A defined benefit (DB) pension scheme, or Final Salary Scheme is the the amount of pension you’re paid. Normally from a large employer or public sector organisation such as local Council, NHS, Police, Teachers Pension to name a few.
It is based on 3 things normally:
- your length of service such as how many years you’ve been a member of that employer’s scheme.
- The rate of salary that you’ve earned during that time of when you leave that employer or retire.
- Along with the accrual rate (1/60ths) as an example, which is set by the scheme actuary.
In the past you would normally have contributed 40 years service to get the maximum amount of benefits payable to you that specific scheme. As per the rules in place set by the board or trustees responsible for running the admin of each scheme.
So what exactly is a defined benefits pension scheme ?
As stated above it will pay a defined or guaranteed income based on the above criteria. It will usually have a set date when it comes into payment. many older schemes may be set at 60 or 65, what they call normal retirement date (NRD). But most current schemes are now bringing the date of payment in line with current state pension age of 66 or 67 dependent on when you were born.
They will pay an individual a guaranteed income for life, which usually increases each year in line with inflation. Bases on the scheme rule and they will increase according to CPI or RPI.
Your employer and you would have both contributed to the scheme to fund the income payable in retirement. It is the up to the Trustee board to look after the investments held for all employee’s to ensure that it can pay out the respective member’s benefits they are entitled to. and is responsible for ensuring there’s enough money at the time you retire to pay your pension income.
How is the scheme managed ?
To ensure that the company can fulfil its requirements to continue paying members benefits due. The scheme actuary and the board of trustees are required to complete a triennial valuation every 3 years to ensure the assets they hold can meet its liabilities.
A scheme may be in surplus, so the benefits can be met from current funding and assets in place. Or it could be in deficit, whereby they will have to make additional or ongoing contributions to meet any shortfall. It could take an employer many years to fund ignorer to meet a shortfall in place, which could have an adverse effect on that company.
As a result, the onus on Defined benefit schemes are at risk to the sponsoring employer to fulfil its duties to pay out pension payments. Where with a defined contribution, the funds in the pot will go up and down on a daily basis. They aren’t guaranteed and the risk is on the policy holder to what they do with it, when accessing from the age of 55 onwards to fund future years.
As the risk is on the employer and not the employee, they were considered gold-plated and couldn’t be bettered. Another benefit of bonus is that they usually continue to pay a pension to your spouse, civil partner or dependants when you die. With the payment normally being 50% of the original members benefits due.
What is a CARE pension scheme ?
Most public sector authorities have transiting in recent to what is known as Career Average schemes (CARE). They still provide excelled benefits to the employee but on different terms.
- Whereby the pension is now based on the average of your pensionable earnings throughout your membership in the scheme, revalued in line with inflation.
- The value of pension earned in each year is calculated using a fraction – such as 1/60th or 1/80th – of your pensionable pay. This is known as the accrual rate.
- Your final pension is calculated by adding together all the revalued pension earned in each year of membership.
The pension scheme’s rules will define what is meant by your ‘salary’ or ‘earnings’. This will then determine how the calculation of ‘final salary’ or ‘final earnings’ is then paid out.
But be aware, as some schemes don’t count extra earnings in their calculations, such as:
- overtime
- rates of commission
- annual bonuses
- any so-called the benefits in kind – these are other benefits that aren’t paid as cash to the member, for example a company car or private medical insurance.
The scheme might also only count a proportion of your wages or salary. The amount of earnings used to calculate retirement benefits is often called ‘pensionable earnings’.
Do I get a tax-free cash lump sum with my defined benefit scheme ?
As well as providing you with a pension income when you retire. The vast majority of final salary and career average schemes also provide a tax-free cash lump sum.
For example, some schemes with an accrual rate for a pension of 1/80th of final pensionable earnings for each year of scheme membership might also provide a tax-free cash sum of 3/80ths of final pensionable or career average revalued earnings for each year of scheme membership.
If you do take a tax-free lump sum, be aware that your over pension provision will be reduced. So the amount of monthly income you receive afterwards will be reduced.
So consider, firstly what will you do with your tax-free lump. Where may you hold or invest that money, as it may be a considerable sum. Especially if you have worked for same employer for many years, or you were earning a decent level of salary. So thereby creating a high level of pension provision within that specific scheme. Secondly, if you income is then reduced can that level of income fund your future years.
Remember, any income you receive after the tax-free lump sum, is classed as taxable income and will be automatically taxed at source by your pension provider and they will notify HMRC. It would be added to any other income you receive during that tax year, or your state pension. So consider what tax bracket you belong to in future, so you don’t get an unpleasant surprise. Greater information about personal tax can be found at https://www.gov.uk/browse/tax/income-tax
When you access you pension at time of retirement, most providers will give you 2 options:
- Annual income with no tax-free cash (known as PCLS)
- Reduced income with tax-free (PCLS) paid upfront. The amount of reduction is known as the cash commutation factor. Which is set by the scheme actuary.
How can I check my pension benefits due to me ?
