What is a defined benefit pension?
A defined benefit pension plan, often known as a final salary scheme, is a type of pension plan in which an employer/sponsor promises a specified pension payment, lump-sum (or combination thereof) on retirement. It is ‘defined’ in the sense that the benefit formula is defined and known in advance. The benefit is calculated based on a predetermined formula that considers the employee’s earnings history, years of service and age, rather than depending directly on individual investment returns. Traditionally, many government and public entities, as well as a large number of corporations, provided defined benefit plans.
The most common type of formula used is based on the employee’s terminal earnings (final salary). Under this formula, benefits are based on how much you are paid when you finally retire. Another formula is called ‘career average’. This takes a percentage of average earnings during a specified number of years at the end of a worker’s career.
In the private sector, defined benefit plans are often funded exclusively by employer contributions.
Over time, these plans may face deficits or surpluses between the money currently in their plans and the total amount of their pension obligations. Contributions may be made by the employee, the employer or both. In many defined benefit plans the employer bears the investment risk.
How do they typically work?
Typically, a DB scheme will state an age at which members can begin drawing from their pension. This is most commonly from the age of 65 but schemes vary with some offering benefits from 60. Once members reach the pensionable age they will receive their promised yearly income until the end of their life. The scheme achieves this by maintaining a pension pot to fund the members’ benefits. The pension pot is invested by the pension fund manager with the aim of growing the pot sufficiently enough to maintain its ability to pay the benefits they have promised. Benefits to members are usually linked to inflation, meaning that the amount a member is receiving should increase annually as prices rise. For a lot of schemes this is capped at 2.5% per year and some schemes just rise at a set amount every year regardless of inflation.
It is possible to take a tax-free Pension Commencement Lump Sum (PCLS), up to 25% of your pensions capital value. This will however reduce the benefits you receive thereafter, and careful consideration should be taken along with professional advice before taking the PCLS. It must be paid after the member has reached normal minimum pension age and within a window starting six months before and ending one year after the member has become entitled to their benefits.
It may also be possible to access your DB pension early. Typically, however, this involves a very substantial reduction to your guaranteed pension and a host of extra risks. Taking a final salary pension at age 55 rather than 65 would normally result in your income being reduced to less than half the amount you’d get at age 65.
What happens if you die?
A DB scheme is not your asset, as such it is not possible to pass it on as part of your estate. Each scheme has their own rules, but typically a spouse would receive 50% of your yearly benefits for the remainder of their lives. The only provision for children to benefit from a DB scheme would be where both parents are deceased before the children are 18, if they are in full time education this is typically extended to 21.
Is a DB scheme secure?
Yes, in the sense that the member’s benefits are fixed, and the investment performance will not affect what they receive. However, in recent times a large number of schemes have ended up in deficit. They are promising more than they have the ability to pay, sometimes to a worrying extent. This is due in part to people living much longer than they used to when these types of pensions were created, and the schemes having to pay members for many more years than they originally anticipated. DB schemes are often described as offering ‘guaranteed’ incomes but they are really only guaranteed so long as the scheme has the ability to pay. As this problem became more prevalent it was evident that a solution was needed, so in 2004 the Pension Protection Fund (PPF) was established to take on the obligations of schemes that have become insolvent. If your scheme falls into the PPF you will most likely receive less than you would have before and there is a cap on the amount any member can receive.
Can you leave a DB scheme?
Absolutely, and more people are choosing to do this. There are many factors to consider and again, advice should always be sought before making such a decision. If you leave a DB scheme you are essentially requesting to take your portion of the pot (Cash Equivalent Transfer Value -CETV). This amount must be moved into another pension, for example a Self-Invested Personal Pension(SIPP) or a Recognised Overseas Pension(QROPS). Once transferred the pension then becomes your personal asset. When exiting the scheme you will be given a cash equivalent transfer value. The CETV is a value that is supposed to represent the value of the benefits given up.