it is possible to take too much, too early and face financial difficulties in your later years. Deciding on a sustainable level of income and regularly reconfirming the calculation, is perhaps one of the key challenges facing people who use Flexi-Access Drawdown.
Typically, the income from a Defined Benefit pension rises each year to combat the effects of inflation.
With Flexi-Access Drawdown, you will need to increase the amount you take each year to offset the rising cost of living due to inflation. However, there is nothing in place to automatically inflation-proof your income, so you may end up running out of money sooner than anticipated.
Pension Commencement Lump Sum (PCLS)
You can take a lump sum of up to 25% of your Flexi-Access Drawdown fund on a tax-free basis.
The amount you can access via Defined Benefit will vary depending on your scheme.
When you enter Flexi-Access Drawdown, you will be asked to nominate your beneficiaries. This is the person, people, organisations or groups who you would like to receive the rest of your pension fund when you die.
You can nominate any person, organisation or charity to be your beneficiary; they do not have to be related to you. It is also possible to nominate multiple beneficiaries and the percentage of your remaining pension fund you wish to allocate to them. Individuals will receive the benefit in one of three ways:
- Lump sum: Taking the remaining fund all at once
- Drawdown: Continuing the Drawdown arrangement you had in place, to provide an ongoing, flexible income to meet their needs
- Annuity: Using the remaining fund to buy an Annuity which will provide an annual income for the rest of their life.
If you are under the age of 75 when you die, and your beneficiary chooses one of the above options within two years, the income or lump sum they receive will not be subject to any tax. If you are over 75, the money they receive will be taxed at their marginal rate.
The death benefits of a Defined Benefit pension plan are different. If you have retired and are no longer working for the sponsoring employer when you die, your surviving spouse will receive a widow or widower’s pension. In some circumstances a pension may also be payable to your partner or civil partner (if you are not married) or other financial dependents.
Every Defined Benefit scheme is different, and it is not guaranteed that they will all offer the above options, so be sure to check the terms carefully and discuss your options with your financial adviser.
Following the introduction of Pension Freedoms in 2015, it is a prerequisite that anyone with a CETV above £30,000 must seek advice from an independent and regulated adviser before being allowed to transfer.
However, we believe that there are other reasons why people considering transferring their Defined Benefit scheme should take independent financial advice:
- The decision to transfer cannot be changed; therefore, if you make the wrong choice you will have to live with the consequences for the rest of your life
- This is probably the first, and only time, you will make this type of decision. Advice, from someone who has been involved with many such decisions, is therefore invaluable
- The decision whether to transfer is often emotionally driven. An adviser can help you look at your options more dispassionately
Deciding whether to transfer your Defined Benefit pension, or run with the status quo, is probably the biggest financial decision you will ever face. Get it right and your retirement will be financially secure. But get it wrong and you might be left worse off and facing an uncertain financial future.
We are here to help.
We’ll make sure that you fully understand the options open to you, while advising you on the right option.
If you are approaching retirement and have a Defined Benefit pension, please do not hesitate to get in touch with us on 02380 633636 or by clicking here to complete our online enquiry form.