Defined Benefit
UNDERSTANDING A DEFINED BENEFIT (DB) PENSION
In the UK, Defined Benefit pensions, also known as Final Salary schemes, are workplace pensions that guarantee a specific income in retirement based on your final salary and years of service with a company. Unlike Defined Contribution schemes where a sum of money accumulates over time, Defined Benefit pensions focus on providing a promised income for retirement.
Employers are responsible for ensuring there’s enough funding in the scheme to meet these income promises for retiring employees.
Defined Benefit pensions were once popular among large employers and are still common in the public sector, although they have become less prevalent in recent years.
DEFINED BENEFIT VS DEFINED CONTRIBUTION PENSIONS
In retirement, a Defined Contribution pension’s value depends on contributions and investment performance, similar to personal investment accounts. In contrast, a Defined Benefit pension promises a specific income based on factors like length of employment and salary.
The company will calculate your pension based on the salary you earned during your employment. Typically, this is your final salary, although some schemes use an average of your salary over your entire employment period. Additionally, they will apply an accrual rate, which determines the proportion of your salary (either average or final) that you will receive as an annual retirement income. This calculation method ensures that your pension accurately reflects your earnings and years of service with the company.
UNDERSTANDING DEFINED BENEFIT SCHEMES
Employers must ensure the scheme is adequately funded to meet retirement income obligations. If the company faces financial difficulties, the Pension Protection Fund (PPF) in the UK may step in to cover pension income, albeit potentially at a reduced amount.
While Defined Benefit schemes don’t have a live cash value like Defined Contribution schemes, members can request a ‘Cash Equivalent Transfer Value’ (CETV) to convert benefits into a Defined Contribution or personally managed pension.
TRANSFERRING DEFINED BENEFIT PENSIONS
Deciding to transfer out of a Defined Benefit pension requires professional advice. Legal advice is mandatory for transfers exceeding £30,000. Requesting a Cash Equivalent Transfer Value (CETV) from the existing scheme is the first step. Companies may encourage transfers to reduce long-term liabilities, impacting the generosity of the transfer offer. Companies concerned 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?
Transferring Defined Benefit pensions can provide financial planning opportunities, especially for long-term expatriates. Flexible access drawdown allows earlier benefit withdrawals than most DB schemes, enabling people aged 55 or older to take a 25% tax-free lump sum while leaving the rest invested for future income. For long-term expatriates, DB pension transfers might be more appealing, especially if there’s a strong likelihood of retiring overseas.
Consulting an authorised Pension Transfer Specialist (PTS) is crucial for DB transfers. As a member, it’s essential to understand:
- The promised benefits you’ll be giving up and the associated risks
- How the transfer fits into your overall retirement planning
- How your retirement income expectations compare to the income promised by the DB scheme, a key analysis point for the PTS
Always seek professional advice to navigate these decisions effectively.
LIFETIME ALLOWANCE AND DB PENSIONS
The lifetime allowance for most people is £1,073,100 for the tax year 2023/24. Previously, exceeding this amount in pension savings incurred a lifetime allowance charge. However, from 6 April 2023, this charge has been reduced to 0%.
WITHDRAWING MONEY FROM YOUR DEFINED BENEFIT PENSION
A Defined Benefit pension provides a retirement income that increases annually to account for inflation.
At age 55, you can withdraw 25% of your pension as a tax-free lump sum. However, if you choose to withdraw a lump sum, your future retirement income will be reduced to reflect the amount withdrawn. Upon your death, a portion of your pension can be paid to your surviving partner or dependents. Understanding these aspects is crucial for effective retirement planning and decision-making regarding Defined Benefit pensions.
