We discussed in the last blog what the two main types of pension are (DB vs DC). The more traditional pension plan, i.e. Defined Benefit Schemes, has become increasingly rare. If you have a defined benefits pension, you are likely working in the public sector or have a legacy scheme in the private sector. If you have a Defined Benefit pension, I want to go into a little more detail about how Defined Benefit plans work.
A defined benefit plan provides retirement income usually based on three factors:
- Length of service
- Salary of Employee
- The accrual rate of the Pension Scheme
The best way to look at this is with an example of the fictitious pension plan. In this example, if an employee worked for a company for 25 years, finished on a final salary of £50K and the accrual rate was 1/50. The calculation for their retirement benefits would be as follows:
Length of service x Accrual x Final Salary = Retirement income
25 x 1/50 x 50000 = £25000
Typically there is also a tax-free lump sum provided as a multiple of the final salary, e.g. three times, so in this case, that would be £75k
The payout is payable at the scheme's set retirement date. However, employees can usually opt to commute their pension (at a set rate) by claiming a greater tax-free lump sum in exchange for less income. This approach can be useful if you plan to continue to work after a pension is drawn.
The pension will then payout for the employee's lifetime before reducing to a fixed amount (typically 50%) for the remainder of a surviving spouse. On the death of the spouse, the benefits stop.
What are the Advantages/Disadvantages of Defined Benefit Pensions?
The risk of the pension sits with the employer
The fund is the employer's responsibility with defined-benefit pensions, although usually outsourced to a private provider. As such, the risk of the pension sits with the employer. However, that is not to say there is no risk to the employee (see below).
Ease of planning for retirement
You know the three variables above, i.e. length of service, wage, and accrual rate, so you can relatively easily determine the amount of income you will receive in retirement. This pension will then payout for the rest of your life regardless of how long you live.
The pension will payout for the remainder of your life, and then a fixed amount will go to your spouse (typically 50% - but it can be different depending on rules) until their death. These are known as survivor benefits and can help plan for retirement if the worst happens. After the surviving spouse's death, no pension benefits are passed from the retirement plan's assets to any beneficiaries.
Cost of living adjustment
Each year in early April, the government decides the Cost of Living Adjustment for the state pension. This adjustment is often made using a measure of inflation (CPI or RPI). Most DB pension schemes (both private and public) are adjusted to take account of inflation. I will do another blog post on different measuring inflation, but it is worth knowing if you have a Defined benefit plan and how this is calculated.
Flexible retirement dates
Defined benefit plans usually have a retirement date. At this date, you can claim the full benefits of a pension. However, this date can be brought forward to the normal minimum pension age (NMPA), which is current 55 but increasing to 57 in 2028. If the pension is drawn early, the scheme will apply what is known as an actuarial reduction to account for the fact the pension is being drawn for longer. This early withdrawal can dramatically affect the income received, often with a 40-50% reduction.
One of the most important advantages of defined benefit plans are the fixed sum you receive and will continue to receive irrespective of how long you live. Unlike the Defined Contribution plans, where you can run out of money, the defined benefits option is considered far more secure.
Death in Service Benefits
Suppose you die before receiving your pension. What happens to your surviving beneficiaries. There is often built-in death in service benefits with a defined benefit pension scheme. These often equate to multiple annual incomes and a percentage of the pension to the surviving spouse. Different schemes have different rules, and it is worth checking if you have a defined benefit pension and the scheme's rules in terms of death in service benefits.
Risks to employees remain
If a scheme goes bust or the organisation fails to exist, there is a risk to the employee. For example, this failure was seen in the BHS Pensions scandal. This type of problem can significantly distress employees and their retirement plans.
Some are not inflation-linked
Although most schemes are inflation-linked (RPI or CPI), some are not; unless you are imminently about to retire, this could make a big difference to your income in retirement. For example, at the time of writing, with inflation around 7-8%, your defined benefit plan will be significantly less unless it is linked to inflation. This problem is particularly true if you have left the organisation and the pension is 'frozen' until the pension can be claimed.
You may need to work longer than you would like
Due to the fact these schemes are becoming more expensive for employers, they are trying to find ways to reduce costs. For example, instead of a final salary scheme, they are moving to look at average career earnings. In some cases, they are changing accrual rates and changing the scheme's retirement age.
A good example here is the NHS pension which in its 1995 edition had a retirement age of 60 and was a final salary scheme. The 2015 pension was calculated on average career earnings and aligned retirement benefits with the state pension age (SPA) of 68. To get the same benefits as the old scheme requires an employee to work for longer.
No pot to hand over to a family member
In defined benefit pensions (unlike defined contribution pensions), there is no pension pot to hand over to a spouse or other beneficiaries.
Why are there fewer DB Schemes?
There have several driving factors reducing the number of defined benefits schemes.
Firstly, they are expensive for the employer and could be unpredictable. Therefore, they would prefer to transfer that risk to the employee and give them responsibility for their pensions.
Secondly, pension freedoms in the UK were introduced in 2015, allowing flexible drawdown on pensions from the age of 55 and allowing the ability of individuals to transfer their defined benefit pensions to defined contribution plans. Although this may be the right thing to do, there was a lot of controversy around this, and some organisations were acting irresponsibly in this area. If you are considering this, you need to speak to a reputable FCA approved Financial adviser and someone accredited/qualified in pension transfers.
Finally, although we are not discussing defined contribution schemes here, the defined benefit pension stopped on the death of the recipient or surviving spouse. The remaining pension pot can be handed down to your beneficiaries outside of your estate for a defined contribution plan for inheritance tax purposes. This approach can be a good tool for building intergenerational wealth and encouraged some to transfer out of the defined benefit schemes. We will cover this in more detail in future blogs, but this did play a factor with the new pension freedoms in encouraging employees to switch out of their defined benefit schemes.
1. Look at what pension you currently have? Is it a defined benefit or defined contribution?
2. If you have a defined benefit scheme, look at the three factors that tell you the benefit - the length of service, accrual rate and whether it is final salary or Career average and try and work out what your pension will be.
3. Look at your death in service benefits - is this enough if the worst were to happen?
4. I love sharing other resources which I find useful. These guys (not sponsored or affiliated) do really good summaries on basic financial topics. You should take a look and subscribe:
5. If you like the blog, subscribe for regular updates like this at www.diarmaidmcmenamin.com
Disclaimer - This information does not represent financial advice in any form and is purely for educational purposes only. For personal advice on your specific needs, you need to seek the advice of an FCA approved financial adviser.