Defined Benefit pensions

We are Defined Benefit and Final Salary pension experts.

These types of pensions pay a guaranteed, index linked pension when you retire.

Historically, most people took an income directly from their Defined Benefit or Final Salary scheme when they finished work. However, the way we retire has changed over the past few years, particularly following the introduction of Pension Freedoms.

While providing an income that will sustain your chosen lifestyle until you die is still of paramount importance, more emphasis than ever before is now placed on flexibility and being able to leave a legacy to your loved ones.

For most people, remaining in their Defined Benefit scheme is the right thing to do.

Giving up that guaranteed, inflation-proofed income is a massive step and, for the majority, not something they should consider. However, for some people, transferring to an alternative arrangement is the most appropriate option.

Our job is to understand your current circumstances, aims and aspirations then make a recommendation.

However, to help you more fully understand your Defined Benefit or Final Salary pension we’ve created a guide, which you can read below or download as well as a short video.

Even though many Defined Benefit pensions are closing, millions of people still have them, which means it is important to understand how they work, and how they compare to the other available options.

This guide will help you to understand your Defined Benefit scheme and the options facing you when you begin to prepare for retirement. It covers everything from how the schemes work, to the advantages and disadvantages of transferring your pension to another scheme.

This guide is simply intended to give you an insight into your current pension scheme and the potential options which surround it. There is no substitute for independent financial advice, which you should seek before making any concrete decisions about your pension and retirement finances.

Finally, we should also point out that Defined Benefit pensions are also known as ‘Final Salary’, but for simplicity, we will continue to refer to them as ‘Defined Benefit’,

We hope you find this guide useful. If you have any questions, would like to understand your pension better, or you are approaching retirement and would like advice on your options, we are here to help.

Regards

Charles Mosley

Director, Independent Financial Adviser, Sustainable Wealth

Understanding your Defined Benefit pension will enable you to make informed, confident decisions about your retirement. The information given in this guide should be used in combination with the specific terms of the scheme you belong to as well as independent financial advice.

What it is?

Defined Benefit pensions are schemes which receive contributions from both you as an employee and your employer.

When you retire, the scheme will pay a guaranteed annual income, which rises in line with inflation, for the rest of your life.

It also provides a pension for your spouse and potentially other financial dependants.

Your income

The income paid by your Defined Benefit pension will depend on four main factors:

  • The number of years you have spent in the scheme
  • The accrual rate of your scheme (for example: 1/60 or 1/80)
  • Your pensionable earnings
  • Any Pension Commencement Lump Sum (PCLS) you choose to withdraw

Knowing that the income you receive during retirement is guaranteed, inflation-proofed for the rest of your life and will continue (possibly at a lower level) to your spouse, partner or financial dependants offers many people comfort and security.

However, ensuring that the funds are available to pay that income is your employer’s responsibility. So, what happens if your employer becomes insolvent and is no longer able to pay your pension?

The Pension Protection Fund (PPF) steps in.

Role of the PPF

If your employer is unable to maintain your pension payments due to becoming insolvent, your Defined Benefit scheme will be transferred to the PPF. They will then continue to pay a percentage of your expected income. However, how much they pay you will depend on your employment status at the time of transfer:

  • If you have already retired: Your income will continue at the same rate as before
  • If you are already retired, but you retired prior to your scheme’s normal retirement age: Your income will depend on how early you retired. For those working until the normal retirement age, this cap is 90%. However, the earlier you stopped working, the lower your entitlement will be
  • If you are still employed when the business fails: You will receive 90% of your expected income if you continue working until the normal retirement age. If you continue working past this age, your pension income will rise to reflect this

You already know that Defined Benefit schemes usually continue to pay an income to the beneficiaries you leave behind. It is understandable that many people are concerned about losing this benefit if their scheme is transferred to the PPF.

The good news is that your dependants and spouse will not be left with nothing when you die. But the exact amount will depend on the terms of your original pension.

Cash Equivalent Transfer Values (CETV)

Defined Benefit schemes don’t have a fund value in a similar way to Money Purchase (Personal Pensions, SIPPs and so on) schemes. Instead your income is calculated using the factors we’ve already mentioned.

Therefore, to understand the value of your Defined benefit scheme you need to request a Cash Equivalent Transfer Value (CETV) from the trustees of your pension.

Your CETV will be calculated by taking into account several factors, including:

  • Your length of time in the scheme
  • The accrual and annuity rates
  • Your pensionable earnings
  • The scheme’s current performance
  • Inflation estimates for the future

Most schemes will accept one CETV application per year, at no cost. However, you may be able to apply for additional calculations in return for a fee. You can do this independently, or ask your financial adviser to do it on your behalf.

As you approach retirement, you will naturally be considering how you can use and position your pension to suit your needs, both in the immediate future and in later life. Defined Benefit pensions offer four options:

  • Take an income from the scheme
  • Take a Pension Commencement Lump Sum (PCLS) and a lower income from the scheme
  • Transfer the value of your Defined Benefit scheme to an alternative arrangement, such as a Personal Pension or Flexi-Access Drawdown
  • Transfer part of your Defined Benefit scheme to a personal pension, leaving the rest to provide a guaranteed income

We explain what each of those options will mean in more detail below.

Take an income from the scheme

Remaining a member of your Defined Benefit scheme is usually the right thing to do. It means you will receive a guaranteed income each and every year after you retire. This income is protected against inflation and will continue to your spouse if you die before they do. It may also pay an income to other financial dependants.

Take a lump sum and lower income from the scheme

Every Defined Benefit pension will offer you the opportunity to take a PCLS, which was previously known as a tax-free lump sum. Your scheme will confirm the amount available.

