fbpx

db pension

Defined benefit pensions – What are they and how do they work?

A defined benefit pension scheme is a type of pension where the amount of money you receive is dependent on the number of years you have worked and the total salary you have earned throughout your working life.

In this article, we will answer some important questions that you may have about defined benefit pension schemes and the terms and conditions associated with them.

The main themes in this guide will help to explain all issues related to defined benefit pension schemes. In this article, we will cover:

  •         What is a defined benefit pension?
  •         Can I cash in a final salary pension?
  •         What is a deferred pension?
  •         What is the maximum tax-free cash lump sum I can take?

What is a defined benefit pension?

A different form of pension scheme, defined benefit plans offer the customer a secure income for life, and this can increase year upon year. They are particularly more commonly used in the public sector, or if you have ever been employed by a large company.

In a defined benefit pension scheme, your employer will make contributions to your final pension pot, and they are held responsible for ensuring there is a sufficient amount within that pot by the time you retire.

Since there is a large responsibility and risk associated to the employer when covering the defined amount owed to their employee, defined benefit plans are intricate, requiring insurance guarantees and actuarial projections. As a result, defined benefit pension plans are becoming increasingly less common and are now relatively superseded by defined contribution pension plans.

However, you can also contribute to the pension fund, should you decide to. This may be particularly useful depending on your financial situation, and the benefit pension is typically paid to your family and other named beneficiaries upon your death.

Your pension income is dependent on numerous factors, and these can influence how much you are eligible to receive.

These include:

  •         The pensionable service, which is the total number of years you have been a member of the defined benefit plan.
  •         Your pensionable earnings, which could be your salary at retirement, also known as your final salary, your salary averaged over your career, also known as the career average, or another deciding formula.
  •         Finally, the accrual rate is calculated, and this is the proportion of the total earnings that you will receive a pension for each year you are entered in the scheme. Typically, the accrual rate will be 1/60th or 1/80th of your final salary.

This YouTube video provides a brief overview of defined benefit pension plans and what to expect from them.

If you do have a final salary scheme you do need to be careful.  You can read our guide on how to avoid pension scams here. 

What is the difference between a defined contribution scheme and a defined benefit scheme?

In a defined contribution (DC) pension scheme, the value of the pension sum available to you upon retirement is dependent on how much you have paid into the scheme, along with how well your investments have performed.

This differs from the defined benefit scheme which is dependent on the 3 factors mentioned in the previous paragraph. While the defined benefit pension plan serves to provide a specific, planned payment into your retirement, a defined contribution pension plan would allow both employer and employee to contribute funds over a period of time.

In summary, the main differences determine who out of employer or employee, face risk on their investment. In a defined-contribution plan, the employee is the primary contributor to their savings, and the employer matches any contributions up to a limit.

Any AVC (additional voluntary contributions) that you make will often be into DC pension schemes.

Calculating your pension income

Calculating your pension income is very simple, and only requires 3 steps. A pension calculator can work out your income using the following factors:

  •         Number of years in the scheme
  •         Divided by the agreed accrual rate
  •         And then multiplied by your pensionable earnings

You can get an idea of how much pension income you may be entitled to by checking your most recent pension statement, and if you haven’t yet received one of these, simply ask your pension administrator to send your latest copy.

These pension statements can provide up to date information about your pension based on current salary, time spent in the scheme and what your final pension may be should you remain in the scheme until the normal age of retirement – which is typically 65 years old.

final salary pension lump sum

When can I take my final salary pension?

You will find that most db pension schemes have a normal retirement age of 65 years old, and this is the time when your employer will cease from paying into your pension and the pension can begin to be paid to you as an income.

However, the age at which you can receive your pension can vary between schemes. For instance, in some schemes, you may be eligible to receive your pension at the age of 55, although this may affect the amount of pension you are entitled to receive.

There are several other options available to you other than taking your pension at the normal retirement age or earlier. For instance, it may be possible to begin receiving a pension income without yet retiring, or you may choose to defer your pension which could increase the amount you receive when you do take it.

Once the pension is first paid, its value can increase each year by a set amount. This set amount can vary between schemes, so it is worth checking with the pension provider you wish to go with.

What is a deferred pension and how do they work?

If you do not wish to begin receiving a pension income at the normal retirement age, you may be able to defer your pension payments, which can make them more valuable in the future.

A deferred pension is simply, therefore, a delayed pension that you can take later in life. By delaying the process of accessing and using your savings, your potential retirement-income can increase significantly.

It is considered relatively easy to defer your pension, although it is definitely worth checking with either your personal or workplace pension scheme for further information regarding intricacies and potential hurdles.

