Defined benefits pension

In this type of pension scheme your retirement income is based on how much you have earned and how long you worked for your employer. It can form a valuable underpin to your retirement plans.

Overview

If you are a member of a Defined Benefits pension scheme you will normally have two broad options available to you at retirement:

  • You can apply to take your pension benefits from your scheme, which will normally be a fixed income for life plus an optional tax-free lump sum
  • Alternatively, you might be able to “transfer out” of your scheme and into a private pension. Not all schemes have this option, including most government pension schemes

In most cases, you will be better off if you remain in your Defined Benefits pension scheme and take your pension benefits from the scheme. However, in some circumstances there are potential benefits associated with transferring out of a Defined Benefits pension scheme and into a private pension.

It is important to note that these potential benefits are not right for most people and they must be weighed up against the various disadvantages associated with transferring out.

This is a very complex topic and the decision you make is irreversible. Therefore the government has made it mandatory to seek regulated financial advice if your “Cash Equivalent Transfer Value” (CETV) is greater than £30,000.

We can review your circumstances and recommend whether you should remain in your scheme or if you should transfer out. We do this by considering  your retirement requirements, comparing this against your other sources of retirement income/savings and by analysing your Defined Benefits pension scheme.

 

 

Defined Benefits and Defined Contribution pensions

What is a Defined Benefits (DB) Pension scheme?

With a Defined Benefits scheme you are paid a secure income for life which increases each year. The amount you are paid is based on how many years you have worked for your employer and the salary you have earned. It includes “Final salary” schemes and “Career Average Revalued Earnings” schemes.

These schemes usually continue to pay a pension to your spouse, civil partner or dependants when you die, often based on a fixed percentage (for example 50%) of your pension income at the date of your death.

You can normally give up (or “commute”) part of your pension in exchange for a tax-free lump sum, plus your scheme might give you a tax-free lump sum without you having to give up any of your pension income.

How your income is worked out

Your pension income is normally based the following factors:

  • Your “Pensionable service” (the number of years you’ve been a member of the scheme)
  • Your “Pensionable earnings” (this could be your salary at retirement (“final salary”), salary averaged over a career (“career average”) or another formula
  • The scheme’s “Accrual rate” (the proportion of your earnings you’ll get as a pension for each year in the scheme (commonly 1/60th or 1/80th))

For example, if:

  • Your final salary DB scheme has an accrual rate of 1/60th
  • You were in this scheme for 10 years
  • You retire at 65 on a salary of £24,000 a year
  • This would give you a pension of:
    • 10 (years) multiplied by £24,000 (salary)
    • Divided by 60 (accrual rate) = £4,000 a year

Most defined benefit schemes have a normal retirement age of 65 but some schemes have a normal retirement age earlier or later than this. Depending on your scheme, you might be able to take your pension from the age of 55, but this can reduce the amount you get.

If you leave your scheme your pension will become “preserved” and you will become a “deferred member”. A preserved pension will normally increase each year until you retire (this might be at a fixed rate or in line with inflation). The government sets out certain minimum rates at which a preserved pension should increase but some schemes are more generous and offer bigger increases. Depending on how long you worked for your employer, different parts of your pension might increase at different rates and some of your pension might not increase at all

The Pension Protection Fund (PPF)

Staying in a defined benefit pension scheme is not risk-free. If your employer is still in business, it usually has to make sure the scheme has enough funds to provide the full entitlement to members, but some employers sponsoring these schemes have gone bust, not leaving enough money to pay the pensions promised. If an employer is going out of business without enough funds in its pension scheme, the Pension Protection Fund might be able to provide compensation. This might not be the full amount of the pension you’ve accumulated and the level of protection depends on whether you are below the scheme’s normal retirement age and whether your pension exceeds the PPF’s compensation limit.

 

 

Transferring out of a defined benefit pension scheme

If you’re a deferred member of a private sector defined benefit pension scheme or a funded public sector scheme (such as the local government pension scheme), you can transfer to a defined contribution pension as long as you’re not already taking your pension.

If you transfer from a DB pension scheme you’re giving up valuable benefits and might find yourself worse off, even if your employer offers you incentives to switch. This is because your future pension income can’t be predicted with any certainty if you transfer to a defined contribution scheme, regardless of whether it’s run by your employer or it’s a personal or stakeholder pension.

If you decide to transfer out of your workplace defined benefit pension scheme, the trustees who run the scheme convert the benefits you’ve built up into a cash sum. This is called a “transfer value” (also known as a “cash-equivalent transfer value” or “CETV”)

What is a Defined Contribution (DC) Pension scheme?

With a defined contribution pension you build up a pot of money that you can then use to provide an income in retirement. Unlike defined benefit schemes, which promise a specific income, the income you might get from a defined contribution scheme depends on factors including the amount you pay in, the fund’s investment performance and the choices you make at retirement.

The fund is usually invested in stocks and shares, along with other investments, with the aim of growing it over the years before you retire. You can usually choose from a range of funds to invest in. Remember though that the value of investments can go up or down.

You can access and use your pension pot in any way you wish from age 55 (although this age might increase in the future).

There are two main ways in which you can use your private (DC) pension to fund your retirement: you can buy an annuity or use drawdown. There are also less common methods, including encashing the full value of your pension as a single lump sum (which is called taking an “Uncrystallised Fund Pension Lump Sum”) or buying a product which shares some its features with an annuity and other features with drawdown.

Please visit the following page to read more about each annuities, drawdown and other options: Private pensions and your options at retirement

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