Defined benefit pensions

What is a Defined Benefit pension scheme?

Defined Benefit (DB) pension schemes (often referred to as Final Salary Schemes) gives an employee a pension based on final salary, and length of service. It produces a guaranteed pension on retirement, in contrast to a Defined Contribution (DC) scheme which is simply a pot of money with no guaranteed income. The higher the salary, and the longer the period of service, the higher the pension will be.

Who is a defined benefit pension for?

DB schemes are traditionally very common in the public sector workplace and, to a lesser extent, in the private sector. They typically fall into two categories: those based on a final salary and, in more recent times, those based on a ‘career average’ salary. In the latter case, the term ‘final salary scheme ’ is a misnomer – employers have taken to using an average salary in order to reduce funding requirements.

Many years ago, DBs were seen as an attractive option for those wishing to stay with their employer for a long period of time. However, it is now rare for an employee to stay with the same employer for the whole of their working life. Businesses have also struggled to fund DB schemes because of the cost of committing themselves to providing a guaranteed pension many years in advance of the employee’s retirement age. As a result, many DB schemes are now switching to DC arrangements.

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Advantages of a defined benefit plan

It’s important to assess the advantages and disadvantages of the various pension plans available to you. One of the strengths of a DB scheme is something called ‘escalation’, whereby your pension income rises in line with inflation, albeit with a ceiling – often around 5% – thus protecting the purchasing power of your pension.

Other advantages of a DB plan include the possibility of receiving a full pension – if you have to retire earlier than anticipated due to ill health – and payments to dependants on death, both before and after retirement. The main attraction of a DB pension is that the amount of your pension is ‘predetermined’ regardless of how the scheme’s investments have performed on the Stock Market. In other words, your employer bears all the investment risk on your behalf.

Limitations of a defined benefit plan

While defined benefit pension schemes suit those who stay for many years with the same employer, it may not be the best choice if you change careers often. Companies may require minimum terms of service before you become eligible for the scheme. Employees can’t choose how their money is invested and the rules can be complex but this is generally a small price to pay for a significant pension – in many schemes the employee has to fund only one-third of the cost.

How to calculate your DB pension

Your circumstances and the scheme’s terms and conditions will influence the value of your DB pension. In most cases, you can take your pension at 55 (rising to 57 in 2028) but there would be a reduction for each year you retire early because you can expect to receive the pension for longer. A reduction in pension of 3-5% for each year you retire early is not uncommon and you should check early retirement reductions with your employer for your particular scheme.

To calculate your pension, take the number of years you have been a member of the defined benefit pension scheme, then divide it by the accrual rate (a percentage of pensionable pay – commonly 1/6oth per year of service), and multiply it by your final pensionable earnings.

For example:

• You’ve worked at your company for 40 years
• Your final year’s income before tax is £27,000
• The scheme’s accrual rate is 1/60^th
• Your annual pension income would be £27,000 x 40/60 = £18,000 pa..

Lump sum payments

There may be the option to take a tax-free lump sum in lieu of some of your pension; the amount is determined by the scheme’s actuary and your pension will be reduced in line with commutation factors set by the scheme.

Transfers

Most schemes offer the possibility of transferring the value of your benefits to another arrangement. You must first cease to be a member of the scheme either by leaving the company or by simply opting out of the scheme. The scheme will offer you a Cash Equivalent Transfer Value (CETV) which reflects the scheme’s view of the cash value of your accrued pension.

If you accept the transfer value, you can arrange to have this paid to any other registered pension scheme. By doing so, you will give up the security of regular guaranteed lifetime payments, in return for the flexibility of being able to manage and invest your money where you see fit. There will also be the option to take a tax-free lump sum but this would be a maximum of 25% of the fund value. Under recent legislation, you can withdraw the entire pension pot in one go but this would be very risky and may result in a large tax liability.

A DB pension transfer is an irreversible decision which can affect your retirement income significantly. If you have dependants, or need regular guaranteed income, it may not be the right choice for you. Individuals who usually benefit from transferring their pension are those who aren’t solely reliant on their workplace pension as retirement income and want top pass the value of their fund on to their family – this is not possible with a DB scheme where the only benefit on death is a spouse’s/dependant’s pension.

If you want your retirement income to be in a currency other than Sterling, a Qualifying Recognised Overseas Pension Scheme (QROPS), is worth considering if you have moved abroad for your retirement. The scheme must comply with UK tax law, and it is important to consider the loss of any perks associated with it.

Due to increased regulation, transferring from a DB scheme to another arrangement has become extremely complex. Our financial advisors can provide guidance on how to assess whether such a transfer is in your best interests based upon your personal circumstances.

Gilt yields and transfer values

Bonds held by the UK Government and across the Commonwealth are referred to as gilts. They generally tend to be low risk and, therefore low return but are strongly influenced by the political climate. DB transfer values are affected by gilt yields – rising yields tend to push transfer values down. Gilt yields tend to rise in tandem with rising interest rates, and we have, therefore, seen transfer values fall substantially over the last few years as interest rates started to move up again from 2021.

Defined benefit pension advice from Blacktower

When it comes to advice on defined benefit pensions, you know you are in safe hands with Blacktower, one of the leading wealth management experts in the UK and abroad. Whether you’re keen to provide for your family, or relocate to your dream destination, our highly qualified, multilingual team is here to help. Alternatively, we can also advise you on defined contribution schemes, SIPPs, QROPS, and QNUPS.