After choosing to defer your workplace pension, you have two options. You can either continue to make contributions into the pension pot, or stop contributing to your pension at all.

If you choose the former, and you wish to continue making contributions while deferring your pension, you are entitled to receive tax-relief on any contribution made until the age of 75. If you do continue paying into a workplace pension and you meet auto-enrolment criteria you are eligible to receive contributions from your employer alongside any contributions you make yourself.

final salary pension scheme

Can I cash in a final salary pension lump sum?

Should you choose to cash in on your final salary pension scheme then you have to ensure you request a CETV from your pension scheme. A CETV, also known as a cash equivalent transfer value, is the overall cash value that is placed on your pension savings.

There are several factors that will determine how much this value actually is, and a complex calculation is undertaken to arrive at the figure.

In most cases, private schemes are under-funded, which means that they do not have access to sufficient assets in order to cover the costs associated with providing pensions to every person within their scheme. As a consequence, you may not receive the full value of your final salary pension lump sum should you choose to cash in.

Furthermore, by offering the choice to cash in on your final salary pension – which is an expensive offer to run – your scheme may offer you an enhanced transfer value, which may be worth more than the scheme would be obliged to pay you in the first case.

Do you need pension advice when cashing in your final salary pension scheme?

You can take a lump sum directly from the pension scheme if your final salary pension benefits are below £30,000 in value, without the need to seek pension transfer advice. However, if your final salary savings are worth more than £30,000, you may be obliged to seek financial advice from a professional financial advisor.

By seeking their advice, you can understand the potential risks to your investment before committing to a final decision.

What is the maximum tax-free cash lump sum I can take?

When you wish to withdraw benefits from your defined pension scheme, you are entitled to receive some of those benefits in the form of a tax-free lump sum.

After you begin drawing benefits from your pension scheme, you may be able to take either a fraction or the whole of your pension benefits as a tax-free cash lump sum. This is often known as the pension commencement lump sum (PCLS).

Depending on the rules of your defined pension scheme provider, the amount of tax-free cash lump sum available to you can vary. However, if you are a member of a defined contribution pension scheme, you will typically be given the option to take up to 25% of your pension pot’s value.

In addition, you may be entitled to take more than 25% as a tax-free lump sum. This may be allowed if you have applied to either one of HMRC’s scheme specific lump sum protection, enhanced protection, and fixed protection or primary protection options, although terms and conditions can vary between these.

Any sum withdrawn that is in excess of the PCLS is liable to be taxed as income, making it subject to income tax rates.

How can you protect your pension fund in a defined benefit scheme?

Although your employer is responsible for ensuring there Is enough money in the scheme, in some instances your company may find themselves unable to reach its commitments due to unforeseen financial difficulty.

If this does occur, the pension protection fund (PPF) can provide insurance for your pension savings upon retirement, although you may be entitled to a lower amount than the sum promised by your employer.

The PPF is sponsored by the government and acts to pay compensation to those whose employer cannot meet their pension commitments to their employees. If this does happen, providing some criteria are met, the PPF can pay your pension.

If the criteria are met, then the PPF is able to pay up to 90% of the benefits expected to those below retirement age. If you are above retirement age, receiving ill-health or early retirement pension benefits or due to receive a survivors pension, you are likely to qualify for full compensation.

pension calculator

What are the advantages and disadvantages related to defined benefit plans?

Advantages:

  •         By surrendering your choice of pension and the responsibility that comes with this choice, you are able to accumulate savings without having to worry about what you are investing and where you are investing it.
  •         This means you can simply continue to work, with the security that your employer is paying into your pension savings, and that these savings will be sufficient to support you in your retirement.
  •         This can help with future budgeting after retirement, and you can even adjust payments to ensure your spouse or other beneficiaries can continue to receive benefits after your death
  •         Most defined benefit pension schemes pay their benefits in the form similar to that of a pension annuity, which lowers the risk associated with low investment returns on any investments in the scheme.

This BBC article highlights how the value of db pension transfer values are on the rise, while this article questions the generosity of pension transfers.

Disadvantages:

  •         You have no choice in how your money is invested, as well as having no choice to invest more money in your plan
  •         While it is comforting to know what you are going to receive as pay- out following your retirement, some plans are restricted in the sense that they may not increase in value along with inflation rates.
  •         A defined benefit pension scheme is often less portable than a defined contribution plan, despite the fact the former allows a lump sum payment upon termination

You can access a pension calculator to work out your potential retirement income, and for any advice concerning defined benefit pensions you can contact us here at UK Care Guide for any queries you may have.