Your pension scheme administrator, responsible for running that scheme, should provide you with an annual statement. It could be on paper or via an online portal.
The latest pension benefits statement should expand and illustrate how much your pension income might be. It should highlight what entitlement you have built up to the current days dn a forecast of what you should receive at normal retirement date.
If you haven’t got one, you should contact your pension administrator to send you recent one.
Statements usually show your pension, based on:
- your current salary
- how long you’ve been in the scheme, i.e your length of employable service.
- illustration of what your pension might be if you stay a member until normal retirement age.
On the statement, it should also include the amount of tax-free cash you are entitled to. If you are unsure of what the figures, then speak to your administrator, or look on their website as they may have some simple videos highlighting how that scheme works and the kind of benefits on offer.
Can I access my pension before the normal retirement age ?
Yes, you can but the scheme actuary may apply what is called an early reduction factor. As the pension will be paid for longer time period, they will apply a reduction to facilitate this scenario. It may be a % amount for each year that you access earlier than expected. So get some exact figures ahead of making that decision to access. The reduction could be around 5% for each year that you access early, so it could be greatly reduced if you do access at a young age.
If you suffer from ill-health and deemed to be unfit to do an existing job or an alternative job offered to you. You could make an application to receive the pension early on ill-health grounds. The amount of pension payable isn’t normally reduced, but it is determined by medical evidence requested from your doctor or independent doctor. Which is the subject to the agreement and discretion of the trustee board to honour.
If you do meet the criteria for ill-health payment you can access your pension benefits before the age of 55 (or age 57 from April 2028).
What happens if I have If left that defined benefit scheme ?
If you were a member of an employer’s defined benefit scheme but have now left, your benefits will usually remain in the scheme. You will then be classed as a deferred member
When you left, the scheme administrator should have provided you with a pension statement. This shows the amount of pension benefits that you have built up in the scheme.
Although you will and your employer will stop contributing to that scheme, so no further accrual is awarded. The amount due to you in later years are usually increased each year in line with inflation.
Can I cash my complete pot as a one-off lump sum ?
You might be able to take your whole pension as a cash lump sum. In doing so, up to 25% of it will be tax-free, and you’ll have to pay Income Tax on the remainder of the pot.
But under some special conditions:
- the total value of all your total pension savings, is less than £30,000
- the pot value is less than £10,000, regardless of how much your other pension savings are.
If is pot is below £ 10,000 it can be classed as a small pots pension. You can do this three times for personal pensions and possibly more times for some workplace pensions.
Can I transfer my defined benefit pension elsewhere ?
As long as you are in a private sector defined benefit pension scheme or a funded public sector scheme. Then you can transfer to a defined contribution pension as long as you’re not already accessed or taking your pension.
But if you transfer from a defined benefit pension scheme, be aware that you will be giving up valuable benefits and might find yourself worse off. That’s why their called gold-plated.
At present the risk of paying the DB pension, is on the sponsoring employer. If you transfer elsewhere the risk goes onto the individual. You then have to decide what you do with those funds in a new format. Do you buy some kind of annuity, access via Flexible Access Drawdown (FAD) or a series of lump sums (UFPLS). Are you then happy making those decisions in future ?
The value of your final salary scheme or career average pension scheme when you transfer is vital. Especially with regard to planing your retirement in later years. These schemes give you guaranteed income in retirement, so if you transfer them, the value you’re offered needs to be appropriate.
If you do decide to transfer out, you will be given what is called a Cash Equivilant Transfer Value (CETV) normally around 20x the amount of amount pension payable. It normally lasts for 90 days, if it runs out you can request another figure. But the administrator may charge you a fee if request a new one within a short timeframe and the new CETV could be higher or lower.
Be aware, it the CETV is worth over £ 30,000 the the Scheme trustees will insist by law that you have to appoint a regulated financial adviser to complete that transfer. This will cost you money to complete, they may not recommend your decision or grant your request. Moving forwards they will then be in control of your funds in a new format at investment risk and they will charge you annual fees to mange the funds in a new investment product.
If you do need to find an IFA, use this simply link via MoneyHelper.org.uk, a free and impartial service offered by the Money & pensions service. https://www.moneyhelper.org.uk/en/pensions-and-retirement/taking-your-pension/find-a-retirement-adviser
It’s a good idea to get advice from a regulated financial adviser who specialises in this type of transfer before you decide. Compare 2 to 3 advisers to check what they products, fees and charges etc, do you get a feel or rapport with them. What services do they provider and what network to products can they promote.
Are defined benefits pension schemes protected in any way ?
The good news is that all defined benefit schemes are protected by the Pension Protection Fund.
This might pay some compensation to scheme members if employers become insolvent and the scheme doesn’t have enough funds to pay their benefits.
But be aware that the compensation might not be the full amount, and the level of protection depends on your age and other factors.
Remember:
If you found this blog post information useful. Please feel free to check out my other posts on https:moneyminted.co.uk which covers pensions, savings, investing, recommended investing books. So you too can improve your financial or investment knowledge and ultimately reach your investing and financial goals.
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