Most people now save for retirement with a defined contribution pension, however, if you work in the public sector or a larger company, you might be a member of a defined benefit or final salary pension.
Often dubbed gold-plated, defined benefit pensions pay a known income when you retire and cannot be rivalled in terms of the guarantees they offer. However, they’re not as flexible as defined contribution plans, especially when it comes to managing your retirement income and passing on your wealth when you die.
Here Telegraph Money gives you the low down on everything you need to know about saving for retirement with a defined benefit pension.
Defined benefit (DB) pensions refer to schemes that pay a guaranteed income in retirement – in contrast to defined contribution (DC) pensions, where the amount you get when you retire depends on how much you paid in and how well your investments performed.
The amount you get will depend on your earnings, the accrual rate of the scheme and the length of time you were a member of it. Both you and your employer will pay into your pension, but all the risk is borne by the scheme.
However, if your employer goes bust, staff pensions will be safeguarded by the Pension Protection Fund. This protects 100pc of your retirement income if you have already retired, or 90pc if you are yet to retire.
With a final salary pension, your retirement income will be based on your salary towards the end of your career, while less generous (and cheaper) career average schemes calculate a figure that represents your average earnings throughout your career.
To calculate your income in retirement, your scheme will take your earnings figure and multiply that by the number of years you were in the scheme divided by its accrual rate. This is typically a 60th or an 80th of pensionable earnings (with the former being the more generous).
Let’s take somebody with an earnings figure of £50,000, whether that’s their final salary or their career average – after 40 years and an accrual rate of 1/60th they would retire with an income of £33,333 a year (40/60 x £50,000).
When you reach your scheme’s retirement age – typically this is the state pension age, but it may be lower with some schemes – you can take a tax-free lump sum and your retirement income becomes payable. Your income will be taxable but you won’t have to pay National Insurance any longer.
The amount you get will normally increase each year to help you cope with rising costs – but how much will depend on the specific rules of your scheme.
When you die, there won’t be a pot of cash to pass on to loved ones. However, if you are married, in a civil partnership or have other financial dependents (which can include children or unmarried partners), a portion of your pension will normally be paid to them. Schemes vary so always check the terms of yours.
The guarantees offered by DB pensions can’t be rivalled by any other pension type but they aren’t terribly flexible and they can make it hard for some people to pass on their pension wealth.
If you want to take more control over your retirement income and have the ability to pass your pension wealth on, you might be able to cash in your DB pension and transfer a lump sum into a DC pension.
However, this isn’t a decision to be taken lightly as it means you will be swapping the right to a guaranteed income for a pot of money that you will be responsible for managing, which can rise and fall in accordance with what it’s invested in.
It’s for this reason that you will be required to seek independent financial first, if your DB pension has a transfer value of £30,000 or more.
For the majority of DB members, a transfer wouldn’t be recommended. However, there are some cases where it could make sense. These could include people in ill health, who don’t have any financial dependents.
For example, if someone had below-average life expectancy they might not fully realise the value of their DB pension. However, by transferring it into a defined contribution pension they could live off the money during the remainder of their life and then leave any remaining funds to the beneficiaries of their choice when they die.
This might be adult children, other family members, friends or charities which would not get anything if they had remained in a DB scheme.
Not all DB pensions can be transferred, however. Some public sector pensions cannot be transferred, including the NHS, teacher and civil service schemes.
If you want to consider transferring a DB pension, you first need to get a cash equivalent transfer value from your scheme.
Your scheme should provide you with a statement of entitlement, which includes that all-important transfer value and details of the benefits you have built up.
If you would like to proceed – and the transfer value is over £30,000 – you will then need to get independent financial advice and consider where you would like to transfer your money to.
Both the trustees of your DB pension scheme and your new DC pension provider will need to see evidence that you have taken advice and that a transfer has been recommended.
It’s also important to be aware that pension transfers are a rich target for scammers. You should never consider transferring out of pension in response to a company that contacted you out of the blue.
You can check whether the company you are dealing with is regulated with the FCA using the Financial Services Register.
You cannot take ad hoc lump sums out of your DB pension, but you can normally take a tax-free lump sum when you first start receiving pension payments, worth up to 25pc of the value of your pension.
However, as the value of a DB pension cannot be accurately calculated, a different method of calculation is needed, to give you an amount that is broadly equivalent to 25pc.
The value of your pension is calculated by multiplying your yearly pension income by 20 and you can take up to 25pc of that as a tax-free lump sum.
Taking this money out of your pension will, in most cases, reduce your retirement income and your scheme will use something called a commutation factor to calculate this. For example, if your pension had a commutation factor of 10 to one, you would lose £1 of retirement income for every £10 you took as tax-free cash.
However, some schemes will let you build up a separate pot of tax-free cash alongside your pension, so taking your tax-free cash doesn’t mean you need to take a hit on your retirement income.
Although DC schemes let you access your money at any time from age 55, DB schemes work differently.
Instead, DB schemes will have a normal pension age at which point retirement income will become payable. This will vary between schemes, but you can expect it to be somewhere between 60 and the state pension age of 66. Some schemes may let you retire at 55, but you would get a reduced income.
If you are ill and need to retire on health grounds, you may be able to start taking your pension benefits early and get the same amount you would have received had you worked until your normal retirement age.
In cases of very serious ill health, where you have less than a year to live, you might be eligible to take the full value of your DB pension as a lump sum.
However, schemes do vary, so it’s important to check the terms to ensure you know what you’re entitled to.
There are a number of important differences between DB and DC pensions. If you are saving for retirement with a DB pension, you will have a guaranteed income in retirement and the amount you get depends on the accrual rate of the scheme, your earnings and the length of time you were a member.
This is very different to a defined contribution pension, where the amount you get is dependent on the amount you pay in and the performance of your investments.
With a DB pension, you also don’t need to worry about managing your pension or what you will do with your pot when you retire.
However, members of DB pensions do not get the same degree of control over their retirement income and cannot change it according to their needs. It’s also harder to pass on pension wealth with a DB pension.
While reduced payments may be paid to any financial dependents that you have once you have died, you cannot pass on unspent funds to the loved ones of your choice as you can with a defined contribution scheme.
This can be frustrating if you are in poor health and want to pass wealth on to loved ones that do not qualify as financial dependents, such as adult children.
2024-09-28T15:02:16Z dg43tfdfdgfd