Remember, taking the PCLS from your Defined Benefit scheme will lower the value of the scheme and will lead to a lower annual retirement income as a result.

Transferring to an alternative arrangement

If you are retiring, transferring your Defined Benefit pension into a Flexi-Access Drawdown arrangement is one of the options available to you. Doing so allows you to control the level, and the timing, of income you take. However, it will also mean that you are responsible for ensuring that the fund is able to support you for as long as you live.

It will also enable you to leave the remaining value of your pension when you die to your nominated beneficiaries.

You may also consider buying an Annuity as an alternative to Flexi-Access Drawdown.

To take either of these options you or your financial adviser needs to apply for a CETV. If the value is above £30,000, you will be required to seek independent financial advice before making any decisions.

Though, this is advisable anyway when making any financial decisions concerning your pension and retirement.

Partial transfer

A small number of schemes may offer you the option of transferring a proportion of your Defined Benefit scheme to an alternative arrangement.

This means that you can freely access and invest a portion of the scheme’s value, whilst maintaining a lower guaranteed income with the remainder.

The administrators of your Defined Benefit pension will confirm whether or not a partial transfer is an option they allow.

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There are many factors to consider when retiring and weighing up your options. The factors which impact you the most will depend on your personal financial goals and objectives.

Again, an Independent Financial Adviser will be able to tell you exactly how each option will affect you; for better or for worse.

Defined Benefit Flexi-Access Drawdown
Income
  • Guaranteed income every year
  • Responsibility of the sponsoring employer to ensure the scheme remains solvent
  • Protected by PPF
  • Inflation-proofed through indexation
  • You are in control of your income
  • Potential to spend too much, too soon and run out of money
  • Flexible income to meet your needs
Life expectancy
  • Provides an income each year in retirement, regardless of how long you live
  • Will continue to pay an income to your spouse and potentially to financial dependants
  • No guaranteed income
  • The remaining value of your pension can be left to nominated beneficiaries when you die
  • Income or lump sums taken by your beneficiaries may be subject to income tax
Inflation
  • Your income will rise each year to combat the effects of inflation
  • Not inflation-proof, so you will have to budget to allow for the rising cost of living over time
PCLS
  • The amount you can withdraw will vary depending on your scheme
  • You can take up to 25% of the fund’s value as a tax-free withdrawal
Death benefits The benefits vary from scheme to scheme. However, they will include a spouse’s pension and potentially an income for other financial dependants.

If you are still employed and an active member of the scheme a lump sum from a death in service scheme may also be payable.

  • You nominate your beneficiary or beneficiaries upon joining the scheme.
  • You can nominate any person, charity, business or group.
  • They can choose to receive the money via drawdown, annuity or lump sum
  • Depending on when you die, tax may, or may not, be payable by your nominated beneficiaries

Consulting an Independent Financial Adviser will enable you to understand the terms and benefits offered by your specific Defined Benefit scheme.

The decision to transfer your Defined Benefit pension is not one to be taken lightly. It can’t be reversed and you will be giving up a guaranteed and index-linked income.

It is now a prerequisite that you seek advice from an Independent Financial Adviser, if your Defined Benefit pension is worth more than £30,000. This is to ensure that you are fully informed and to help you avoid making a damaging mistake.

However, in summary the advantages and disadvantages of transferring your Defined Benefit pension can be summarised as follows.

Advantages

  • Flexible access to funds: A Defined Benefit pension will provide a set annual income with no flexibility. However, transferring the value into a Flexi-Access Drawdown arrangement allows you to access the money as and when you decide. This gives you full control over how much you take and when. Of course, this comes with potential problems; take too much, too soon, and you could be left struggling financially in later life
  • More options when you die: A Defined benefit pension will continue to pay an income to your spouse, and possible other financial dependants, should you die before they do. However, a Flexi-Access Drawdown arrangement offers your beneficiaries more options, including taking a lump sum or an income; both of which may be subject to income tax
  • Potential for a larger PCLS: The PCLS available from an alternative arrangement may be higher than from your Defined Benefit pension. However, you should also remember that the more you take in PCLS the lower the annual income
  • The possibility of early retirement: Transferring away from your Defined Benefit pension can open up the possibility of early retirement. This option needs to be considered very carefully as the earlier you retire the greater the chance of running out of capital in years to come

Disadvantages

  • Loss of guarantees: Where a Defined Benefit pension is guaranteed for the rest of your life, it is up to you to ensure that a Flexi-Access Drawdown arrangement can support you, your spouse and financial dependants until you die. Taking too much, too early, could see you struggling in later life; especially if you live longer than you expected
  • No inflation protection: Defined Benefit pensions are protected from inflation through indexation. Transferring away means this valuable benefit is lost
  • Investment risk: The income from your Defined Benefit pension is guaranteed. Even if the sponsoring employer fails, the PPF is there as a fail-safe. However, transferring to an alternative arrangement, such as Flexi-Access Drawdown or a Personal Pension Plan means your pension fund is exposed to investment risk, potentially reducing the value of your fund and cutting the income available

Of course, this is not an exhaustive list of the ways in which transferring could affect you. Personal circumstances will define whether transferring is a beneficial move for you, or not. Therefore, it is vital that you weight the advantages and disadvantages, in conjunction with financial advice given in relation to your personal circumstances.

It is human nature to want to take control of your own finances and make your own decisions. That is one of the main reasons why people put off seeking financial advice when they are considering their pension options.

However, research has proven that, those who take financial advice are not only better equipped to make financial decisions; they also save money more efficiently and end up better off, on average, than those who never seek financial advice.

People who take independent financial advice save an average of £98 more per month than those who don’t. Resulting in higher retirement income, to the tune of £3,654 each year.

For more information on pensions, retiring and planning for the future, feel free to get in touch with us.