While this may seem like another bland financial question, it may have real world consequences. Even if you think retirement is so far in the future that it does not affect you, it is a really important time to understand this topic.
When I speak to people about their pensions, they usually have one of three responses. Firstly, some people are all over their pensions and understand the implications. Secondly, many have blind faith that their organisation contributes to their pension; therefore, things will work out in the future. The final response I get is that pensions do not affect them yet, and it is a topic they will make time for in the future.
If you are in the last two groups, I hope this blog post can help shine some light on why this is an important topic and why you should look at it now rather than at some future point. Finally, if you are in the first group, I hope this post can add some value to your understanding of your current pension situation.
Types of Pension
Very broadly there are 2 types of pension - Defined Benefit (DB) and Defined Contribution (DC).
A DB pension is a pension provided by the employer that guarantees an income for the rest of a person's life (no matter how long they live), usually based on salary and length of service within an organisation. They were previously called final salary schemes and often led to the perception that your retirement will be looked after. DB pensions have largely been replaced by DC pensions in a corporate setting. However, DB pensions are still commonplace in public sector organisations.
DC Pensions are a pot of money that is usually invested over time. They can be contributed to by the employee or employer. At retirement, that pot of money can be used to provide an income. These pensions can also be built up by individuals separate from their employers. There are potentially significant tax benefits to doing this.
So what are the main differences?
Who contributes to the pension?
Traditionally, with a DB pension, the employer contributed to the pension. With a DC, the employee was the main contributor. However, the reality is more complex than that, with Additional Voluntary Contributions (AVCs) available in DB pensions. Different levels of contribution can also be made by employees/employers with DC Pensions.
Who makes the investment decisions?
With a DB Pension, it is the employer's responsibility to ensure that there is enough money to pay out to employees on retirement no matter how long they live. They do this by appointing a manager to invest on their behalf, and the employee has no control over this.
With a DC Pension, the employer will often outsource the scheme associated with their organisation's pension. This can lead to employees having multiple pension schemes across multiple organisations. These can be left in one scheme or consolidated. Ultimately the decision around this is left with the employee.
How much is guaranteed in retirement?
With a DB Pension, the employers guarantee a set amount in retirement based on salary and length of service. So even if you live to 110 years old, this will be paid. It is therefore considered a much more secure option.
With a DC Pension, the money can literally run out. There are different ways to take this out tax-efficiently (more in later posts), but this needs to be planned. In the past many bought annuities with their pension pots which provided a fixed income for life. Usually good value if you lived another 40 years but less good value if you lived for 5 years on retirement. Recently the rates on annuities have been very low, making this a much less favourable option.
When can a pension be drawn?
A DC Pension can be drawn at 55 (increasing to 57 depending on your date of birth). At this point, you can draw 25% of the lump sum tax-free (until age 75) and the rest as needed for income.
With a DB pension, this can be drawn when the scheme's retirement date dictates. If drawn before then, this usually incurs what is known as an actuarial reduction. An example would be the NHS pension drawn at State Pension Age(SPA) which is currently 66 but rising over the next few years. If an NHS Pension is drawn at age 57, this can significantly reduce the pension's amount.
What are the costs of the administration of a pension?
The costs of administering a DB pension are higher and are the employer's concern. The fees charged vary greatly by different providers but are lower overall than a DB pension with a DC pension.
Who carries the risk of the pension?
The employer carries the risk with the DB Pension, providing the organisation remains viable. However, there have been several high profile cases recently of mismanagement of corporate pensions.
Whilst the outsourced DC pension is a concern of the organisation, the employee carries the risk of their pension pot. This is particularly true once this has been consolidated outside a company scheme.
Can the pension be moved?
A DC pension can easily be moved between organisation pension schemes or consolidated into one pot to allow employees to see what their DC scheme is doing.
A DB pension is normally not movable and provided by the organisation until death. This is particularly true in the public sector. With the new pension freedoms introduced in 2015, there was the possibility for corporate DB Pension to be converted to DC Pension. There were obvious significant pros and cons of doing this. There was a mandatory requirement that individuals seek financial advice before doing this.
Can the pension be handed on to my family on death?
DB and DC Pensions are treated very differently when you die.
With a DB pension, a proportion (normally 50%) is given to your spouse until their death. After that, nothing is handed to your children.
On death, the full amount of a DC pension is given to your spouse, which can be passed down to your children on your spouse's death. Crucially, and a little known fact, this sits outside your estate for inheritance tax purposes. This means a significant amount of wealth can be handed down as part of your inheritance planning.
So what should I do about this?
Actionable steps:
- Look up and understand what pension schemes you have - if you are unsure Pensionbee is a good place to start searching for old pension schemes.
- Ask yourself are they DC or DB?
- How much will you get in retirement, and when can you claim it?
- No matter what type of scheme/s you have the most important point is to start early and understand how you can maximise your pension in retirement
- If this has been helpful and you would like more topics like this please subscribe to the blog (home page)
