Defined benefit pension schemes explained
Last updated: 5 August 2018
Defined benefit pension schemes are often referred to as final salary pension schemes and is a pension scheme that promises to pay an income based on your final salary when you left the company/retired from that company.
Unlike other schemes, the amount you’ll receive in your retirement is guaranteed, paid directly to you based on the normal retirement date of the scheme and, as a result, you won’t have to decide how to access your pension pot at any time – other than the choice of whether to take a pension commencement lump sum or not.
What is a defined benefit pension scheme?
A defined benefit pension scheme is a pension scheme which you and your employer pay into throughout your career. This money is invested into various investment vehicles over time. However, unlike other type of pension schemes, the amount you pay in is irrelevant when calculating your retirement income. This is because the amount of income you receive in retirement is guaranteed when you initially agree on your pension.
There are two types of defined benefit pension schemes, one which is based on your final salary when you retire, while the other is based on the average salary you receive throughout your career.
The value of your pension will also rise in value, known as index-linking, which means that the income you receive will rise each year, often in line with inflation, although the actual increase will often be capped.
Why do people like defined benefit schemes?
The biggest issue with any investment is that the risk of investment is typically on the person making the investment – i.e. the value of an investment can go up or down.
One of the major benefits of a defined benefit scheme is that the full risk of the investment is taken by the scheme as they have already promised to pay an income at a specific rate, irrespective of how the investments have actually performed.
Limitations of defined benefit schemes
A number of factors, including the major fact that people are living longer than ever, means that defined benefit schemes are expensive as they have to pay out a certain amount for however long the retiree lives.
Therefore, a lot of defined benefit schemes are closed to new members.
This also means that the many schemes have insufficient funds to cover the open-ended nature of the pension promise of paying a set amount in retirement.
To counter this, the UK government set up the Pension Protection Fund (PPF) which is designed to cover such losses and ensure that people continue to receive their pension and ensures that people receive the full amount at 65 years old of their pension scheme (up to £36,400) or 90% of their expected pension at 65 years old, up to a limit of £32,760 per year.
What income will you receive from your defined benefit pension scheme?
Your final income that you will receive from your defined benefit pension scheme will depend on the following factors:
- How many years you have paid into the pension scheme (Y)
- Your salary (either an average throughout your career or your final salary) (S)
- The accrual rate (either 1/60th or 1/80th) of your pension scheme (R)
The amount you will receive per year from your pension will be calculated as follows:
(Y x R) x S or (Years x Accrual Rate) x Salary
For example, if you earned £65,000 when you retired, worked for the company for 15 years and had an accrual rate of 1/60th your annual pension would be £16,250.
This is calculated by: (15 x 1/60) x 15 = £16,250
Defined benefit schemes and lump sum payments
The UK Government allows people to take a lump sum of 25% of the total value of their pension pot tax free. Unlike schemes where the final value is a calculation of the amount invested, defined benefit schemes work a little differently.
It is still possible to take a lump sum, or even transfer the entire amount of the pension pot, but it depends on how much of the lump sum you get for every £1 of income you give up. This is called a communication factor. In simple terms, if you have a communication factor of 15, for every £1 you give up, you would receive £15 in return as a lump sum.
In each case, you would need to ask you pension fund directly how much lump sum you would receive from your defined benefit pension scheme.
Defined benefit schemes and expats
As the scenario for expats is slightly different for anybody who remains in the UK, there are additional options and risks for expats with regards to defined benefit schemes.
As with any investment decision, everybody’s circumstances are different and therefore there is no set rule or preferred route and it is vital that you seek professional advice from an independent financial adviser who fully understands the intricacies of defined benefit pension schemes.
As with any investment, making the wrong decision can be extremely costly and can end up causing a significant loss.
However, in recent months, the 10-year gilt yields have decline which have meant the cash equivalent values of defined benefit schemes have been at record highs.
Also, as mentioned earlier, as people live longer, the pension fund deficit (i.e. there is not enough in the pot to pay everybody) means that there could be a greater risk to their income in the longer term. It is estimated that the defined benefit pension deficit is growing by as much as £100bn every month, and is currently estimated at £1.54tn – according to PwC.
What are "gilt yields" and why are they important?
Gilts are bonds issued by the UK government, often considered as low risk investments. The gilt yield is the income received from such bonds. The higher the gilt yield, the higher the income, conversely, the lower the gilt yield the lower the income received.
Defined benefit pension schemes are heavily linked to these low risk investment vehicles and are therefore heavily impacted by significant changes. Following the vote to leave the EU, 10-year gilt yields fell to an all-time low of 0.61% (from 1.3%) which means they are paying out historical lows and therefore contributing to an ever-increasing pension deficit.
The continued focus of the Bank of England to keep interest rates low as well as a continued push for quantitative easing means that these gilt yields are unlikely to increase any time soon.
All of this means that some pension companies are increasingly unlikely to be able to pay out promised dividends.
Options for people with defined benefit pension schemes
While traditionally it has not been considered prudent to transfer defined benefits schemes out of the UK, this is now becoming a more common occurrence as guaranteed incomes come under more pressure. After all, if the money isn’t available, the income cannot be paid.
One relatively logical consideration is to therefore take control of the pension pot and transfer into a SIPP - or if you no longer live in the UK, a QROPS - i.e. a pension scheme where the investor (i.e. you) is able to take more control of the investments themselves, and also take the funds away from the UK where the pound remains relatively weak. This means that you can consider each investment option to identify opportunities to grow your pension value, as well as consider whether you wish your pension pot to be managed in a different currency.
Before any decision is made, there are many factors which need to be considered before making such a huge leap. As yet, there is no suggestion that defined benefit schemes will not pay out the guaranteed amount, and therefore any transfer would forego such guarantees. However, the risk remains that in a number of years the deficit will be so great, that companies are simply unable to pay the guaranteed rate.
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