What is a defined benefit (DB) pension?
In the UK (United Kingdom), Defined Benefit pensions, sometimes called Final Salary schemes, are a type of workplace pension that will pay a promised income in retirement. The income level paid to you is calculated based on your salary at the point of departure (hence the term ‘Final Salary’) and the total number of years of employment with the company or organisation in question.
Unlike Defined Contribution schemes, there is not an accumulated amount of money that is built up over time through continual contributions – simply an income promise that the employers’ scheme administrators then must ensure that they can fulfil.
It is the employer’s responsibility to make sure that sufficient funding is available within the scheme to pay and its other members the promised income when you reach retirement.
These days, Defined Benefit schemes are quite rare but were immensely popular among large employers up until the turn of the millennium. They are also commonly used across the public sector.
Defined benefit vs. defined contribution pensions
The value of a Defined Contribution pension when you reach retirement completely depends on how much you have paid in and how well your investments have performed, much like any type of personal investment account.
In contrast, a Defined Benefit pension promises an income in retirement rather than a pot of money and this is calculated based on several factors, the first of which is the length of time you worked for the company.
The company will use the salary that you were earning whilst working for the company (most commonly this will be your final salary, but some schemes will use an average of your salary over your entire period of employment) and factor that into the calculations. There is also something called the accrual rate, which is the proportion of your salary (be it average or final) that you will get as an annual retirement income.
Understanding Defined Benefit Schemes
A key point to understand with Defined Benefit schemes is that your employer is responsible for making sure that the scheme is sufficiently funded to fulfil the retirement income obligations that it is promising to you and its other members. If the company gets into financial difficulty and cannot fulfil that income promise then the Pension Protection Fund (PPF) in the UK can step in and cover your pension income, but the outcome here will normally be that you receive a lower amount than you were promised by your employer.
Whilst a Defined Benefit scheme does not hold a live cash value in the same way as a Defined Contribution scheme does, a member can request a ‘Cash Equivalent Transfer Value’ to be calculated by the scheme if they wish to exit the DB arrangement and convert the benefits into a Defined Contribution type scheme or personally managed pension.
DB VS DC WEBINAR
Transferring defined benefit pensions
Deciding to transfer out of a Defined Benefit pension is not something that should be done without professional advice and analysis. There is a lot to understand and required procedures to complete before committing to an authorised transfer of what may well be an incredibly significant sum of money.
One of the first steps that will need to be taken will be to make a request to the existing scheme to calculate the CETV (Cash Equivalent Transfer Value). This will effectively be a settlement offer from the scheme to convert your promised benefits into a cash value and make this available to you as an alternative to retaining the promised benefits of the DB scheme. Some companies will be keener than others to encourage members to transfer out of their scheme – and this will play a part in dictating how ‘generous’ the cash offer is and how the calculation is made. Companies that have concerns about the scale of their long-term income commitment to members may elect to try and encourage members to transfer out to reduce their liability.
When can you transfer out?
Defined Benefit pension transfers into Defined Contribution or personal pension plans can provide valuable financial planning opportunities in the right circumstances. Flexible access drawdown allows benefits to be taken earlier than most Defined Benefit schemes do, and many people will use this facility to withdraw their 25% tax-free lump sum (if they are at least 55 years old) and leave the remainder of their pension fund invested for use for income later.
For members who have settled outside of the UK as long-term expatriates, Defined Benefit pension transfers have additional factors which need to be considered and can make this a more logical action if there is a strong possibility that they will retire overseas.
It is essential to take advice from an authorised Pension Transfer Specialist (PTS) with respect to DB transfers and as a member, it is imperative to make sure you understand:
- The promised benefits that you will be giving up
- How the transfer will fit in with your overall retirement planning
- How your retirement income expectations will be achieved and how this projection compares to the income that the DB scheme was promising you – this is a key part of analysis that the PTS is required to work through with you.
Lifetime Allowance and DB pensions
The Lifetime Allowance (LTA) limit in the UK is a key factor to be considered too for members with larger CETVs calculated. Currently, the LTA limit is 1,073,100 GBP (Great Britain Pound) and this means that any pension (DB or DC (Defined Contribution)) that exceeds this amount in value will create a tax liability of between 25% and 55% on the amount over and above the LTA limit. Protection can be applied for up to 1,250,000 GBP but is not available to everyone.
For non-UK residents (expatriates) the LTA can be avoided for life if they transfer their benefits into an overseas scheme such as a QROPS (Qualifying Regulated Overseas Pension Scheme) – depending on where they are now residing there may be an overseas transfer charge applied, which will also need to be factored into the transfer analysis by your Pension Transfer Specialist.
Withdrawing money from your defined benefit pension
A Defined Benefit pension pays you an income in retirement and your pension income increases each year to consider the rising cost of living.
You can take the option of withdrawing 25% of your pension as a calculated tax-free lump sum when you reach 55. If you choose to do this the pension administrators will reduce the retirement income that you are being promised to reflect how much you have withdrawn from your pension as a lump sum.
When you die, typically a percentage of your pension can be paid to your surviving partner or dependents.
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